Low carbon: a unique global equities solution George Thomson, Consultant, Not-for-Profit EXECUTIVE SUMMARY In this document, we explain how we can help investors manage the potential investment implications of a transition to a low carbon economy, without introducing significant investment risk. Going beyond reduction of carbon footprint alone, our solution tilts a global equity portfolio away from companies with the greatest exposure to carbonrelated risk and towards companies expected to contribute to, and benefit from, an energy transition. This solution also avoids some of the pitfalls prevalent in existing strategies, and will continue to evolve as the nascent carbon management sector develops. Climate change risk and decarbonisation Institutional investors must contend with numerous risks, and potential risks, to their portfolios. Garnering increased attention more recently is the potential for portfolios to be exposed to risk associated with the varying global responses to climate change. As a first step, measuring this risk has been encouraged through initiatives such as the development of the Montréal Carbon Pledge. Launched in 2014 by the Principles for Responsible Investment (PRI), it requires signatories to both measure and disclose the carbon footprint of either part or all of their equity portfolios. This attracted 120 signatories, representing over US$10 trillion in assets under management 1. In the same year as the Montréal Carbon Pledge, the Portfolio Decarbonisation Coalition (PDC) was formed, which required members to not only measure and disclose the carbon footprint of their equity portfolios but that they commit to decarbonising their portfolios in the future in line with the PDC guidelines. According to the PDC, decarbonisation refers to the systematic efforts by investors to align their investment portfolios with the goals of a low-carbon economy. It includes efforts to reduce the carbon footprint of investment portfolios, to increase investment in areas such as renewable energy, to withdraw capital from high energy consumption activities and to encourage companies and other entities to reduce their carbon emissions. Today, the PDC convenes 25 investors overseeing the decarbonisation of US$600 billion in commitments, out of US$3.2 trillion in assets under management 2. As illustrated in the figures above, there is growing interest from a number of investors investigating how best to implement a decarbonisation strategy within their equity portfolios. 1 Source: montrealpledge.org; as at 15 August 2016 2 Source: http://unepfi.org/pdc/; as at 15 August 2016 Russell Investments // A novel solution to help you manage climate change exposures in your portfolio SEPTEMBER 2016
Based on the insight gained from our research into decarbonisation strategies 3, we have developed a novel, rules-based solution which goes beyond simple exclusions of sectors or companies. It is designed to reduce exposure meaningfully to carbon-intensive holdings, but also to invest more in climate-resilient and renewable energy opportunities, without materially impacting performance. Investment approach and objectives Our approach uses the market-cap benchmark as a starting point and incorporates the following objectives: 1. Reduce carbon footprint by at least 50% 2. Reduce exposure to stranded assets (fossil fuel reserves) by at least 50% 3. Exclude companies with more than 20% of revenue from coal-related activities (unless carbon capture and storage procedures are used) 4. Invest in companies expected to contribute positively to the transition to renewable ( green ) energy sources 5. Ensure the aggregate portfolio has positive bias towards companies with high environmental, social and governance (ESG) characteristics 6. Maintain tracking error of no more than 1% Below we look at each of these aspects in more detail. 1. Carbon footprint We define the carbon intensity for each security in the portfolio in terms of greenhouse gas CO2 emissions per million USD of revenue. We incorporate direct emissions (Scope 1) and indirect electricity consumption (Scope 2) 4. Figure 1: The aggregate carbon footprint of the MSCI World by decile 100% 80% 60% 40% 20% 0% 20% of Companies, 90.5% of Aggregate Carbon Footprint 1 2 3 4 5 6 7 8 9 10 Carbon Footprint Cap Weight Cumulative Contribution Source: Russell Investments as at 30 June 2016 In a global equity benchmark (MSCI World), approximately 20% of the securities account for 90% of the total portfolio s carbon footprint (see Figure 1). Also, two-thirds of the carbon intensity is concentrated in Energy, Materials and Utilities. These concentrations mean that simply targeting the highest carbon emitters can increase the tracking error risk significantly, relative to the original portfolio. However, we take this concentration as an advantage as we only need to tilt away from a small number of stocks to achieve a significant carbon footprint reduction. We find a 50% carbon footprint reduction of the portfolio optimal as it is the most meaningful reduction without incurring significantly greater tracking error. At reduction targets lower than 50%, tracking error is about the same, but it starts to increase significantly when trying to achieve more than 50% reduction (see Figure 2). 3 The Russell Investments Decarbonisation Strategy: Investigating different approaches to reducing the carbon footprint of an equity portfolio without materially impacting performance, Sean Smith, Scott Bennett and Pradeep Velvadapu April 2016 4 See our January 2016 Carbon risk management case study for more details Russell Investments // A novel solution to help you manage climate change exposures in your portfolio 2
