Low carbon or no carbon? The energy trade-off

Fossil fuels are widely blamed for climate change. Should we exclude companies that own fossil fuels entirely from socially responsible investments? This blog looks at the methodology employed in Nutmeg’s socially responsible portfolios and what this means for carbon exposure.

Since launching our socially responsible investing (SRI) portfolios at the end of November 2018, we’ve had an overwhelming response from customers. As of 30th June, we manage more than 6,250 socially responsible investment portfolios on behalf of clients in the UK¹.

One topic of interest since launch has been that of companies involved in the fossil fuels industry and what role they will play in investment portfolios in the future.

What is the approach to fossil fuels in Nutmeg’s socially responsible portfolios?

While Nutmeg’s SRI portfolios on average offer a significant reduction in carbon intensity when compared to their non-SRI equivalents, they do not exclude all companies with involvement in fossil fuels (see table below).

Nutmeg’s team of investment experts construct SRI portfolios using data and analytics from one of the world’s preeminent voices on environmental, social and governance (ESG) research, the financial data provider MSCI. ESG scores from MSCI take into account thousands of data points across 37 ESG ‘key issues’ focusing on the intersection between a company’s core business and the risks facing its industry².

These scores are constructed using both quantitative and qualitative research. Companies aren’t scored based on one aspect of their operations, but on their overall performance against ESG criteria. They are assessed relative to their industry peers, adjusting for the materiality of a risk within an industry. For example, carbon emissions and pollution are likely to be more relevant when assessing oil companies than technology stocks.

There are significant restrictions on companies with exposure to thermal coal in the portfolios, but companies that sit within the wider global energy sector are eligible for inclusion (as detailed in our white paper, all companies deriving 30% or more revenue, either reported or estimated, from the mining of thermal coal, including lignite, bituminous, anthracite and steam coal, and its sale to external parties, are excluded).

Why are SRI portfolios not zero carbon, and why are energy companies eligible?

The methodology employed in our SRI portfolios achieves two things: companies engaged in controversial activities are avoided, as outlined in our white paper, and those that have strong sustainability profiles relative to their sector peers are rewarded.

Both parts of this process are important. Companies are reliant on investor capital to operate. By taking away their access to capital, or by making that access more expensive relative to their peers, we can influence behaviour.

In industries such as fossil fuels, we think we can achieve better results by remaining an active stakeholder. We invest in companies that are making progress on ESG matters and withhold capital from those that aren’t.

The energy sector is a leading contributor to the world’s carbon emissions issues, but remains a key global economic sector, with energy businesses accounting for approximately 6% of global stock markets³.

It is also a sector undergoing significant transformation. The world is shifting to a lower carbon economy and, despite being criticised for the speed of their response, even oil majors such as BP acknowledge that renewable energy will be the world’s main power source within two decades⁴. In fact, this structural shift has forced major energy companies to become some of the largest investors in renewable and clean energy businesses and technology globally⁵.

However, with global demand for fossil fuels expected to be 40% higher in 2035 than in 2010⁶, it could remain difficult for these businesses to balance the need for investment in future energy sources with the demands of near-term competitiveness and corporate profitability.

Where do Nutmeg SRI portfolios stand on carbon and fossil fuels?

Nutmeg’s SRI portfolios offer on average 25% lower weighted average carbon intensity than equivalent portfolios without SRI screening¹. Carbon intensity is measured by calculating the scope 1 and scope 2 emissions for each security (normalised per million US dollars of sales)². Scope 1 emissions are direct emissions from owned or controlled sources and scope 2 emissions are indirectly produced from the generation of purchased energy.

We use this data to understand a portfolio’s potential exposure to climate change risks. We’re proud that our SRI portfolios offer such a significant reduction on average.

We can also measure the portfolio’s exposure to high carbon industries in a variety of other ways. The below table shows how Nutmeg’s socially responsible portfolios compare to our non-SRI equivalents across a range of metrics, including the percentage of companies within the portfolio that own fossil fuel reserves and natural gas reserves, and the percentage of companies within the portfolio that have been deemed to be facing severe environmental controversies.

While these portfolios can contain companies within the energy sector and fossil fuels supply chain, the above table demonstrates the significance of the reduction in fossil fuel related activities, such as ownership of reserves.

Take portfolio five, a medium-risk portfolio, as an example. In the SRI portfolio, 5% of the holdings own fossil fuels. In contrast, the non-SRI equivalent of portfolio five has 10.4% of holdings that own fossil fuels. In other words, the SRI portfolio’s exposure to holdings that own fossil fuels is 52.2% less than the non-SRI equivalent (see the third table, ‘difference in percentage holdings’).

There are similar reductions on the proportion of holdings that own natural gas reserves and “high impact” fossil fuel reserves (a distinct category that includes thermal coal, oil sands, shale oil and shale gas).

Across the board, SRI portfolios own no holdings that MSCI considers to be facing severe environmental controversies.

Involvement not withdrawal

We know it may seem counter-intuitive for a socially responsible portfolio to hold positions in companies that own fossil fuel assets, but we strongly believe that the best way to influence responsible behaviour is by holding overweight positions in companies that are taking progressive action on SRI metrics, and underweight positions in companies with poor SRI scores, rather than excluding whole sectors entirely. By investing in firms that are making progress with renewable energy, for instance, we can incentivise the remainder of the energy sector to make the same efforts.

Clearly, climate change poses grave risks to humanity as a whole. We think the constructive response to the challenge is adaptation. Fossil fuels will inevitably make up part of the global energy mix for some time yet – the task is to wean ourselves off these polluting fuels through greater investment in renewables, energy efficiency and pollution management. Our socially responsible portfolios aim to support these goals while providing a portfolio that is diversified across the global economy.

Sources

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.