Image of wind turbines on wind farm.
Image of wind turbines on wind farm.

A new approach to reduced-carbon portfolios

Interest in reduced-carbon portfolios has surged in recent years, as environmental, social and governance (ESG) investing picks up steam industry-wide. At Russell Investments, we’ve seen interest levels rise in pretty much every part of the world in just the past two years. This has led to an evolution in the strategies behind reduced-carbon portfolio management as new data becomes available and investing approaches become more sophisticated.

Problems with the basics

When looking to reduce carbon exposure within a portfolio, individuals often divest from companies that hold fossil fuel reserves or aim for a low carbon footprint. While both approaches are common, we believe they aren’t as effective as they could be—in fact, either one may lead to unintuitive outcomes. One such unintuitive outcome was our finding that reducing exposure to high carbon emitters can also lead to cutting out exposure to renewable energy1. One may also be surprised to learn that a low-carbon portfolio may not come with a higher ESG profile compared to the portfolio’s benchmark.

In the case of reduced exposure to renewable energy, our research2 has found that companies currently involved in energy production are positioned to invest in renewable energy programs, and are strongly incentivized to do so. But because energy production is among the most carbon-intensive activities, these types of companies are frequent targets for underweighting in a standard decarbonization approach. Given that a transition to a lower carbon economy will necessitate shifting to less carbon-intensive forms of energy, we feel this standard approach ignores opportunities and instead focuses only on excluding the negatives.

Examining the ESG profile of reduced-carbon funds is also illuminating. Many individuals interested in low-carbon investing also have broader ESG objectives. Our research has found that the standard approaches to carbon reduction did not have higher-than-benchmark ESG scores—in fact, in many cases the scores were lower.3 By not considering both criteria in one solution, dealing with carbon and broader ESG criteria separately was moving the portfolio in opposite directions. Again, our research suggests that given the goals are closely aligned, there may be a better way to tackle the issue.

What might a different investing approach entail?

By combining multiple sources of information, it is possible to take not only the risks of a transition to a low-carbon economy into account, but also the opportunities.  A multi-pronged portfolio management approach identifies a set of ways that may help individuals reach their reduced-carbon portfolio goals, such as:

  • Reduced exposure to fossil fuels and high carbon emitting companies
  • Increased exposure to renewable energy
  • Incorporation of ESG considerations beyond carbon emission reductions
  • Differentiating between fossil fuels to focus on the most carbon-intensive, such as coal

What’s down the road?

Decarbonization is a relatively new area for investors and one that will continue to develop and evolve. As data quality improves, and new concepts and challenges arise, we believe that these strategies will need to evolve and adapt accordingly. As part of this philosophy, Russell Investments maintains an active ESG research agenda and continues to seek out innovative ways to advance both our understanding of ESG investing and our solutions designed to tackle these issues.

 

1 Source: Research paper: Steinbarth, E. & Bennett, S. “Decarbonization 2.0: Russell Investments’ sustainable investing solution for the energy transition.” 

Source: Research paper: Steinbarth, E. & Bennett, S. “Decarbonization 2.0: Russell Investments’ sustainable investing solution for the energy transition.” 

3 Source: Research paper: Steinbarth, E. & Bennett, S. “Decarbonization 2.0: Russell Investments’ sustainable investing solution for the energy transition.”