The effect of carbon emissions on investment returns

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1 CARBON EMISSIONS REPORT The effect of carbon emissions on investment returns June 2017

3 Key Takeaways Carbon dioxide is a greenhouse gas that exerts a major influence on the planet s temperature. Greenhouse gases such as the carbon dioxide (CO 2 ) produced from burning fossil fuels are the source of much of the rise in global temperatures over the past 50 years. This is the reason why a company s CO 2 emissions, or carbon emissions, is a particularly significant measure for those investors who are concerned about climate change. Larger companies tend to have higher emissions than smaller companies, even though many large companies are actually more efficient. Therefore, screening out companies with high emissions simply screens out large companies. We believe a better metric is carbon intensity which standardizes emissions based on company sales (emissions per million U.S. dollars in revenue). Carbon intensity is very high in the Canadian stock market owing to the market s high concentration in the Energy sector. Over the course of seven years, our research indicates that carbon intensity had a 9.2% cumulative drag on portfolio performance after accounting for influential factors, such as value, momentum, and other risk factors. In other words, a portfolio with greater carbon intensity, all other factors being equal, would have underperformed a portfolio with less carbon intensity. The suite of Genus Fossil Free funds has a carbon intensity that is significantly below the carbon intensity of the S&P/TSX Composite. The Genus Fossil Free CanGlobe Equity Fund and Genus Fossil Free Dividend Fund both have carbon intensities that are more than four times lower than their benchmark of 35% S&P/TSX Composite, 65% MSCI World. 01

4 Carbon emissions and climate change Over the last 150 years, the rising demands of industrialization have increased the levels of carbon in the atmosphere from 280 parts per million to 400 parts per million. 1 The United Nation s Intergovernmental Panel on Climate Change concluded that it is extremely likely that the greenhouse gases emitted by humans, such as the carbon dioxide (CO 2 ) produced from burning fossil fuels, are the dominant contributor to the rise in global temperatures over the past 50 years. 2 This is the reason why a company s CO 2 emissions, or carbon emissions, are a particularly significant measure for those investors who are concerned about climate change. Today s investor and the carbon conundrum Is the pursuit of financial returns or environmental stewardship more important for my portfolio? How much investment return am I willing to sacrifice in order to adhere to my values? Financial goals and values are often perceived as being at odds with one another. It comes as little surprise then that many investors see carbon and returns as an unfortunate but necessary pairing. This misperception is especially common in a country like Canada, where Energy comprises approximately 20% of the stock market. It comes as little surprise then that many investors see carbon and returns as an unfortunate but necessary pairing. In this report, we investigate this carbon conundrum for investors as we analyze the effects of a company s carbon emissions on portfolio performance and show that the values versus financial goals dilemma shouldn t exist. In fact, our findings underscore that there is genuine financial risk associated with exposure to fossil fuel companies as their assets become compromised by a number of factors including climate change, policy shifts, rising costs, sector volatility and declining demand. Finally, we discuss strategies for constructing portfolios based on our findings, even in the energy dominant Canadian market. 02 See page 13 for all endnotes.

Carbon emissions and your portfolio The carbon emissions produced by a company (measured in tonnes) is a crucial statistic that investors evaluate when assessing the environmental impact of a

5 Carbon emissions and your portfolio The carbon emissions produced by a company (measured in tonnes) is a crucial statistic that investors evaluate when assessing the environmental impact of a potential investment. Carbon emissions are calculated by taking the most recently reported or estimated Scope 1 and Scope 2 carbon emissions: Scope 1 emissions - those from sources owned or controlled by the company, typically caused by direct combustion of fossil fuels, such as in a furnace or vehicle. Scope 2 emissions - those caused by the generation of electricity purchased by the company. Carbon emissions: Importance of comparing apples to apples Measuring the environmental impact of your investments based purely on carbon emissions, however, makes it difficult to compare companies of different sizes. Larger companies tend to have higher emissions than smaller companies even though many large companies are actually more efficient. Therefore, screening out companies with high emissions is simply a screen for size. We need a common denominator to standardize companies emission levels and ensure that we are comparing apples to apples. We could standardize emission levels based on market capitalization the total value of a company s outstanding shares but here we inevitably encounter factors such as valuations, capital structures, ownership structures, and stock fluctuations. We believe that the better method to standardize emissions is based on a company s sales. Scope 1 + Scope 2 carbon emissions normalized by a company s sales in U.S. dollars is called carbon intensity. In more precise terms, it measures the tonnes of carbon emissions used to create $1 million (USD) in sales at the company. 03

