Leveraging our recent paper, ‘Reducing carbon intensity in portfolios: Better news than you think’, which analysed the investment impact of reducing carbon exposure versus the benchmark; we turn our attention to how we can reduce carbon risk in our Value strategies. This aligns with our commitment to reducing carbon exposure across our strategies, as outlined in our Realindex Climate Statement.
How does climate risk affect a company’s fundamentals?
Climate risk is multi-faceted. This includes the risk of stranded assets, reduction in demand for a company’s product as consumers shift away from high carbon to low carbon products, as well as changing government regulations including harsher carbon pricing. Those companies generating higher carbon emissions face a greater risk of some of the issues listed above and a greater potential impact on their revenues and profitability. If we can find a measure of the portfolio’s exposure to this risk, as well as a company’s transition pathway, we can then more accurately construct our portfolios to achieve better potential long term outcomes for our clients.
Although it can be difficult to accurately price carbon risk, in part due to the limitations of data availability and the subjectivity associated with defining a company’s transition to net zero and assessing the credibility of these transition plans; one common and objective component of measuring climate risk exposure is to look at the current carbon emissions of the company.
We look at carbon intensity, defined as Scope 1 and 2 emissions (millions of tonnes of CO2 equivalent) per million dollars of revenue, as a metric to determine our exposure to carbon risk.
The impact of reducing carbon intensity in our Value portfolios
We ran a number of backtests that looked at the impact of reducing carbon intensity in our portfolios. These backtests showed that for reductions of up to 50%, the return and risk characteristics were relatively unchanged whilst still maintaining the Value characteristics of the strategy.
Why do we get these results? Carbon emissions are concentrated not only in a small number of industries but also around a small number of stocks within those industries. Carbon reduction can be achieved through stock selection within sectors, rather than changing sector allocations. By rotating to another stock with a similar alpha and risk profile but with a lower carbon exposure, a similar overall portfolio risk and return could be achieved whilst reducing the carbon exposure. Hence, we can achieve carbon intensity reductions through portfolio construction, rather than a targeted removal or exclusion of stocks resulting in active weights to industries remaining relatively constant.
The table below shows the simulated risk, return and value characteristics of our Value portfolios.
|Simulations Jan 2012 to June 2022|
|Australian Shares||Australian Small Companies||Global Shares||Emerging Markets Shares|
|No carbon reduction||30% carbon reduction||No carbon reduction||30% carbon reduction||No carbon reduction||30% carbon reduction||No carbon reduction||30% carbon reduction|
|Total Return (% p.a.)||10.89||11.00||12.75||12.64||13.81||13.81||8.46||8.47|
|Total Risk (%)||13.97||13.99||16.08||16.20||11.17||11.16||11.91||11.91|
|Cash Flow Yield||0.10||0.10||0.12||0.12||0.16||0.16||0.22||0.22|
*Note the carbon reduction for these simulations are versus our theoretical core portfolio to provide a context of any potential risk, return and portfolio characteristic impacts. The implementation is versus the live portfolio’s carbon intensity as at 30 June 2020. Source: Realindex, MSCI. Data as at 31 December 2022
In practice: applying and implementing carbon reduction in Realindex Value portfolios
Having found that we could achieve the carbon reduction in our portfolios whilst still maintaining our Value characteristics and with very little impact on risk and return, we have set a 2025 target with a goal to reduce carbon intensity in our portfolios by 30%, relative to the carbon intensity of the portfolio as at 30 June 20201. We will be gradually implementing this reduction over the next 2.5 years to 31 December 2025. Pleasingly, a number of our portfolios are already below these levels given market movements and the impact of our signals2.
|Carbon Intensity (tonnes/sales in AUD/USD)||Jun-20||Jun-23||%Change||Jun-20||Jun-23||%Charge|
|Australian Shares (AUD)||191.4||148.1||-22.6%||155.4||121.3||-21.9%|
|Australian Small Companies (AUD)||104.1||101.1||-2.9%||108||141.7||31.2%|
|Emerging Markets (USD)||449.8||261.9||-41.8%||268.2||322.6||20.3%|
Source: Realindex, MSCI. Data as at 30 June 2023
1 The date of 30 June 2020 denotes the end of the previous financial year when we initially started looking at the carbon reduction in our portfolio and our potential net zero commitments.
2 The levels of carbon reduction currently achieved are not static and are subject to change between now and Dec 2025.
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