Whether Canada chooses to adhere to its responsibilities to meet its climate change targets or not, investors in Canada have a lot to be concerned about, articulated by some as the carbon bubble. In recent research undertaken at the University of Waterloo, I explored the Canadian equity market through the lens of an investor who is interested in investing with particular strategies that address climate change.
Given that greenhouse gas emissions (equivalent carbon emissions) are directly linked to climate change, the ways in which an investor can mitigate their exposure to carbon-related risks and reallocate their capital to support a lower-carbon society was analyzed.
Research findings suggested that investors using either Modern Portfolio Theory or Behavioral Finance Theory should be concerned about the climate-change-related risks; the two theories’ contending paradigms are bridged on the topic of socially responsible investing (SRI) concerning carbon-related risks with respect to climate change. That is, investors of all types are starting to be concerned about this subject, whether it is from a stranded asset and regulation risk perspective or a moral/ethical perspective.
The two techniques utilized for portfolio construction were: tiered divestment of non-renewable energy sector and utilizing carbon footprinting metrics to create best-in-class portfolios. In the first technique, divested capital was reinvested in two ways: equally reinvested into the stocks already within the portfolio; and reinvested in the S&P/TSX Renewable Energy and Clean Technology Index. The carbon footprinting approach used two different investment strategies: companies’ equivalent carbon emissions/sales (carbon efficient/carbon intensive portfolios) and companies’ equivalent carbon emissions/total float market capitalization (low/high carbon portfolios). These investment strategies were back-tested throughout the period of January 2011 to August 2015. The benchmark universe was the S&P/TSX Composite.
Throughout the tested period, the resulting portfolios of the two strategies outperformed relative to their associated benchmark; that is, offering a superior risk/return while mitigating the risk associated to carbon emissions. The greater the energy sector divestment, the higher the Sharpe ratio, demonstrating that the energy sector performed poorly at all levels throughout the five-year period. Reinvesting into the green index drew down the outperformance of the divested portfolios, given the lower-than-benchmark returns. The carbon metrics did not increase return significantly, but did lower the associated carbon footprint of the portfolio dramatically.
The following points highlight additional results and conclusions:
*Portfolios free of fossil fuels received a higher Sharpe ratio compared to the S&P/TSX Composite Index over the period. Therefore, index investors who invested in ETFs that were fossil-fuel-free over this period would have received superior returns.
*Divesting away from the firms listed on the Carbon Underground 200 (the firms with the largest amount of fossil fuel reserves) resulted in returns increasing most dramatically relative to the number of stocks that were divested; the stocks on the Carbon Underground 200 performed the worst within the energy sector. It cannot be determined that these poor returns are due to stranded asset risk, but it is a relationship nonetheless.
*The change in oil price decreased dramatically throughout this period. This is an important concern when addressing how applicable this investment model is for future use. The decrease in oil price, dropping from around $100 to under $50 a barrel marked a rapid change in the commodity price, which affected the entire supply chain for oil. This investment model should be used alongside tracking the commodity price for oil.
*The systemic problems of the overall market are shown within the reinvestment potential. The opportunities for an investor to reallocate their capital to seize the opportunities of a low carbon society, investing in green companies, are limited and offer noncompetitive returns.
*The financial and nonrenewable energy sectors are heavily weighted in the overall equity market, and their linkages need to be analyzed further. Divesting from the energy sector and reinvesting into the financial sector does not mean one has cut their support to the nonrenewable energy sector. Some socially responsible indices heavily weigh the financial institutions, which is a misleading approach for sustainable investing.
These results contribute to the body of the literature that analyzes the link between socially responsible investing and financial performance. Additionally, it adds justification for investors of all types to invest in accordance with Canada’s climate change targets and suggests that SRI portfolios can outperform conventional portfolios. Non-financial criteria for investments are important to shape one’s investment philosophies, to avoid risks, and to support moral and ethical ideologies the recipients of the investment have.
Courtesy Fundata Canada Inc.© 2016.Chelsie Hunt is a Master’s student at the University of Waterloo specializing in SRI and impact investment research. This article is not intended as personalized advice. Securities mentioned are not guaranteed and carry risk of loss. No promise of performance is made or implied.