6 When looking at emissions and carbon intensity in terms of the world s stock markets, we see that Canada leads the developed world. The Canadian market, represented by the S&P/TSX Composite Index, has lower weighted-average carbon emissions but significantly higher intensity. The high carbon intensity of the Canadian market is due to the dominance of the Energy sector in the Canadian market. The Energy sector accounts for 21.4% of the S&P/TSX Composite market capitalization while the same sector comprises only 6.6% and 5.0% of the S&P 500 (U.S. market), and MSCI EAFE (developed international markets), respectively. 3 When looking at emissions and carbon intensity in terms of the world s stock markets, we see that Canada leads the developed world. Investors interested in lowering the carbon intensity of their portfolios encounter an even more significant challenge if they are benchmarking against the S&P/TSX Composite Index. Reducing exposure to the Energy sector will mean losing exposure to approximately one-fifth of the Canadian index. How the Major Markets Stack up on Emissions 444 7,525,765 6,746,934 6,553,885 2,877, S&P/TSX S&P 500 msci eafe Canada U.S. INTERNATIONAL MSCI world Carbon Emissions (Weighted Average in Metric Tonnes) Carbon Intensity (Weighted Average in Tonnes/Million USD Sales) Data as of March 31, 2017; Source: MSCI, Genus Capital 04

Skewed Distribution: 10% of Canadian Companies Account for 80% of Emissions Regardless of which metric we focus on, the distribution of companies based on emissions and emissions intensity is heavily

7 Skewed Distribution: 10% of Canadian Companies Account for 80% of Emissions Regardless of which metric we focus on, the distribution of companies based on emissions and emissions intensity is heavily skewed. A company that falls in the top 10th percentile of carbon emissions is likely to produce 1.6 to 51 times more emissions than the average emissions of its domiciled region. In Canada, the top 10% of carbon emitters account for 80% of emissions. The top emitters account for an even greater percentage of the total emissions in U.S. and international markets. The average intensity for the top 1% of companies in the S&P/TSX is 25.6 times higher than the overall average for the index. 4 A Handful of Emitters are Responsible for Most Emissions 80% 81% 86% TOP 10 % of emitters S&P/TSX S&P 500 EAFE Percentage of Total Carbon Emissions in Index Data as of March 31, 2017; Source: MSCI, Genus Capital 05

8 The average intensity for the top 1 % of companies in the S&P/TSX is 25.6 times higher than the overall average for the index. Carbon Emitters Tend to Underperform Genus has found that removing the top carbon emitters not only drastically lowers the average emissions and carbon intensity of a portfolio, it has also had significant investment implications over the past seven years. Our initial investigation into the effect tested a hypothetical portfolio with historical data where we bought the top 10% of carbon emitters and sold short the bottom 10% of carbon emitters. 5 In other words, this portfolio was designed to increase in value when the companies with the highest carbon emissions increased in value relative to the companies with the lowest carbon emissions. Ultimately, our research revealed that top carbon emitters had a negative relative performance during the seven-year period. We started the analysis on the first month that MSCI Carbon Metric data was made available to investors in January 2010 and ended it on March 31, Ultimately, our research revealed that top carbon emitters had a negative relative performance during the seven-year period. The U.S. and international portfolios were down over 30%. The Canadian portfolio was down by only 11%, due to a rally at the end of

9 EMISSIONS-CENTRIC PORTFOLIO NOT REWARDED Cumulative returns by stock market 20% 10% CANADA U.S. EAFE 0% -10% -20% -30% -40% -50% -60% Source: MSCI, Genus Capital A Similar Underperformance Trend for Carbon Intensity When we conducted the strategy based on carbon intensity, the underperformance was repeated. The same methodology was applied where we purchased the top 10% of companies for carbon intensity and sold short the bottom 10%. With this test, the results were more significant and pronounced across the indices. CARBON-INTENSE PORTFOLIO SUFFERS EVEN GREATER SETBACKS Cumulative returns by stock market 30% 20% CANADA U.S. EAFE 10% 0% -10% -20% -30% -40% -50% -60% Source: MSCI, Genus Capital 07

