How to build a low-carbon efficient investment portfolio
Sector-neutral carbon-efficient screening used to identify companies with a low-carbon footprint to build portfolio
WHEN it comes to environment, social and governance (ESG) investing, investors cannot control what corporates are doing or attempting to do to reduce the carbon footprint of their respective portfolios.
Different sectors have different levels of carbon footprint. The financials, healthcare and information technology (IT) sector, for example, would have lower carbon footprint when compared to the materials, utilities or energy sector.
Hence, a portfolio made up predominantly of financials, healthcare and IT companies may achieve a low-carbon profile but it will be overly exposed to these sectors in terms of risk profile. Likewise, a portfolio made up predominantly of materials, utilities or energy companies would have a high-carbon profile and also be overly exposed to these sectors in terms of risk.
According to a study by S&P Dow Jones Indices (S&P DJI), there are two alternative approaches for creating an equity portfolio with a low-carbon profile. One way is to create a portfolio without any sector balance. This means the portfolio will be more dominated by companies in the financial, healthcare and IT sector.
However, this is not ideal for investors who want a more balanced sector exposure to the market to maintain portfolio diversification.
Another way is to create a portfolio by doing “carbon-efficient screening” on a sector-neutral basis which is basically going into each sector and seeking out companies with a low-carbon footprint and putting these companies together into a portfolio that is sector neutral and carbon efficient.
“We believe the sector-neutral approach for low-carbon investing will be more accepted by the institutional investors,” said Priscilla Luk, managing director, Global Research & Design at S&P Dow Jones Indices.
S&P DJI’s study covers seven Asian markets—Australia, China, Hong Kong, India, Japan, South Korea, and Taiwan—and the base universe for each market includes companies from its respective broad market-cap-weighted benchmark index with carbon intensity scores available.
The study also measured the effect of integrating low-carbon and factor strategies, particularly value, momentum, and low volatility, with the sector-neutral approach to build a carbon-efficient portfolio.
“In our study, carbon-efficient screening resulted in the highest weighted average carbon intensity reduction to low volatility and value portfolios across Asian markets. Carbon-efficient screening also improved risk-adjusted returns for the quality, value, and momentum portfolios, but lowered returns for the low volatility portfolio,” Luk says.
For the value factor, the study found that carbon-efficient value portfolios had better risk-adjusted returns and lower volatility than their respective pure factor portfolios in all markets, except India and Taiwan.
For the momentum factor, the study also found that carbon-efficient momentum portfolios had higher risk-adjusted returns than their respective pure factor portfolios in most markets (except Australia and Taiwan) and weighted average carbon intensity score reductions of at least 70% across all markets.
For the low volatility factor, the study found that carbon-efficient low volatility portfolios had lower risk-adjusted returns than their respective pure factor portfolios in most markets (except China) and weighted average carbon intensity score reductions of at least 75% across all markets.
The study measured a company’s carbon efficiency based on its carbon intensity score provided by Trucost (a unit of S&P DJI that specializes in estimating the cost of environmental damage by listed companies) which is defined as the GHG (greenhouse gas) emissions from a company’s direct operations and first-tier suppliers, measured in metric tons of carbon dioxide equivalent (CO2e) per US$1 million of revenue.
Companies were screened by their carbon intensity scores to form the carbon-efficient portfolios where carbon efficiency for portfolios was measured by their weighted average carbon intensity scores.
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