Smart investors can build a net zero portfolio today, but you shouldn’t want them to. It won’t have a stellar risk-return profile, and it’s likely to only produce “paper” decarbonization rather than cutting real-world emissions.

By Ariel Fromer Babcock, CFA

Divestment and exclusion are approaches based on an organization’s principles, or those of their stakeholders (e.g., clients and beneficiaries), limiting investment in carbon-intensive assets or industries. As a result, it’s a strategy often supported by those who prefer to avoid carbon-intense assets. These stakeholders argue that divestment and exclusion raise the cost of capital for carbon-heavy activities, sends a market signal to companies engaged in those activities meant to inspire more rapid change, and ensures that the investor feels comfortable with the sources of its returns.

If the objective is to reduce carbon emissions on a broader scale, a principles-based approach won’t achieve that goal. Divestment emphasizes the importance of rapid portfolio decarbonization while exclusions keep carbon-intense or difficult-to-abate assets out.

Principles-based approaches such as these can leave meaningful risks unaccounted for and cause investors to miss out on powerful return opportunities. With regard to addressing climate risk specifically, divestment and exclusion on the basis of carbon emissions may be the most used portfolio-construction techniques at the moment, but they aren’t suitable long-term solutions.

Despite these perceived benefits, there are six (and possibly more) limitations to a divestment- or exclusion-based approach:

  1. By excluding assets from the investable universe based on their current carbon-footprint, investors cannot invest in companies or industries that are transitioning to a more sustainable business model, missing out on potential returns.1 As Carlyle CEO and FCLTGlobal board director Kewsong Lee noted, “We can’t invest in the energy transition if we stop investing in energy.”2
  2. The practice of exclusion often means that large segments of the economy are not represented in the portfolio, resulting in potential portfolio construction challenges that may introduce more risk into the remaining portfolio from sector concentration.3
  3. Exclusion leaves the investor with no seat at the table and little means of influencing change with transitioning assets.4 As Mark Carney has observed, “It’s the reason John Dillinger robbed banks, because that’s where the money is. We need to go where the emissions are…and in many cases it’s about investing with existing actors to support that transition.”5
  4. Divestment may simply transfer carbon-intense assets from one owner to another; the carbon may have been removed from the portfolio, but nothing has changed in the real economy.6
  5. Divestment and exclusion may raise a company’s cost of capital, but that results in a higher return to the remaining investors, perversely rewarding investors who are happy to hold more carbon-intense assets.7
  6. Transferring assets out of the portfolio also commonly removes them from the public markets sphere and puts them into private hands, reducing transparency and monitoring efforts.8

Taking a principles-based approach to decarbonization may be satisfying in the near-term, but true investment in the sustainable transition – allocating capital to catalyze development of new technologies and industries while providing scale capital to remake the economy for a resilient future – is far more satisfying – and rewarding, in the long term.

To understand how long-term investors remain invested in the sustainable transition while pursuing decarbonization goals, read our report here.

 

1. Laura Sanicola. “Oil Prices Rise to Three-Year High on Back of Supply Deficit Forecasts.” Reuters. October 15, 2021. www.reuters.com/business/energy/oil-prices-rise-tight-supply-set-weekly-gain-more-than-2-2021-10-15/;

David Blitz and Laurens Swinkels. “Does Excluding Sin Stocks Cost Performance?” June 25, 2021. https://ssrn.com/abstract=3839065.

2. https://fortune.com/2022/02/10/we-cant-invest-in-the-energy-transition-if-we-stop-investing-in-energy-climate-net-zero-kewsong-lee/

3. Tamas Barko, Marijn Cremers, and Luc Renneboog. “Shareholder Engagement on Environmental, Social, and Governance Performance.” Journal of Impact and ESG Investing. July 2021. https://jesg.pm-research.com/content/early/2021/08/20/jesg.2021.1.028.

4. Eleaonora Broccardo, Oliver Hart, and Luigi Zingales. Exit vs. Voice. National Bureau of Economic Research Working Paper 27710. Cambridge, MA: NBER, August 2020. https://www.nber.org/papers/w27710.

5. Going Long podcast

6. David Carlin. “The Case for Fossil Fuel Engagement.” Forbes. March 2, 2021. https://www.forbes.com/sites/davidcarlin/2021/03/02/the-case-for-fossil-fuel-engagement/?sh=5568a624d726;

Jonathan Berk and J. Binsbergen. “The Impact of Impact Investing.” Stanford University Graduate School of Business Research Paper. November 5, 2021. https:// papers.ssrn.com/sol3/papers.cfm?abstract_id=3909166.

7. Belinda Gan. Divestment—Does it Drive Real Change? New York: Schroder Investment Management North America, July 2019. https://www.schroders.com/getfunddocument/?oid=1.9.3338808.

8. Hiroko Tabuchi. “Private Equity Funds, Sensing Profit in Tumult, Are Propping Up Oil.” New York Times. October 13, 2021. https://www.nytimes.com/2021/10/13/climate/private-equity-funds-oil-gas-fossil-fuels.html.

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