Ex Ante tracking Error Figure 2: Footprint reduction vs tracking error (As of June 2016) 2.0 1.5 1.0 0.5 0.0 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 Footprint reduction relative to MSCI World benchmark Source: Russell Investments as at 30 June 2016 2. Stranded assets Stranded assets are those which suffer unanticipated or premature write-offs on the balance sheet, downward valuations or may incur future liability (e.g. carbon tax). Assets may become stranded by one-off transformational shifts in valuation, or over time, as a result of appropriate risks not being analysed and priced into the anticipated future value of the assets. In the case of fossil fuels, the concept of asset stranding first came to light in 2011, when Carbon Tracker released its Unburnable Carbon report. 5 The report developed the investment thesis that, should we wish to avoid catastrophic climate change, and thus limit global atmospheric temperature rise to 2 C, the majority (80%) of fossil fuel reserves listed on global stock markets should not be burnt, leaving these fossil fuel reserve assets stranded. Figure 3: Carbon dioxide emissions potential of listed fossil fuel reserves Fossil fuel reserves owned by the top 100 listed coal and top 100 listed oil and gas companies represent total emissions of 745 GtCO2. 80% of these listed reserves are vulnerable to being stranded. Source: The Carbon Tracker Initiative, http://www.carbontracker.org/report/carbon-bubble/ 3. Coal exclusions Coal has the highest carbon content of all fossil fuels and produces the highest CO2 emissions per heating unit produced. Worldwide, coal supplies 30% of energy use and is responsible for 42% of global CO2 emissions 6. In the US, coal production is projected to decline by about 26% between 2015 and 2040 7, as illustrated in Figure 4. In recognition of this disproportionate contribution, we implement a direct exclusion of companies where the extraction of coal represents a majority of their revenues and/or where it represents a majority of their power generation. 5 http://www.carbontracker.org/report/carbon-bubble/ 6 https://www.eia.gov/tools/faqs/faq.php?id=79&t=11 7 Energy Information Administration Annual Energy Outlook 2016 https://www.eia.gov/tools/faqs/faq.cfm?id=73&t=11 Russell Investments // A novel solution to help you manage climate change exposures in your portfolio 3
Figure 4: Energy consumption in the United States (1776-2040) Source: Energy Information Administration Annual Energy Outlook 2016 https://www.eia.gov/todayinenergy/detail.php?id=26912 4. Renewable Energy Sources Should the move towards the 2 degree Celsius target for global warming gain traction, we expect to see a dramatic shift away from traditional (brown) sources of energy to more renewable (green) sources of energy. We developed the Energy Ratio to help ensure that our portfolio is well positioned, should the world become more focussed on trying to meet the 2 degree Celsius target. The ratio looks at energy producers and calculates the percentage of total energy produced from green energy sources (see below for classification of energy sources). The green energy ratio ranges from a maximum score of 1 (entirely green sourced energy) to a minimum of 0 (no exposure to green energy sources). Energy sources classification ENERGY SOURCES Coal Power Generation Natural Gas Power Generation LPG Power Generation Petroleum Power Generation LNG Power Generation Nuclear Power Generation Landfill Gas Power Generation Other Power Generation Wind Power Generation Solar Power Generation Biomass Power Generation Geothermal Power Generation Wave & Tidal Power Generation Hydroelectric Power Generation Source: Trucost, Russell Investments ENERGY TYPE Grey Grey Grey In our process we calculate the green energy ratio for all applicable companies in the benchmark and create an aggregate score for the portfolio. In our portfolio construction process we target a green energy ratio that is at minimum the same as the parent universe. This ensures that our strategy is targeting those firms that are positively exposed and contributing to a transition to a greener energy regime. 5. Environmental, Social, and Governance We have also integrated Environmental, Social, and Governance (ESG) scores into our strategy to ensure that the portfolio has a positive bias towards companies with high ESG characteristics. The explicit incorporation of ESG characteristics into the process ensures that we take a broader view of a company s activities and policies which may not be fully captured by looking just at the standard CO2 metrics. Russell Investments // A novel solution to help you manage climate change exposures in your portfolio 4
In our portfolio construction process, we look to achieve an aggregate ESG profile that is at a minimum matching the benchmark but on average greater than the benchmark through time. We find this is an appropriate measure to ensure the portfolio is investing, on average, more in companies with positive ESG characteristics. Within our strategy we utilise ESG data provided by Sustainalytics. Sustainalytics ESG ratings provide a measure of how well issuers proactively manage the environmental, social and governance issues that are the most material to their business. Sustainalytics ESG ratings reflect three dimensions: Preparedness, Disclosure and Performance. The ESG scores range from 0 100 based on a balanced scorecard approach, where the overall ESG score for a company is the sum of the weighted average of underlying indicator scores. In addition, certain sectors are excluded from our portfolio, based on ESG considerations. Currently, these are producers of cluster munitions, anti-personnel mines, nuclear weapons (and key systems and componentry) and tobacco. 