Reduce carbon without sacrificing returns – can investors have it all?

From net zero pathways to climate action to the perils of greenwashing, the business headlines do not always paint a positive picture for investors pursuing strong returns in their portfolios with a sustainability agenda in mind.

Climate change isn’t going away and although it feels like a battle to be fought by governments, businesses and fund managers, the truth is that the drive for climate action is much closer than you think, at least in your investment portfolio. Increasingly, fund managers recognise the transition to net zero as both a risk to control and a potential source of investment opportunities¹, while aligning portfolios with a net zero trajectory. For investors, there is potential to drive a powerful trend towards greater climate action by selectively investing in funds.

Top of mind for most investors, however, is whether exposure to the decarbonisation megatrend sacrifices returns. Can we have it all? The answer actually is yes, but it’s also complicated.

While rarely considered by average investors, tracking error is an important measure to assess how closely to the benchmark a portfolio will likely perform – broadly speaking, it measures the width of the bell curve of annual portfolio performance relative to the benchmark. Of course, the more a portfolio’s allocations differ from a benchmark, the higher the tracking error is likely to be.

For investors who want to incorporate environmental, social and governance (ESG) characteristics, like reduction in carbon emissions, into their portfolio but with a preference for benchmark-type risk and returns, low tracking error is important.

Intuition suggests that reducing carbon intensity would have a marked effect on tracking error, and perhaps returns. Our analysis tells a surprising story.

Investors wanting to integrate decarbonisation into their overall investment strategy might consider sector exclusions or divestment of companies that generate significant carbon emissions. Selling down positions in companies in the highest carbon intensive sectors can get investors the biggest carbon intensity reductions, but it can also introduce more portfolio risk and tracking error, as well as having a material impact on returns.

However, it is possible to achieve carbon reductions in a portfolio without necessarily selling out of a sector. To do this in a controlled way, we use each stock’s carbon intensity as our central measure (carbon intensity is Scope 1 and 2 greenhouse gas emissions per million dollars of sales.). This scores stocks strictly on their emissions through their operations and is agnostic to the value of a company.

Within individual sectors or industries, it is worth noting that stocks have broad ranges of carbon intensity – many stocks with little or no carbon intensity and a few stocks with a great deal. Indeed, in most sectors of the global stock market, we found that a 30% reduction in carbon intensity could be achieved by excluding less than 10% of the stocks by value – energy was the exception, requiring 11.5% to be excluded.  

Our central analysis – and our main results – show that it is possible to achieve moderate levels of carbon intensity reduction in a portfolio with minimal addition of tracking error. By ‘trading up’ for carbon leaders – those with less carbon intensity – within the same sector or industry instead of shifting sector weights when reallocating portfolios, we also found that there is little effect on portfolio alpha, the return generated above that of the benchmark.

Different geographies will offer different opportunities for reductions in carbon intensity and tracking error for investors.

Perhaps not surprising is the finding that it is more challenging to decrease carbon intensity with minimal addition of tracking error in Australian equities portfolios. This reflects the concentration of higher carbon intense sectors in the Australian index compared to broader global equities indices.

Compare Australian portfolios to global portfolios that have a larger stock universe. In global, we find surprisingly small tracking error for quite large reductions in carbon intensity. For example, a 40% reduction in carbon intensity in MSCI ACWI ex-AU, an international equity index excluding Australian stocks, would only have generated a historic tracking error of 0.10% p.a in the period of December 2008 to June 2022.

For Australia, with a smaller and more resource-oriented market, the impact is higher. For example, decreasing carbon intensity by 30% for the ASX200 adds about 0.50% p.a. of tracking error. This can hamper an investor’s ability to rotate to stocks with less carbon intensity within a sector because there are less options to do so.

For the carbon conscious investor, aligning to the net zero agenda is possible with minimal risk and reward implications in reallocating portfolios. Our study found that moderate adjustments towards lower carbon stocks in well-diversified portfolios can result in substantial carbon intensity reductions with minimal addition of tracking error.

¹ For example, there are 301 signatories representing USD 59 trillion in AUM to the Net Zero Asset Managers initiative. This is an international group of asset managers committed to supporting the goal of net zero greenhouse gas emissions by 2050 or sooner, in line with global efforts to limit warming to 1.5 degrees Celsius, and to supporting investing aligned with net zero emissions by 2050 or sooner.