Return of inflation poses problems for asset managers and owners looking to track pace of decarbonisation across portfolios.
ESG investing has had to overcome numerous challenges, ranging from investor caution to multiple cases of greenwashing. Now it faces a new enemy – resurgent inflation.
By puffing up nominal money values, inflation can reduce a company’s carbon intensity on paper, even though nothing has changed in real terms, according to Sudhir Roc-Sennett, Head of Thought Leadership and ESG at Vontobel Asset Management.
Carbon intensity, usually measured as tons of CO2 per US$1 million in revenue, is a common way for investors to track the quantity of greenhouse gas (GHG) emissions from the companies in their portfolios.
But, as Roc-Sennett notes: “Money as a measure is a strange beast.” He added: “If inflation in 2021 and 2022 pulls average revenue up say 15% for companies in a portfolio or a benchmark, this could knock 13% off their carbon intensity figures.”
Inflation is currently running at near 40-year highs in a number of major economies, with the US headline rate currently sitting at 8.3% and the UK rate at 9.9%.
In his analysis, Roc-Sennett went on to look at how inflation could distort the record of firms moving to a 50% cut in emissions by 2030, compared with 2019, and to net zero by 2050, focusing on the Standard & Poor’s 500 and the MSCI Emerging Market (MSCI EM) index.
“On this trajectory, a 13% fall in carbon intensity from where it stood at the end of the last quarter (Q2 2022) amounts to 2.5 years of ‘progress’ for the S&P 500 and three years for the MSCI EM.
“All without lifting a finger.”
The problem, Roc-Sennett said, stems from the use of revenue as a yardstick against which to measure CO2 emissions. This is a useful way of making comparisons among different industries and different sized businesses. But what worked well in low-inflation times is now proving far less useful.
“Fortunately, in the operating world, most companies with an announced [CO2] abatement plan are targeting cuts on absolute tons.
“This challenge is primarily for asset managers who need to track change across a portfolio and deal with practical problems such as how to factor in the contribution from a company without a reduction plan.”
Around 270 asset managers have committed to reducing GHG emissions by tracking carbon intensity as part of their membership of the Net Zero Asset Managers initiative.
Roc-Sennett suggested some possible alternative yardsticks against which to measure CO2 emissions. The volume of industrial units produced could be one, electricity production another and even hours worked by telephone operators. “Although intensity is not then compatible [correct] within industries, the rate of change is,” he added.
“If investors are using revenue-backed carbon intensity as their central tracking metric, then inflation needs to be addressed.”
Reality is more complex
Nor is inflation the only challenge facing investors looking to reduce carbon levels in their equity portfolios. At least three other potential pitfalls confront them, according to independent investment consultancy bfinance.
The first is what it calls the “restricted manager universe”, adding: “Not all active equity managers are willing to deliver carbon reduction targets.
“While it should theoretically be possible to create a portfolio with a lower carbon footprint in almost any type of strategy, the reality is more complex. In practice, an overly strict target can constrain the potential universe of equity strategies available to investors.”
Bfinance’s second potential pitfall is referred to as “sub-optimal or unintended investment consequences”. It said: “Depending on an equity manager’s style and approach, a strict target may limit an equity manager’s ability to execute their strategy as intended.”
The consultancy noted that efforts to reduce portfolio emissions can lead to increased concentration risk, pointing also to unpredictable performance outcomes. It contrasted the negative performance against benchmarks resulting from divestment from fossil fuel firms with the positive relative returns achieved by funds not exposed to the sector in Q1 2020.
How to exercise greater positive influence
A third possible pitfall is described as “undermining climate objectives”. Bfinance explained: “A low carbon footprint today is typically achieved by severely reducing or eliminating exposure to the ‘worst’ emitters, However, these high emitters are often the firms that have the greatest scope for impact.
“They may be important to new, climate-friendly technologies – as is the case for chip manufacturer TSMC – or they may have huge potential for reducing direct emissions, as exemplified by Danish multi-national power company Orsted.”
As such, bfinance flagged the benefits of engagement strategies by investors, which allow them to “exercise greater positive influence than they would achieve by simply avoiding these companies”.