10 The pro-carbon intensity long/short portfolios performed very poorly. The Canadian portfolio s performance fared much worse than in the previous version of the backtest, based on carbon emissions, declining 40%. The U.S. and international portfolios were down 53% and 33%, respectively. One thing to keep in mind is that this analysis is subject to correlation with other external factors. We would argue that this performance is not entirely representative of the impact of carbon as a factor because performance is influenced by other movements in the economy. The impact of carbon on a portfolio analyzed in this fashion is therefore not pure, and, hence, we undertook a further exercise to isolate the investment impact of carbon on portfolios. CARBON INTENSITY GENERATES A NEGATIVE EFFECT We believe that a cleaner way to identify and isolate carbon s investment impact is using a regression-based factor return analysis. Using this statistical method, factor return analysis takes out other factors that can influence price, such as overall market movements, company size bias, and momentum. Once the influence of these other factors is taken out, an investment manager is left with the effect of the single variable or factor on portfolio performance. Essentially, we removed the influence of other factors to find the real effect of carbon intensity. To better reflect a typical client's geographical mix, we performed the analysis based on a blended 35% S&P/TSX Composite/65% MSCI World portfolio, a benchmark for many of our Genus Fossil Free funds. We removed the effects of influential factors, and measured the monthly carbon intensity effect on returns. 6 EFFECT OF CARBON INTENSITY ON PORTFOLIO PERFORMANCE 2% Carbon Intensity Factor Performance 0% -2% --4% -6% -8% -10% -12% Source: MSCI, Genus Capital 08

11 Our findings indicate that over the course of seven years, carbon intensity had a 9.2% cumulative drag on the portfolio performance. In other words, a portfolio with greater carbon intensity, all other factors being equal, would have underperformed a portfolio with less carbon intensity. The factors used in the analysis are very similar to the factors we normally use to determine our stock rankings at Genus (our Genus Alpha forecasts). This means that if we were to include low carbon intensity as an additional factor in our model, we could expect performance to improve. We also found that the effect certain industries had on portfolio performance was very similar to the effect of carbon intensity. This is due to the fact that certain industries Utilities in particular have substantially higher carbon intensity than other industries. If we are actively avoiding carbon intensity, we typically remove Utilities and a few other industries. Without these more carbon intense industries, the average carbon intensity in a portfolio will decrease significantly. Our findings indicate that over the course of seven years, carbon intensity had a 9.2 % cumulative drag on portfolio performance. 09

12 Portfolio Management Application Carbon Emissions Analysis in Practice The suite of Genus Fossil Free funds features a carbon intensity that is significantly below the carbon intensity of the benchmark. The theoretical research that we ve outlined closely mirrors our portfolio management in practice. When constructing a portfolio, investors can add factors to their portfolios that help positively contribute to performance. For example, there have been time periods when increasing the value of a price-tobook factor (value stocks) has enhanced portfolio performance. 7 Conversely, managers can also take out factors that will negatively affect the portfolio. In order to avoid or lower the effect of carbon intensity, an investment manager can undertake the following: 1. Lower the portfolio weightings of companies with high carbon intensity 2. Exit positions contributing to the most to carbon intensity. By simply removing the top four companies for carbon intensity from their portfolio (totaling 0.91% of the index weight), an investor could lower the carbon intensity of their portfolio by 17.5% if they were holding the S&P/TSX Composite Go fossil free by simply cutting out all of the major fossil fuel extractors, transmitters, and emitters, including utilities. 4. Go fossil free and optimize the portfolio as Genus Capital has done with its Genus Fossil Free CanGlobe Equity Fund, Genus Fossil Free Dividend Fund, and Genus Fossil Free High Impact Equity Fund. In fact, the suite of Genus Fossil Free Funds features a carbon intensity that is significantly below the carbon intensity of the benchmark. Our benchmark for many funds (35% S&P/TSX Composite, 65% MSCI World) has a carbon intensity of 289, which is 5.9 times higher than the intensity of the Genus Fossil Free High Impact Equity Fund. The Genus Fossil Free CanGlobe Equity Fund and Genus Fossil Free Dividend Fund both have carbon intensities that are four times lower than the 35% S&P/TSX Composite, 65% MSCI World. 10

13 HOW CARBON INTENSE ARE GENUS FOSSIL FREE PORTFOLIOS? 300 Weighted-average carbon intensity (tonnes/u.s. dollar sales) % S&P/TSX, 65% MSCI WORLD GENUS FOSSIL FREEE HIGH IMPACT EQUITY FUND GENUS FOSSIL FREE CANGLOBE FUND GENUS FOSSIL FREE DIVIDEND FUND Data as of March 31, 2017; Source: MSCI, Genus Capital At Genus Capital, we solve this problem in our equity-based fossil free funds by combining Canadian and global stocks into a single optimized strategy that helps to diversify the portfolio and fill the energy gaps with strong companies in other economically sensitive sectors. Even in our funds that are not fossil free, we may still cut out companies with the highest carbon intensities and greatest level of carbon emissions in order to actively manage risk. As we earlier highlighted, cutting out fossil fuels from a Canadian equity portfolio poses a significant challenge given the market s heavy weighting in the Energy sector. This is an especially relevant issue for an investor trying to track the index to a reasonable degree. A PROVEN APPROACH At Genus Capital, we solve this problem in our equity-based fossil free funds by combining Canadian and global stocks into a single optimized strategy that helps to diversify the portfolio and fill the energy gaps with strong companies in other economically sensitive sectors. Taking a broader global viewpoint, the Energy sector and its related industries account for only eight percent of the MSCI World Index, which means that we find ample opportunity outside of Canada. 11

