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Today, when many managers are engaged in a “carbon hunt”, the notion of “decarbonising” portfolios is often mentioned. What does this mean?
Several approaches exist to decarbonise your portfolio while taking all necessary precautions. It should be borne in mind that this concept is based on methodologies that are still imperfect. Not every plant or company is equipped with a carbon emission measurement sensor. Emissions are therefore reported or estimated at the overall company level, with the additional difficulty of calculating direct emissions (which were used to produce the product itself) and indirect emissions (related to the use of the product).
In addition, decarbonisation approaches focus on a single aspect of the portfolio, namely climate risk, while leaving aside other portfolio management aspects.
A first method is to invest in low-emission sectors. For example, a portfolio that would avoid (totally or partially) exposure to the energy, utilities, industrial and materials sectors. This is a fairly restrictive approach in several respects: First, because of the wide variety of industrial sectors and materials. In addition, the witch-hunt against fossil energy can lead some people to make a radical departure from the gas and oil sectors. If their efforts are deemed insufficient in this regard, exclusion may lead to a point of no return on the issue. The energy transition to a low-carbon economy must be accompanied by a dialogue with all actors and stakeholders for there to be an ambitious and achievable transition.
A second and more widespread method of decarbonisation is to calculate the carbon footprint of a portfolio and aim to reduce it either over time or in relation to another portfolio or benchmark. The objective of the portfolio’s carbon footprint is to assess the portfolio’s carbon risk with a view to a transition to a low-carbon economy. To do this, the carbon emissions of individual emitters are generally calculated and reported in relation to their turnover (carbon intensity approach). The calculation method is based on the one recognised by the Global Greenhouse Protocol and includes scope 1 emissions (direct emissions from sources owned or controlled by the issuer reporting the emissions) and scope 2 (direct emissions related to the energy consumption (electricity, heat, steam) required for the manufacture of the product itself).
This method has two advantages: First, even if it is still imperfect, carbon footprint measurement allows an initial global estimate of the risk as well as comparison against different indicators. In addition, aiming to reduce this footprint shows a strong desire for progress and a real environmental awareness.
However, it also raises several methodological concerns. First of all, the carbon footprint calculation methodology has several weaknesses (direct and indirect emissions, deferred or estimated emissions, applications to less traditional asset classes, etc.). Therefore, an investment and portfolio building process based exclusively on this measure is inherently risky.
The majority of investment solutions are based on optimising the portfolio’s carbon footprint by overweighting or underweighting individual lines based on their emission estimates. In addition, this approach aims to reduce the portfolio’s total emissions over a time horizon. However, as technology progresses, with an unchanged portfolio, the carbon footprint can gradually decrease. Depending on improvements in the calculation methodology, the latter will either increase or decrease due to a simple methodological change.
There is therefore a consensus that the carbon footprint is an imperfect measure. It would be dangerous to build an investment strategy based exclusively on the carbon footprint. Nevertheless, it represents an indication of the climatic risk incurred and is therefore relevant since climate change poses financial and economic risks in the short and medium term. The integration of climate risk in its own right before the investment process is essential. It must be carried out in a thoughtful and sensible manner by analysts and managers who have full awareness of all the issues at stake in their economic sectors as a result of in-depth fundamental research.