Articles - Investors warned of simplistic method of carbon footprinting

Climate change is a risk to investment portfolios. So far, so much scientific – and actuarial – consensus. However, addressing this risk in the context of an investment portfolio is a murkier prospect, and one that sometimes results in perverse outcomes. Most approaches and initiatives have taken a two-pronged approach: first, assess and quantify the carbon footprints of existing portfolios.

 By the QUAERO CAPITAL Accessible Clean Energy investment team
 The natural inference is that step two will involve the reduction of that carbon footprint, often by seeking to reduce holdings in fossil-fuel intensive companies. These approaches variously include the Montreal Carbon Pledge, the UN Principles of Responsible Investment, carbon reporting frameworks incorporated into company annual reports such as that proposed to be implemented from 2019 through the UK Companies Act, or in France for pension funds, and campaigns for divestment from fossil fuels by pension funds and university endowments such as
 The result is a strong incentive to reduce holdings in businesses that have an apparently higher carbon footprint.
 Unfortunately, this can have the perverse result of reducing holdings in companies in the clean energy space. Coal mining companies often report lower carbon footprints than natural gas or even solar or wind companies because coal extraction does not actually release CO2 into the atmosphere – the downstream coal-burning power plant does. Investing in a services business in Switzerland will have a much lower carbon footprint than investing in a zero-carbon offshore wind project in Germany, even though one is directly related to emissions reductions.
 Many so-called clean energy or sustainability funds will, on inspection, include companies such as Google, Amazon and Apple, while “low carbon” funds can reduce their overall carbon exposure by reducing clean energy investments and maintaining holdings in ExxonMobil and Kinder Morgan.
 The fault lies in the approach to carbon footprinting itself. When assessing a product, it is relatively straightforward to add up the total greenhouse gas emissions used to produce it. This includes direct emissions to produce the product, as well as indirect emissions such as those made in the process of producing electricity that powers company facilities.
 However, the carbon footprint of an investment – and particularly an investment in listed company shares – is less straightforward and involves looking at a company’s entire operations, both direct and indirect. It will include greenhouse gases emitted by the company’s facilities and vehicles (known as Scope 1 emissions). It also includes Scope 2 indirect emissions, such as purchased electricity and steam for use in company operations. This is then assigned on a per-share basis and reported as kilograms of CO2 equivalent (CO2e) greenhouse gases per dollar value.
 On this basis, Apple and Google emit just a fraction of a tonne of CO2e per $100 invested thanks to extensive purchases of renewable energy in its operations. An aircraft manufacturer like Boeing will emit approximately 1.5 tonnes of CO2e, whereas a solar company like FirstSolar in fact has an almost five times higher carbon footprint because it is using more fossil fuels to build and install distributed solar panels.
 The mathematically minded will grasp these numbers and assume that by taking a weighted average of the reported carbon footprints of all the companies in a portfolio, you can compare two portfolios’ carbon footprint, and the one with the higher weighted average is therefore worse for the environment. The second assumption would be that by selling the higher carbon footprint companies, and buying the lower ones, the real-world impact of carbon emissions would be reduced.
 Both assumptions are in fact incorrect. Merely going along a supply chain and stages of production and adding up carbon emissions is a rather poor guide to a company’s overall climate impact, for two reasons. First, extraction companies such as coal miners do not count the emissions from the coal they mine in their carbon footprint, because they are not burning the coal they mine.
 As a result, the carbon emissions are pushed downstream -- and a coal miner can look pretty good from a carbon footprint perspective. For instance, the Canadian coal miner Teck has a 30% lower carbon footprint than natural gas producers, even though coal is 60% more carbon-emitting than natural gas. Solar panel and wind turbine manufacturers use much more electricity than a bank or an insurance company – they use carbon-emitting power sources to manufacture and install their products, while getting no reduction in their carbon footprint for the CO2e that their products have avoided being emitted into the atmosphere.
 Taking this one-in-one-out approach to carbon footprinting, therefore, can have the perverse result that one might sell a solar company and buy a services company, or worse – a coal miner. Therefore, actively reducing carbon footprints of an average portfolio without considering what those companies are actually doing, and the effect they are having on the environment, can result in less investment going to clean and zero carbon technologies and failing to reduce any greenhouse gas emissions.
 While project finance can use the concept of “avoided emissions” to give a solar or wind company credit for all the CO2e they have prevented being emitted for the same amount of electricity generated, equity and debt investments have yet to incorporate this concept to reduce the reported carbon footprint of their companies.
 In the meantime, using carbon footprints remains an important discipline and a commitment to reducing carbon exposure. However, they should be used with care – and with the knowledge that a lower carbon footprint does not always translate into real-world reductions in carbon emissions.

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