New indices a market route to lowering carbon footprint

As the fossil fuel divestment movement gathers pace, work is proceeding in parallel on strategies with the potential to convince other investors that they can reduce the carbon footprint of their portfolios and still meet their financial goals.

Professor Patrick Bolton of Columbia Business School in New York has outlined to a conference at the University of Technology, Sydney (UTS) a “simple, dynamic investment strategy” that allows long-term passive investors to hedge climate risk without sacrificing any financial return.

Prof Bolton says these “decarbonised” indices will stand on their own investment merits while complementing public policy on climate change mitigation.

There is too little discussion in financial markets about investment risk related to climate change, he told the annual conference of the Paul Woolley Centre for the Study of Capital Market Dysfunctionality at UTS Business School.

“At some point in the future we will have to price greenhouse gas emissions, and we may have to set a very steep price because this will be done in a crisis environment,” he says. Yet there is little discussion of carbon pricing risk as a core issue for investors, and climate change risk remains largely an unpriced risk.

Bolton and collaborators have been working on a strategy where investors gain access to substantially decarbonised indices that replicate or beat the returns of benchmark market indices such as the S&P 500, the MSCI and the FTSE.

This is achieved by ranking stocks in a benchmark index according to their carbon intensity, removing perhaps the worst 20 per cent of carbon performers, then optimising the new index to mirror the financial risk of the reference index. In essence, stocks with a high carbon footprint are replaced with stocks that have identical financial risk but a lower carbon footprint.

It is possible to construct a decarbonised index that has 50 per cent less carbon footprint and almost no tracking error, Bolton says. “We could achieve 100 per cent carbon reduction, but that comes at a cost of huge tracking error,” he says.

'If companies worry
about being excluded,
they know what to do'

And by not fully divesting there is also an incentive for companies to make efforts to reduce their carbon footprint in the hope of remaining in, or joining, the decarbonised index. The high carbon footprint companies of today may be the low carbon footprint companies of tomorrow, he says. “If companies worry about being excluded, they know what to do.”

Bolton says that by investing in such decarbonised indices, investors would be buying a free “option on carbon”. The decarbonised portfolio replicates market returns until greenhouse gas emissions start being priced, at which point the decarbonised portfolio starts to beat the index.

Back testing has shown such a portfolio, with 50 per cent carbon reduction and minimal tracking error, outperforming the MSCI Europe index, he says. The decarbonised S&P 500 introduced in November 2012 has already outperformed the S&P 500 by about 14 basis points.

“A decarbonised index stands on its own as a hedging strategy,” he says. “But it’s also important to note that it’s a nice complement to climate change mitigation policies.

“Financial markets have their role to play in mitigating climate change as well.”

The Paul Woolley Centre conference also heard from research economist and commentator Professor John Quiggin of the University of Queensland and Associate Professor Peter Docherty of UTS Business School on financial sector inquiries past and present, including the implications for regulation of “black swan” events. 

Dr Luci Ellis from the Reserve Bank of Australia looked at the future of research into financial stability while Dr Giovanni Dell’Ariccia, of the International Monetary Fund, considered the role of monetary policy in the wake of the global financial crisis.

Among other presentations, Paul Woolley Centre director Professor Ron Bird presented new research on characteristics that may help to identify the better fund managers, while Professor Susan Thorp, who holds the chair of Finance and Superannuation at UTS, provided some early results from research looking at why people set up self-managed funds.

The Paul Woolley Centre was set up by Paul Woolley, a former chairman of GMO Europe, to finance research into capital markets dysfunctionality. There are three centres in the network, at the London School of Economics, the University of Toulouse and at UTS.

The Paul Woolley Centre at UTS researches dysfunctionality in financial markets and financial institutions. Its researchers analyse why inefficient outcomes arise, the economic and social impacts, and how adverse effects can be mitigated.

Photo: Professor Patrick Bolton speaking at the Paul Woolley Centre Conference    Credit - Lesley Parker