14 This optimization strategy can help investors achieve Energy sector-like stock price exposure without actual exposure to the sector ultimately allowing their investments to align with their values. Currently, some of the sectors we use to replace fossil fuel investments are in the global Information Technology, Consumer Discretionary and Financials sectors. Our proven optimization approach using global equities is how we enable Canadian investors to benefit from the growing area of fossil free investing. OUR ENERGY REPLACEMENTS INFORMATION TECHNOLOGY CONSUMER DISCRETIONARY FINANCIALS TELECOM SERVICES OUR RESEARCH ADVANTAGE In the information age it s essential to have a systematic way to gain insights from the mega data available. For over 26 years, Genus has built and enhanced its leading-edge investment research and analysis platform - RAMKit. This proprietary software equips Genus to collect and continually interpret vast amounts of new information globally. Through RAMKit, we can find determinants of performance, integrate ESG scores, develop and test asset allocation strategies, and explore new security selection and portfolio construction techniques. RAMKIT MEGA DATA PROCESSING SOFTWARE 12

15 ENDNOTES 1 NASA. "Carbon Dioxide Concentration NASA Global Climate Change". Climate Change: Vital Signs of the Planet. N.p., Web. 10 June IPCC, 2014: Climate Change 2014: Synthesis Report. Contribution of Working Groups I, II and III to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change [Core Writing Team, R.K. Pachauri and L.A. Meyer (eds.)]. IPCC, Geneva, Switzerland. 3, 4 As of March 31, Method: Buy companies in the top 10% of Scope 1&2 Carbon Emissions and sell short the bottom 10%. The portfolio is rebalanced monthly to reflect any changes in rankings and ensure the long and short portfolios have equal weighting. Source: MSCI ESG data 6 Method: Multi-factor regression using many common factors. The contribution of each factor, including carbon emission intensity, was calculated monthly from January 2010 to March Currency used is U.S. dollars. 7 Fama, E. F., & French, K. R. (1992). The Cross-Section of Expected Stock Returns. The Journal of Finance, 47(2), 427. doi: / fama French The Cross-Section of Expected Stock Returns the_cross-section_of_expected_stock_returns.pdf 8 As of March 31, 2017 This document was prepared for general information purposes only and should not be considered a substitute for specific professional advice. In particular, its contents are not Intended to be construed as the provision of investment or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this document should not be relied upon for investment or other financial decisions and no such decisions should be taken on the basis of its contents without seeking specific advice. This document is based on information available to Genus Capital Management Inc (Genus) at the date of issue, and takes no account of subsequent developments after that date. In addition, past performance is not indicative of future results. In producing this document, Genus has relied upon the accuracy and completeness of certain data and information obtained from third parties. The contents of this document may not be reproduced or distributed to any other party, whether in whole or in part, without Genus Capital Management s prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Genus and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document including any opinions expressed herein. It should also be noted that past performance is no guarantee of future results. 13

16 ABOUT GENUS CAPITAL Genus Capital Management Inc., Canada s fossil free investment leader, was founded in 1989 and is an independent investment management firm based in Vancouver. We are passionate about creating innovative investment solutions that meet our clients changing needs. With more than $1.2 billion in assets under management, our clients include leading environmental organizations, foundations, Indigenous communities, pensions and individuals across Canada. As the world took notice of climate changes environmental impact, our clients, such as the David Suzuki Foundation, began to see its impending economic impact, and asked for higher standards in socially responsible investment. In 2013 we enhanced our socially responsible strategies and created Genus Fossil Free to better align the values of our clients with their investments and help address some of the world s pressing socioeconomic and environmental challenges. Today, Genus Capital is at the forefront of Canada s Divest-Invest movement with a complete suite of fossil fuel free funds that are tailored to meet the needs of investors who wish to divest from the world s worst polluters and invest in a sustainable, clean energy future. 14

18 Genus is dedicated to creating innovative solutions that better meet changing client needs. GENUS CAPITAL MANAGEMENT INC., Howe Street, Vancouver, BC, V6Z 0C8 Tel Toll Free Fax info@genuscap.com

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