For many asset owners, decarbonizing their investment portfolio has become a key policy objective supported by internal stakeholders. Debate persists, however, about how to most effectively do this. While exclusions may seem like the simplest solution, all divestment policies have tradeoffs.
1. Real-world impact is unclear
- While fossil fuel exclusions can rapidly reduce a portfolio’s carbon footprint, their effect on real-world economic decarbonization takes much longer. High-emitting assets may continue to operate long after an asset owner exits a position. And, as more emissions-focused shareholders divest, company management teams may feel less pressure to decarbonize.
- Emerging markets (EMs), which are significant fossil-fuel producers and consumers, typically have fewer transition resources. Limiting capital flows to EM-domiciled assets may drive up costs of capital, making it even harder for EMs to participate in the low-carbon transition.
2. Data can be problematic
Data informing exclusion policies generally reflect point-in-time disclosures that may not represent a company’s evolution or its intention to reduce carbon emissions. Third-party data based on estimates may also fail to capture the full range of business activity — and emissions. Relying on these data sets can result in exposure to an issuer that engages in activities the asset owner aims to exclude.
3. Exclusions may penalize companies assisting the energy transition
- Natural gas companies, for example, are often netted in fossil-fuel exclusion polices yet produce lower emissions than from oil or coal (provided methane leaks and flaring are minimized). Reducing exposure over time may still be appropriate, but investors should acknowledge natural gas’s contribution to the transition in the near term.
- Some oil sands companies may be well positioned to lead on carbon-capture use and storage (CCUS) technologies. While questions about scalable infrastructure remain, we believe innovation in this sector is critical to facilitate to a lower-carbon economy and could generate positive investment returns.
4. Definitions can have unintended consequences
Asset owners should mind how exclusions are worded. Narrowly defined exclusions tend to be less disruptive to the opportunity set but can miss significant emissions drivers. Broader divestment policies tend to capture more real-world emissions but can materially shrink the eligible investment universe.
- Revenue-based exclusions may be heavily influenced by commodity prices and may not accurately represent stranded-asset risk. The number and market value of restricted stocks tends to be small.
- Production-based exclusions only target direct Scope 1 emissions; they fail to capture Scope 3, which can be much larger. Railways that transport coal, for example, would be eligible for inclusion. The number and market value of restricted stocks tends to be small.
- Electricity-based exclusions target Scope 2 emissions. These point-in-time snapshots may not reflect an issuer’s emissions improvement. Many electric grids are transitioning to renewable energy sources, which will significantly improve their future emissions profile. These exclusions often affect EM exposure more than developed market (DM) exposure, as EM-based companies tend to rely more on coal. The number and market value of restricted stocks can be small.
- Weighted-average carbon intensity (WACI) constraints embed market cyclicality (carbon intensity is often measured per unit of revenue). They also fail to capture Scope 3. WACI-based constraints can result in the exclusion of stocks across utilities, materials, energy, and industrials. In aggregate, these issuers represent approximately 20% of the MSCI All Country World Index (ACWI) and over 80% of the index’s total WACI.
- Financed-emissions-based constraints can be skewed by corporate actions (financed emissions are measured per unit of enterprise value) and do not yet include Scope 3. Like WACI, financed-emissions constraints can affect a broad range of stocks.
- Science-based-target (SBT) constraints, unlike aforementioned exclusions, are forward-looking and do capture Scope 3 emissions, provided Scope 3 are greater than 40% of total emissions. Strictly interpreted however, these constraints could significantly limit the investment universe: approximately 36% of companies in the ACWI have set (or committed to set) SBTs. Expansion of this opportunity set is unlikely until the Science-Based Target initiative (SBTi) publishes emissions-reduction pathways for all sectors, including oil and gas.
Implementation options for asset owners
- If exclusions are desired, asset owners could consider a phased approach: Start with a few narrowly defined exclusions to ensure stakeholders are comfortable with potential tradeoffs, and consider expanding policies over time as company disclosure and data quality improve.
- To support a just transition, consider applying different thresholds and timelines for EM and DM exposures, as companies operating in EMs may need more time and resources.
- Establish a policy for exceptions and assign a committee to ensure transition plans are accounted for in exclusion lists or constraints.
- Use engagement, paired with a robust escalation policy, as an alternative to exclusions. Engagement allows companies to act on shareholder feedback to develop and execute on decarbonization plans.