Climate change

The Global Property Securities team is committed to achieving our net zero targets. However, the full scope of the real estate sector’s contribution to global carbon emissions has not been fully quantified, which creates challenges in achieving this goal.

We believe that Scope 1 & 2 emissions data only gives a partial picture of property portfolio emissions and does not provide for full landlord accountability. Our carbon analysis is based on all owned real estate, including whether the energy is ‘controlled’ by the landlord or where it may be ‘non-controlled’. For instance, a Real Estate Investment Trust (REIT) may only own a minority stake in an asset or be in a leasing arrangement where the tenant has direct control of energy (typically under triple net lease contracts), which we see impacting the level of disclosures available to the market.

Currently, the built environment does not have a standardised methodology to account for the full range of Scope 3 and embodied carbon emissions, such as those associated with modernisation programmes. However, we view this as a key contributor to a building’s carbon emissions. Our investment process considers all emissions listed below and seeks company data on them:

• Scope 1: Direct GHG emissions occur from sources that are owned or controlled by the company, for example, emissions from combustion in owned or controlled boilers, furnaces, vehicles, etc.
• Scope 2: Accounts for GHG emissions from the generation of purchased electricity consumed by the company. Purchased electricity is defined as electricity that is purchased or otherwise brought into the organizational boundary of the company.
• Scope 3: Is an optional reporting category that allows for the treatment of all other indirect emissions. Scope 3 emissions are a consequence of the activities and operation of the reporting company within its value chain.

REITs have higher reporting standards in comparison to private owners and are therefore more scrutinised than their private counterparts.

We believe REITs are well-placed to standardise the measurement of Scope 3 and embodied carbon emissions, which will flow through to the rest of the built environment. Hence, we have taken steps to position ourselves to drive change in our investment universe and encourage REITs to set more ambitious net zero goals.

Through comprehensive research, we developed a tool³ capable of undertaking high level analysis on all embodied carbon associated with development, redevelopment, and maintenance capital expenditure programmes at a company level.

As a result of our in-depth carbon analysis, we are now able to identify issues and to form a measurable carbon reduction target in our engagement process with companies. We are planning to continue our engagement and reporting on the issue going forward.

³ Ernst & Young was engaged by First Sentier Investors Global Property Securities team to undertake ‘limited assurance’ as defined by International Auditing Standards, over the team’s Portfolio Operational Carbon Emissions (Scope 1 and 2) Forecast to Net Zero for the year ended 30 June 2021. Based on the review, Ernst & Young determined the forecast was prepared and presented fairly, in all material respects, in accordance with the defined Criteria.

While many investors and asset owners are looking to decarbonise their portfolios they are often concerned about the impact of such a move on their returns profile. Quantitative team, RQI Investors, considered this in a research paper entitled: Reducing carbon intensity in portfolios: Better news than you think.

Carbon intensity provides insights into the carbon efficiency of a company, showing how much carbon an organisation emits per unit of output. The research measured carbon intensity by considering emissions output (Scope 1 and 2)⁴ for every million dollars of sales, to come up with a carbon intensity score for each company. It took a range of capitalisation-weighted benchmarks, and reduced carbon intensity by 10%, 20%, and more⁵. The study then measured the realised tracking error and returns of these carbon-reduced portfolios.

The analysis found that small moves towards lower carbon intensity in well-diversified portfolios can result in carbon intensity reductions with minimal addition of tracking error. For global portfolios (which have many stocks) this leads to surprisingly small tracking error for quite large reductions in carbon intensity. For example, a 40% reduction in carbon intensity relative to the index (in this case, MSCI All Companies World Index, ex‑Australia) would only have generated a tracking error of 10 basis points per annum when averaged across the whole period covered by the analysis (December 2008 to June 2022).⁶ This result is a little surprising, but reflects optimal portfolio construction, in the sense that there is rotation within sectors (from high carbon intensity stocks to low carbon intensity stocks) rather than between sectors. This is accomplished without greatly affecting expected portfolio risk or return, at least for moderate levels of carbon intensity reduction. The team is now implementing these insights in their portfolios going forward.

Figure 1. Ex post annualised tracking error against cap weighted benchmarks (December 2008 to June 2022) as carbon intensity is reduced

Source: FactSet, MSCI Carbon Metrics, RQI database

⁴ Scope 1 allows for an understanding of how much carbon is emitted through the company’s operations. Scope 2 covers the company’s purchase of energy.

⁵ That is, attempting to minimise tracking error to the benchmark while applying a carbon intensity constraint.

⁶ Tracking error is the volatility (or standard deviation) of active returns, and measures the variation of returns around a benchmark (for example). An index fund has low tracking error as it closely tracks the benchmark, while a highly active fund can have a tracking error of 5% or higher.