Sam Gill, CEO of ET Index, a company helping investors understand, manage and reduce carbon risk, makes a case for the transformational potential of environmental tracking.
Investing in carbon intensive companies is acknowledged to be both ethically and financially risky. As Carbon Tracker helpfully highlighted, the risk of a multi-trillion dollar ‘carbon bubble’ in the financial markets is real, over four-fifths of current known fossil fuel reserves will need to stay underground to prevent temperature rises going beyond 2C.
As the debate around fossil fuel divestment reveals, shareholders – aware that the future of our world is hanging in the balance – are increasingly demanding a wholesale transformation of the real economy and capital markets to avert catastrophe. But while the moral and financial cases begin to align – the business case for incorporating sustainability into investment decisions in order to maximise long-term financial performance is robust – this has yet to materialise into large-scale concrete action in the financial sector.
A number of providers are proffering ‘carbon-tilted’ equity indexes which are designed to help investors reduce their exposure to carbon risk. While these redefine risk to reflect the value at risk from potential stranded assets in clients’ portfolios based on the probability of future scenarios, these mechanisms do not, however, harness the power of the financial system to address the new realities of the 21st century and meet the needs of investors.
Environmental Tracking is a systemic solution that aims to align investors’ financial interests with real climatic impacts by tying share price to carbon emissions. Underpinned by a public carbon ranking, a chosen benchmark, such as the FTSE 100, can be ‘tilted’ in accordance with the carbon emissions of each company in the chosen universe. For companies, the only way to move up the ranking is to lower their emissions and pressure companies operating within their supply chains to do the same, in turn gaining a greater weighting in the index and therefore a greater share of investment from those tracking the index.
A win-win solution
From an investor’s point of view the mechanism is a win-win solution; not only does it significantly reduce carbon exposure – Environmental Tracking Indexes offer tilts with over 25 per cent, 50 per cent and 75 per cent carbon reduction – but closely tracks ‘traditional’ non-carbon adjusted index. Crucially it will protect investors from ‘carbon price shock’ as and when high carbon companies start to suffer in the transition to a low carbon economy. The mechanism is also built to incentivise disclosure of emissions data, with companies unwilling to disclose their emissions being ranked as equal to the worst performer in their sector.
Adding supply-chain emissions to the equation makes the mechanism truly transformational, cascading these effects throughout the world economy. As companies face financial pressure to clean up their supply-chains, every company along the value chain must in turn respond to significantly cutting its own emissions. In this way financial incentives can come to serve the most immediate needs of humanity, rather than continuing to hamper the continued prospective survival of our species on this planet. The Environmental Tracking mechanism is designed to address carbon risks at an individual investor level and at the aggregate level, redirecting global capital flows. The transition index, for example, reduces a portfolio’s carbon intensity by over 75 per cent whilst closely tracking the market.
Engagement vs divestment
Environmental Tracking stands at the crux of the debate between engagement and divestment, arguably satisfying both needs. Not only do Environmental Tracking indexes actively engage with companies by directly influencing company share price, each index comes with a fossil free version for investors looking to divest completely from fossil fuel holdings. Carbon tilted indexes, done right, can create a significant emissions reduction, a focus on Scope 3, or supply-chain emissions whilst severely penalising sectors that produce highly carbon-intensive products – such as fossil fuels. The methodology not only allows for an evaluation of a company’s direct emissions, but makes it responsible for the life-cycle emissions of its product, be it a barrel of oil or an automobile.
Environmental Tracking is no silver bullet, but by combining divestment and shareholder engagement it is already putting pressure on actors in the financial system to credibly address climate change.
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Photo credit: Therese Tjernstrom from Flickr