Greenhouse gas is the newest metric in portfolio allocation.

The hardest investor questions are those you don’t have the answers to, especially when it could be the difference between an allocation or a “we’ll keep you on the watchlist.”

Historically, fund managers have never considered carbon emissions as an essential metric. However, as asset owners move towards low-carbon portfolios, each investment’s carbon contribution matters.

Consider this, one third of global banking and the world’s largest asset owners, both groups responsible for trillions of investable capital are moving to low-carbon investment portfolios. For these investors, every investment’s carbon emissions contribute to their portfolio impacts their climate strategy centered around carbon emissions.

Does this mean that fund managers need to build zero carbon portfolios to raise assets? Absolutely not, it only means that carbon emissions have become a crucial metric being considered in the asset allocation matrix, and its relevance is only going to increase in the future.

For example, assume a pension fund has $100 million to allocate and is considering three identical fund managers. Further, assume the pension fund has committed to lowering its carbon footprint by 50% over the next 10 years. Table 1 shows the three funds being considered for an allocation. All things remaining equal, Fund B wins the allocation since it contributes the least amount of carbon to the pension fund’s portfolio. Fund C would be passed over since the unknown of its carbon footprint makes it too risky of an allocation.

Table 1 – Carbon Contribution
AUM
(in millions)
Carbon
Footprint
(CO2 MT)
Carbon
Contribution
(per $million)
Fund A
$5,600
400,000
71.43MT
Fund B
$2,300
80,000
34.78MT *
Fund C
$10,400
unknown
unknown
* contributes 34.78MT of ghg per million invested

Fund managers seeking institutional money are well advised to consider carbon when selecting their own portfolio investments. For instance, if you’re considering between two similar investments, consider favoring the one with the lower carbon impact. Or at least be aware how much carbon an investment adds to your portfolio, and how this may impact the carbon targets of asset owners.

How to calculate portfolio carbon emissions?

There are three levels of emissions, scope 1, scope 2 and scope 3. Most firms combine scope 1 & 2 emissions for reporting and forgo reporting on scope 3. Calculating scope 1& 2 emissions for small and medium size enterprises is straightforward and can usually be accomplished in a day or two. Unlike scope 3, which may take a team of consultants months to calculate for a single company.

Scope 1 – emissions generated on or by company property (i.e. natural gas, diesel, coal, company owned vehicles, etc.).

Scope 2 – indirect emissions related to company operations (i.e. purchased electricity).

Scope 3 – emissions from all downstream & upstream activities not included above.

The scope 1 and 2 emissions calculations are as follows:

Step One

Determine scope 1 and 2 fuel consumption over the past year and multiply by the relevant emissions factors.

Step Two

Multiply step one results by your ownership percentage in company.

Evaluate results based the investment’s carbon contribution to the portfolio vs the investments projected IRR. Investments with high carbon emissions and average IRR might not be the most desirable investments.

Conclusion

Institutional investors are increasingly considering carbon emissions when making investment allocations. These institutions are looking to minimize each investment’s carbon contribution to their portfolio while at the same time maintaining superior returns. Fund managers who measure and actively manage their portfolio’s carbon emissions will have a superior offering for these institutional investors, especially when they can show superior carbon efficiency.

For more information on this topic or how ESG Administration can help you calculate your own portfolio emissions contact ESGA at joe.holman@esgadmin.com.