6. Tracking error risk The portfolio construction process begins with the starting universe. We then look to optimise the trade-off between taking on as little active share and transaction cost as necessary to achieve our climate change risk reduction objectives (aggregate carbon footprint, carbon reserves, green energy ratio and ESG profile). These objectives and the sources and definitions are summarised below. We also employ several risk-related constraints to ensure sector, industry, country, and company biases are controlled. Summary of climate change risk reduction objectives FACTOR OBJECTIVE RUSSELL INVESTMENTS DEFINITION DATA SOURCE Carbon Emissions Carbon Reserves ESG 50% reduction 50% reduction Greater than benchmark Active Risk Less than 1% Exclusions Zero Holding Scope 1 & Scope 2 CO 2 Emissions/Total Revenue Carbon Reserves/Total Assets Holdings-weighted E,S & G score Annualised tracking error (ex ante and ex post) Various as defined by Russell Investments 8 Energy Transition Positive Exposure Energy/Total Energy Trucost Trucost Sustainalytics Axioma Sustainalytics/ Russell Investments Russell Investments/Trucost The final portfolio achieves the climate change risk reduction objectives within a 1% tracking error constraint while positively positioning the portfolio to contribute to a transition to a low carbon economy. Summary of our carbon risk management solution Negative tilts Our approach looks to mitigate the risk that performance of carbonintensive securities will lag behind the broad market in a transition to a lowcarbon economy. We also look to protect against the potential future risk of sudden write-downs of those fossil fuel reserve assets that may never be extracted or burned 9. Positive tilts Once we have allocated capital away from these sources of climate change risk, we look to reallocate towards companies that demonstrate positive ESG characteristics and/or are expected to contribute positively to the energy transition through development of renewable energy sources. Minimise tracking error We recognise that in the near term the carbon exposure of those stocks from which we ve tilted away could have very little negative impact on their performance. Therefore, we want to minimise the variation from our starting BACKWARD LOOKING ESG SCORES CARBON FOOTPRINT POSITIVE TILT + - NEGATIVE TILT RENEWABLE ENERGY STRANDED ASSETS FORWARD LOOKING 8 Current exclusions are companies that derive greater than 20% of revenues from coal, and producers of cluster munitions, antipersonnel mines, nuclear weapons (and key systems and componentry) and tobacco. 9 This is referred to as the risk of stranded assets if these fossil fuel reserves can never be burned or extracted in order to try to avoid a significant rise in global average temperature. Russell Investments // A novel solution to help you manage climate change exposures in your portfolio 5
investment strategy, preserving as much as possible the underlying factor, sector, country and currency exposures. We do this by applying modest constraints on the stock, sector and country weights to minimise unintended risks. To avoid the pitfalls of using a risk model/covariance matrix (see boxout) but still obtain the desired low tracking error risk, we have focused on maximising the commonality (minimising active share) between the portfolio and its benchmark. WATCHPOINT: NOT ALL OPTIMISERS ARE CREATED EQUALLY Tracking error is a measure that we use to monitor the portfolio, but it is not explicitly targeted in our optimisation. There are two key reasons why we do not target tracking error as our measure of active risk in the optimisation process: 1. By incorporating a minimise tracking error objective we would introduce an additional dimension to the portfolio which is the co-variance matrix of the risk model. This means that differences in individual security weights are driven not just by CO2 emissions but also by their covariance. This can result in two securities with the same CO2 emissions having opposing active positions (i.e. same carbon footprint but one held at an overweight and the other at an underweight). For example, we often see risk-model based optimisations with solutions that have large underweights across the energy sector (e.g. Shell, Total, Chevron etc.) and a single large offsetting position in one energy company (e.g. Exxon Mobil). These positions are driven primarily by the stocks co-variance, which is driven by their return and risk characteristics as opposed to their carbon footprints; we don t believe that a strategy that holds a large position in ExxonMobil (for example) is the desired intent of a decarbonisation strategy. 2. The underlying risk models that generate the co-variance matrix and subsequent tracking error can be very unstable over time. This can lead to dramatic changes in the portfolio despite no changes in the underlying carbon footprint characteristic. We control tracking error (active risk) by ensuring that we have the highest possible commonality with the underlying benchmark (i.e. lowest possible active share). We further minimise the tracking error through conservative asset, sector, industry and country constraints. These pragmatic constraints ensure that the strategy delivers consistently low tracking error and that our forecasted tracking error is very close to the realised tracking error. A unique solution for investors Our solution offers three benefits relative to many other index or quantitative solutions: 1. More than just carbon reduction Our approach tilts the portfolio away from those companies with high exposure to carbon-intensive activities and increases weight in those companies with positive environmental, social and governance (ESG) characteristics and/or involved in the development of renewable energy sources. 2. Avoids unintuitive outcomes by not optimising tracking error We believe it is extremely important for a low carbon strategy to display a direct relationship between a company s carbon footprint and its subsequent weight in the portfolio. The use of an optimisation model which targets low tracking error can compromise this direct relationship and result in unintuitive outcomes. For example, holding two securities with the same CO2 emissions in opposing active positions in the portfolio. 3. Proactive evolution over time The risks of carbon exposure are currently unknown and unquantifiable, and will evolve. This highlights the importance of adapting the strategy as new opportunities and risks become apparent in the market. We are committed to actively evolving this solution for you. Russell Investments // A novel solution to help you manage climate change exposures in your portfolio 6
