The extreme heat in the Northern Hemisphere this year and the wildly unfavourable climate conditions everywhere have finally caught the attention of investors. Climate change due to unchecked greenhouse gas (GHG) emissions has caused economic and social damage. And most of these emissions are attributable to listed companies1 , which are effectively controlled by minority shareholders.
Recently, there has been an acceleration in the launch of emission reduction plans by investors. The number of investors signing up to alliances such as the Zero Emission Asset Owners Alliance (NZAOA) and the Zero Emission Asset Managers Initiative (NZAM) has become significant. The NZAM Initiative alone has 273 signatories, representing $61 trillion of AUM. Although we are not signatories to these alliances, we should note up front: the Vontobel Quality Growth Global Equity strategy currently has a carbon footprint below its benchmark2.
Beyond these global initiatives, there are fundamental imperatives that dictate why portfolio managers should make emissions reductions a priority, based simply on the risks to profits. One example is the Carbon Boundary Adjustment Mechanism (CBAM) – essentially a carbon tax on imported emissions – which was approved by the European Parliament in June 2022. It requires EU exporters to buy carbon import permits for every tonne of CO2 if their home market does not have a similar tax system. The initial targets are cement, iron and steel, aluminium, fertiliser and electricity. This can be particularly challenging for low value-added products (low margin and price sensitive), which require large amounts of energy to produce and are produced in coal dominated countries. To date, 46 national jurisdictions have some form of carbon pricing mechanism in place, covering about 23% of global GHG3 emissions. China launched its emissions trading scheme in 2021.
So it is time for portfolio managers to figure out how to track and reduce emissions within their portfolios. In this article, we share some of our views on emissions tracking and how our Quality Growth Global Equity strategy evaluates its performance against a benchmark, but importantly, against its own trajectory towards net zero.
The starting point is the need to align our investment philosophy and approach to emissions reduction. We want to enable portfolio managers to meet climate targets while retaining as many investment opportunities as possible. Of course, we need to ensure efficiency and emission reductions.
There are two main approaches a portfolio manager can take to target emissions reductions:
Rebalancing – In this approach, assets with higher carbon intensity are sold and assets with lower carbon intensity are bought. From the perspective of portfolio management to reduce emissions, the ‘rebalancing’ method is a reliable tool for achieving the target. However, to achieve it, a manager may have to sell off more favoured holdings, thereby jeopardising performance. Furthermore, and importantly, in reality this may not lead to any change.
Rate Of Abatement – this approach focuses on the average rate of abatement from companies that are owned. The advantage of this approach is that it retains the companies chosen in the first place; however, it is accompanied by less predictability of emission reductions. An important positive point is that the need to reduce emissions in the real world is a direct incentive for the manager.
Emissions are divided into three groups or areas. Scope 1 is closest to home and covers the emissions produced directly by company activities, such as the fuel burned when driving a company-owned van. Scope 2 is further away and covers emissions from energy production, mainly electricity purchased from a third party. Scope 3 is the broadest and includes all emissions both up and down the company’s value chain. For example, it covers the full range of points of contact with a company’s products, from raw materials, components and transportation (considered as ‘upstream’) to the use and disposal of its products by its customers (downstream).
There are a number of other issues that a manager needs to consider, which we discuss later in this article, including engagement, Scope 3 management and accounting for inflationary distortions in measuring carbon intensity on a revenue basis.
