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Climate Change and Sustainable Investing: How Investors Can Make a Difference

By 3p Contributor

By Daniel Kern

“There’s one issue that will define the contours of this century more dramatically than any other, and that is the urgent and growing threat of a changing climate.”

— U.S. President Barack Obama, U.N. Climate Change Summit, September 23, 2014

Last December, 195 countries met in Paris to discuss climate change at the 21st Conference of the Parties of the United Nations Framework Convention on Climate Change (UNFCCC). The Paris Agreement commits to limiting global temperature rise to a maximum of 2 degrees Celsius above pre-industrial levels, while setting an aspirational goal of 1.5 degrees Celsius. Under the agreement, governments targeted replacing fossil fuels almost entirely with clean energy in the second half of this century.

Thirty-four countries representing 49 percent of greenhouse gas emissions formally joined the agreement, or committed to joining the agreement as early as possible, at a high-profile April signing ceremony at the United Nations. The climate agreement becomes “operational” when formal approval is received from at least 55 countries accounting for 55 percent of global emissions. The White House said countries accounting for about half of the world’s greenhouse gas emissions would join the Paris climate agreement this year, bringing the agreement close to the finish line.

Consumers are reducing their own “carbon footprint”

Many of our clients at TFC Financial Management are reducing their personal “carbon footprint,” buying energy-efficient appliances, turning to renewable energy, driving hybrid cars, or using ride-sharing services. Some clients want to incorporate sustainability into their investment portfolios, by investing in companies that have a gentler climate impact. Many proponents of sustainable investment strategies argue that traditional fossil fuel companies will be in structural decline in coming decades, challenged by governmental and consumer actions to limit the impact of oil, gas and coal on the environment.

Low-carbon and fossil fuel free strategies

There isn’t a universal “climate-friendly” investment strategy that has captured the hearts and minds of investors. Some investors gravitate toward low-carbon investment strategies, others prefer fossil fuel free strategies. Despite similar intentions, there are notable differences between low-carbon and fossil fuel free strategies.

Low-carbon investment strategies attempt to minimize the overall carbon footprint of the companies owned in the portfolio. Several first-generation low carbon products are diversified portfolios that attempt to track a broad-based index, while minimizing aggregate carbon emissions and fossil fuel reserves. A “low-carbon” ETF offered by a major ETF provider reports a 77 percent reduction in current carbon emissions and a 97 percent reduction in future carbon emissions relative to a broad-based index; a “sustainability” mutual fund offered by a major mutual fund company reports a 73.6 percent reduction in emissions and a 99.7 percent reduction in potential emissions.

Low-carbon investors evaluate the carbon footprint of both fossil producers and consumers of fossil fuels. A low-carbon portfolio may avoid or underweight significant fossil fuel consumers such as airlines; they include energy services companies that provide fossil fuel production, transportation and storage services but often have low emissions and reserves. Some low-carbon products include major energy companies such as ExxonMobil, but at lower position weights than in a broad-based index.

Fossil fuel free investment strategies approach climate change differently. Fossil fuel free products typically exclude companies that explore for, process, refine or distribute coal, oil or gas. Fossil fuel free products also typically avoid utilities companies that produce or transmit electricity derived from fossil fuels or transmit natural gas. Fossil fuel free products will completely avoid energy companies such as Exxon Mobil and Chevron, while also avoiding energy services “enablers” such as Schlumberger and Kinder Morgan. Fossil fuel free products focus on production rather than consumption, so airlines and other consumers of fossil fuels are included as potential investments.

Investors who have social preferences beyond climate change may consider other exclusionary factors. Some of today’s fossil fuel free strategies were originally socially responsible products that excluded investments in companies in the alcohol, tobacco, gambling, firearms, and nuclear power industries. Some first-generation low carbon products, which may not carry a socially responsible investment (SRI) heritage, include alcohol, tobacco and other companies typically excluded by SRI strategies.

Impact investing

Some clients may wish to go beyond strategies that avoid fossil fuel stocks or minimize the carbon footprint of a portfolio. Impact-focused clients want their investment funds to contribute directly to societal change. Impact investing is a distinct approach, through investing in projects or companies with the intent to effect mission-related social or environmental change.

Progress in the adoption and cost competitiveness of renewable power such as wind and solar has made clean energy a popular focus for climate-sensitive impact investors, and we’re also seeing growing interest in water-related investments. We recommend that impact investments supplement a well-diversified core investment portfolio, as investments in clean energy or water are often more volatile, less liquid, and reliant on technology innovation and a favorable policy environment.

Investment considerations and closing thoughts

Researchers have reviewed mutual fund performance to evaluate whether there are performance trade-offs associated with values-driven investments. Results have been mixed. Academic theory suggests that any investment constraints potentially limit returns, however, proponents for sustainable and responsible investing argue that either the constraints have limited impact or that the impact is balanced between offsetting positive and negative contributions.

Actively managed values-driven funds have had the same difficulty in beating passive benchmarks that their non-responsible investing peers have had. The high cost of many strategies may have some impact, serving to erode returns and reinforcing the frequently heard refrain that low cost, low turnover, disciplined strategies “win” in many asset classes.

Investors who have both climate change and financial objectives should:

  • Define what you want to accomplish: Defining the investment objective, climate change considerations and time horizon are a critical step in the process.

  • Do your homework: Understand the investment strategy and costs of each potential solution.

  • Review the risks: There may be financial trade-offs associated with a climate change strategy. Understand the investment risks associated with different investment strategies, so that you’re fully informed about the environments in which the strategy will thrive or struggle.
Image credit: Pixabay

Daniel Kern joined TFC Financial Management in 2015 and is responsible for overseeing TFC’s investment process, research activities and portfolio strategy. Prior to joining TFC, Dan was the president and chief investment officer at Advisor Partners, a boutique asset manager in the San Francisco area that manages equities and asset allocation products for advisors, financial institutions and family offices. Dan’s previous experience included a managing director/portfolio manager role at Charles Schwab Investment Management where he was head of asset allocation. Prior to Charles Schwab, Dan held a managing director/principal role at Montgomery Asset Management where he managed global and international equity portfolios. A CFA charterholder, Dan is a member of the CFA Institute and a Trustee for Green Century Funds. Dan is a graduate of Brandeis University with a Bachelor of Arts in Economics degree. He also holds a Master of Business Administration degree from the University of California, Berkeley - Haas School of Business.


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