With the ever-increasing need to decarbonize our global economy, investors are now focused not only on the why behind decarbonizing, but also the how. What do we mean by this?
3 ways to reduce a portfolio’s carbon footprint
Well, as an investor, there are three potential ways to lower the carbon footprint of your portfolio. The first is to re-allocate away from carbon-intensive sectors. In practice this could mean excluding or reducing investments in the energy, utilities and materials sectors. Alternatively, you could prioritize security selection and allocate capital to the most carbon-efficient firms within their respective sector. Finally, you could decide to hold securities and work to organically reduce their emissions over time.
These are very different approaches, and the optimal choice will ultimately depend on your investment and decarbonization goals. For example, are real world emission reductions a stated objective? If so, we see a new push for investors to place less emphasis on option 1 (reducing exposure to high-emitting sectors wholesale), and greater emphasis on achieving reductions via option 2, allocating to the most efficient firms within a given sector, and option 3, working to reduce emissions at the companies you already hold.
Why might this be the case? The sectors that bear some of the highest average carbon footprints also happen to be those sectors which are most material in deciding our global decarbonization pathway, and are therefore responsible for our success in achieving a net-zero economy. By reallocating away from these carbon-intensive sectors, investors could potentially be hindering the global energy transition.
Quantifying your portfolio’s decarbonization
While this may make intuitive sense, the real question then becomes: how do investors begin to decompose and quantify the type of decarbonization achieved by their portfolio? In their recently published paper, "Sustainability Attribution: The Case of Carbon Intensity”,1 Guido Bolliger and Dries Cornilly sought to answer this exact question. They borrowed from the widely utilized Brinson performance attribution methodology and developed a way to decompose the carbon reduction of a portfolio. By comparing the portfolio’s carbon intensity to a benchmark (the portfolio’s active carbon intensity) they were able to decompose the carbon reduction into an allocation effect, selection effect and a residual effect.