Conclusion We are committed to helping our clients implement sound ESG practices within their portfolios. Where clients express strong investment beliefs relating to the importance and impact of a transition to a low carbon economy, a more focussed solution may be appropriate. Going beyond carbon reduction alone, this global equity solution helps clients systematically overweight stocks that they believe will benefit from a transition to green energy. Our methodology helps clients to reduce their risk related to exposure to carbon-intensive securities with limited investment risk relative to the original portfolio. This results in index-like performance with lower exposure to carbon, a positive ESG skew, and the exclusion of specific industry sectors. Finally, we are committed to proactively evolving our process as the carbon management sector continues to develop. Russell Investments // A novel solution to help you manage climate change exposures in your portfolio 7
ABOUT RUSSELL INVESTMENTS Russell Investments recognises the importance of environmental, social, and corporate governance (ESG) issues to our clients and is committed to continual capability enhancement in partnership with our clients and other industry organisations. Russell Investments has more than $378 billion in assets under management (as of 30 June 2017) and works with 1,700 clients, independent distribution partners and individual investors in over 33 countries globally. Russell Investments invest approximately $75 billion in sustainable investment solutions. In 2017, Russell Investments received an A+ grade from the PRI, the highest possible, in the eight categories for which the firm reports data, encompassing strategy, governance, direct active management, manager selection, manager appointment, and manager monitoring. A UNPRI Signatory since 2009, Russell Investments aims to integrate each of the UN-supported principles into our investment processes and decision-making. As a member of both the Institutional Investors Group on Climate Change and the Investor Group on Climate Change Australia/New Zealand, Russell Investments collaborates with investors to encourage public policies, investment practices, and corporate behaviour that address long-term risks and opportunities associated with climate change. Russell Investments has also been a signatory of Carbon Disclosure Project (CDP) since 2010, which includes CDP Climate Change, CDP Forest, and CDP Water. FOR MORE INFORMATION Speak to Alister Van der Maas, Managing Director, New Zealand on +64 9 357 6633 or email avandermaas@russellinvestments.com For Professional Clients Only. Unless otherwise specified, Russell Investments is the source of all data. All information contained in this material is current at the time of issue and, to the best of our knowledge, accurate. Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Any data on past performance, modelling or back-testing contained herein is no indication as to future performance. No representation is made as to the reasonableness of the assumptions made within or the accuracy or completeness of any modelling or back-testing. The information contained in this publication was prepared by Russell Investment Group Limited based on of information available at the time of preparation. This publication provides general information only and should not be relied upon in making an investment decision. Before acting on any information, you should consider the appropriateness of the information provided and the nature of the relevant Russell Investments' fund having regard to your objectives, financial situation and needs. In particular, you should seek independent financial advice and read the relevant Product Disclosure Statement or Information Memorandum prior to making an investment decision about a Russell Investments' fund. Accordingly, Russell Investment Group Limited and its directors will not be liable (to the maximum extent permitted by law) for any loss or damage arising as a result of reliance being placed on any of the information contained in this publication. None of Russell Investment Group Limited, any member of the Russell Investment group of companies, their directors or any other person guarantees the repayment of your capital or the return of income. All investments are subject to risks. Significant risks are outlined in the Product Disclosure Statements or the Information Memorandum for the applicable Russell Investments' fund. Past performance is not a reliable indicator of future performance. The Product Disclosure Statements or the Information Memorandum for the Russell Investments' funds (as applicable) are available by contacting Russell Investment Group Limited on 09 357 6633 or 0800 357 6633. Copyright 2017 Russell Investment Group Limited. All rights reserved. First used: August 2017 Russell Investments // A novel solution to help you manage climate change exposures in your portfolio 8