DR.CHENJIAZI ZHONG

Investors gain confidence that an equity or corporate bond portfolio is invested in companies that are helping to address climate risk. To support a transition to a net-zero carbon economy, climate-aware investors monitor the carbon impact of the companies in their portfolios. However, climate issues are complex. A purely quantitative-driven process that rewards companies with lower carbon emissions is likely to prove inefficient.

A carbon footprint is the total greenhouse gas emissions (GHG) caused by an individual, event, organization, service, place, product or business activity, which is expressed as carbon dioxide equivalent. A carbon footprint measures the negative impact of a company’s operations on the environment. Some providers, such as MSCI, have created a range of carbon footprint metrics that compare the carbon characteristics of a portfolio with a benchmark.

For bond investors, the most relevant metric is the weighted average carbon intensity of a portfolio, which measures the carbon footprint of a portfolio in terms of the volume of carbon dioxide emissions per value of sales. This metric is applicable across asset classes. It is simple to calculate. It does not need the market cap or sales data required for other equity ownership-related measures and can be expressed in a score for the portfolio and a score for the benchmark.

The carbon footprint investing approach aims to identify key sustainability issues. One is whether the issuing company’s strategy is aligned with recognized carbon-reduction targets. The other is how the companies are financing their transition to net-zero carbon. It is also important to stay aware of the wider picture and whether conventional analysis adequately reflects reality.

However, a carbon footprint approach does not tell the whole story of the impact of a company. It can sometimes be misleading. For one, a carbon footprint is only a snapshot in time, which cannot look forward to allowing for companies’ carbon-reduction plans. Secondly, it cannot capture the nuances of carbon use. The GHG Protocol distinguishes between direct and indirect sources of carbon emissions; the distinctions depend on whether a company emits the carbon itself as an intrinsic part of its business or as a user of energy or further up or down the supply chain. Moreover, taking bond portfolios as an example, existing carbon intensity reporting tools do not differentiate between carbon footprints from conventional bonds and those from green bonds or other ESG-labeled bonds. These structures raise capital either for specific green projects via a green bond issue, or to support firm-wide carbon-use reduction via sustainability-linked bonds targeting key performance indicators.

Using the carbon footprint approach, companies that have a relatively large carbon footprint might be overlooked even if they are making significant contributions to decarbonization through climate solutions. Many products needed to help curb global emissions over the long term require industrial commodities, such as steel, cement, lithium and cobalt, which are energy-intensive to produce. Similarly, companies with a low carbon footprint might be included even if they rely heavily on carbon offsets. Carbon offsets help make up for the GHGs that an entity produces by allowing it to buy, sponsor or fund a carbon-reduction initiative elsewhere; however, offset projects that are not certified by reliable third parties may not be as effective as advertised.

A carbon handprint, by contrast, measures the positive impact or carbon avoided by using the products of a company. Using the carbon handprint approach, a clean energy company will be judged on the amount of zero-carbon energy generated, while a resource efficiency company is ranked on its ability to save energy for other companies or entities. Products and services that address the physical effects of climate change include drought-resistant crops, coastal infrastructure to protect cities and communities, and smart irrigation systems to improve water use efficiency. Such progress is needed in many areas, such as resource efficiency solutions, clean energy solutions, transportation solutions, agriculture solutions, food waste solutions, and recycling solutions.

The three investing principles for a carbon handprint approach are: (a) search for climate solutions across regions and sectors; (b) make sure that target companies have solid fundamentals; and (c) invest in portfolios that actively engage with their portfolio companies. By assessing carbon handprints, actively engaging with management, and conducting independent research of business fundamentals, investors can obtain the information needed to measure a company’s carbon handprint accurately and convincingly, and create a portfolio of companies with superior long-term return potential that are providing solutions to the biggest climate challenges.

Using carbon handprints to invest in climate-focused companies can also help investors create differentiated portfolios. The MSCI Climate Change Index or the MSCI Climate Paris Aligned Index, are carbon footprint measures. As a result, these popular climate benchmarks look very similar to the MSCI ACWI Index. A carbon handprint index would look very different than the broader equity benchmark.

Climate-aware investors also need to dig much deeper into the business and emission policies of each company to understand whether a low carbon footprint is truly indicative of a good environmental actor. Investors should also be clear about the key milestones as well as the end goal of the carbon-reduction journey of the companies.

Lastly, sustainably reducing carbon emissions means that companies’ strategic plans should aim to reduce their future emissions. Therefore, it is vital to identify companies that have credible climate commitments for the long run. Drawing on independent sources of expertise and transparent climate pledges, such as the Science Based Targets initiative and the Net-Zero Banking Alliance can help differentiate between companies with demonstrable long-term commitments and those who are not yet willing to walk the walk.