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“A code red for humanity. The alarm bells are deafening and the evidence is irrefutable.”
UN Secretary General Antonio Guterres discussing the most recent Inter-Governmental Panel on Climate Change (IPCC) report published in August 2021.
For advisers looking to incorporate a Net Zero approach into a client portfolio, where ESG preferences are high, we would advocate a three-step approach.
1.Understand the Carbon footprint of your existing portfolio
2.Consider how substitutions of traditional with ESG-screened funds could reduce that Carbon footprint
3.Consider whether, and to what extent, an allocation towards climate solutions, which by their nature may be higher risk investments, will actively contribute to achieving the path to net zero.
A bias towards ESG and a moderate investment in climate solutions, can help achieve those objectives for those clients who seek climate-oriented values in their investment portfolio, as well as their day-to-day living,
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What is Zero Carbon investing
The Zero Carbon Society at Cambridge University is one of many campaign groups calling for university endowment funds to divest from all fossil fuels. This has been termed “Zero Carbon” investing.
The divestment trend started in the US in 2012 when the city of Seattle divested from fossil fuels. In 2014, Stanford University followed suit. Campaigns across the US and UK led to other universities following suit. Some of the reasons universities found it hard to ensure that their investments were “fossil free” is because:
When set this challenge by a university college, we proposed to do two things. Firstly to create a Zero Carbon SRI benchmark to show how Zero Carbon investing could be done whilst also focusing on other ESG considerations. Secondly, to create a Zero Carbon portfolio to deliver on the primary aim of full divestment.
Creating a Zero Carbon SRI benchmark
We wanted to create a benchmark for the endowment’s managers that not only screened out fossil fuels, but went further to screen out one of the main consumer of fossil fuels, the Utilities sector, as well as other extractive industries – namely the Materials sector. We also wanted to screen in companies with high ESG scores and low controversy risk and cover the global equity opportunity set. We worked with MSCI to create a custom index, the catchily-named (for taxonomy reasons) the MSCI ACWI ex Energy ex Materials ex Utilities SRI Index (the “Custom Index”, please refer to Notice below).
Creating a Zero Carbon portfolio
The second part of the project was to create an implementable investment strategy that maintained a similar risk-return profile to World Equities, but fully excluded the Energy, Materials and Utilities sectors. Rather than creating a fund which introduces additional layer of costs, this was achievable using sector-based ETF portfolio.
This portfolio meets the primary objective of creating a Zero Carbon, fully divested, world equity mandate. In the absence of ESG/SRI sector-based ETFs, it is not yet possible to create a sector-adjusted ESG/SRI ETF portfolio. But we expact that to change in the future.
Custom Index Performance
The back-test of both the custom index could deliver similar risk-return characteristics to global equities. The concern was would those back-test results continue once the index and portfolio went live. The answer is yes. Whilst the custom index has shown outperformance, that was not the objective. The objective was to access the same opportunity set, but with the fossil-free, ESG and socially responsible screens in place.
Fig.1. Custom Index performance simulation from June 2012 & live performance from June 2018
Zero Carbon Portfolio performance
Similarly, the Zero Carbon portfolio has delivered comparable performance to MSCI World – hence no “missing out” on the opportunity set whilst being fully divested from fossil fuels. Although not intentional, the exclusion of Energy, Materials & Utilities has benefitted performance and meant that the performance, net of trading and ongoing ETF costs, is ahead of the MSCI World Index.
Fig.2. Zero Carbon ETF portfolio performance from June 2018
Whatever your views on the pros and cons of divestment, Zero Carbon investing is not an insurmountable challenge, and the combination of index solutions and ETF portfolios solutions creates a range of implementable options for asset owners and asset managers alike.
IMPORTANT NOTICE ABOUT THE CUSTOM INDEX
With reference to the MSCI ACWI ex Energy ex Materials ex Utilities SRI Index (“Custom Index”). Where Source: MSCI is noted, the following notice applies.
Source: MSCI. The MSCI data is comprised of a custom index calculated by MSCI, and as requested by, Queens’ College Cambridge. The MSCI data is for internal use only and may not be redistributed or used in connection with creating or offering any securities, financial products or indices. Neither MSCI nor any third party involved in or relating to compiling, computing or creating the MSCI data (the “MSCI Parties”) makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and the MSCI Parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to such data. Without limiting any of the foregoing, in no event shall any of the MSCI Parties have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages.