Where do Emissions Fit into Socially Responsible Investing?

Investors focused on ESG (Environmental, Social and Governance) opportunities often question the suitability of the emerging carbons markets. ESG investment policies typically screen traditional equities and bonds for opportunities. How can a commodity-like instrument, like a carbon credit, fit into this investment framework?

Carbon credits do behave more like commodities than stocks or bonds. They are, indeed, commodity securities. However, it is important to note these instruments have direct environmental impact through:

(1) Securitizing global “clean” development projects;

(2) Re-directing capital away from polluting activities to environmentally sustainable products and processes.

Carbon credits represent an investment in the Environmental component of ESG, and should be included in any well-diversified portfolio in order to take advantage of its growth opportunities.

The Evolution from SRI to ESG and Measurability

Socially Responsible Investing (SRI) increasingly focuses on environmental stewardship and Sustainable Investing (SI). The progression from SRI to SI has been underscored by the transition from purely negative screening to positive screens that combine environmental, social and corporate governance parameters. In addition to SRI screens, typical SI screens include:

Negative Screening (SRI Screen): Companies are excluded from portfolios because they are in certain industries, such as mining or tobacco, or because they have poor track records on sustainability issues.

Best-In-Class (BIC) Rankings: Companies in each industry are ranked on sustainability criteria and portfolios are based on relative sustainability performance. Sustainability Leaders Only: Companies are considered only if they show a high level of commitment to work toward a sustainable future.

Pioneers Only: These companies are in problem-tackling industries like alternative energy and organic food.

As investors have come to understand the gravity of the environmental challenges we face globally, SI has been adopted by large plan sponsors. These institutional investors have redefined their investment selection processes to incorporate environmental, social and governance factors. Many SRI portfolios look very similar to non-SRI portfolios, only with a smaller set of securities following a negative screening. Investors using ESG concepts assume that the resulting investment opportunities should, by definition, lead to greater efficiency and therefore higher financial returns.

How Is Emissions Investing Related to ESG Investing?

ESG Investing is focused on three areas: the environment; the social impact of business activities and good corporate governance.

Environmental: criteria include climate change impacts, pollution, energy and water/natural resource management. Generally speaking, the focus is on using fewer natural resources for a given activity and then trying to reuse or recycle to minimize environmental impacts along the value chain throughout a given product’s lifecycle;

Social: criteria include working conditions, labor relations, fair wages, community impact and use of child labor among other things;

Governance: criterion include shareholder rights, board structure, accounting quality, executive compensation and resource stewardship, ranging from natural to human resources.

The evolution from SRI to ESG by institutional investors has enhanced the nature and scope of investment criteria. Simply put, investors follow the same process as before with a simple addition:

1. Find the best investment opportunities;

2. Identify those that have strategic advantages, above average return potential, strong management teams, strong financial position, and favorable valuation levels;

3. Specifically identify those that have innovative and progressive approaches to ESG issues, and allocate to them.

Institutional investors readily accept and understand the principles underlying the Social and Governance aspects of ESG investing, but are often troubled by the implementation of the environmental part. Terms like ‘green’, ‘clean’, ‘climate change’, and others raise different ideas in different people’s minds. Additionally, given that capping emissions from CO2 seems to be the focus of much of the environmentally targeted legislation being debated and implemented globally, the question often arises – what does carbon have to do with ESG Investing? Another question that arises is – given a cap-and-trade system where carbon can be traded, isn’t investing in carbon simply an investment in a commodity? This question is best answered by the example in Box 1: ‘Emission Reduction Investment as ESG’.

This example is not unique. There are hundreds of similar opportunities throughout North America and the rest of the world. These listed companies and/or private projects range from those involved in building alternative energy production capacity to those that reduce waste and promote energy efficiency, all carried out to capture growth opportunities provided by current or anticipated environmental regulation. The carbon credit, a traded commodity, is the representation of a net environmental ‘good’ that can be used to offset ‘bad’ environmental activities. Simply put, it is a way to measure and value environmental activities that have a positive impact. This valuation becomes more accurate as the $120 billion dollar global carbon market continues to increase in volume and liquidity.

Incorporating Emissions into an ESG Investment Framework

ESG investment frameworks focus on traditional equity portfolio construction, i.e. the tried and true methods of sector and style selection to optimize allocations. Social and governance issues are generally accepted by most investors, while environmental issues are tougher to integrate into the investment selection process. Environmental criteria can be addressed by following the same structured approach to investment identification and selection as used with governance and social issues. Take climate change. A prudent investor may ask “What current activities are specifically aimed at reducing greenhouse gas emissions? Are these activities specific, measurable, and enforceable?” Ultimately all products and business processes are connected in some way to energy, which itself is directly connected to the global market for controlling and reducing greenhouse gases. It is a market created by international treaty, with national enforceable policies, where gases are measured, users are evaluated, and reporting is transparent.

Moving backward through the supply chain there are international regulatory institutions responsible for enforcing legal standards, then operating firms which implement business policies. These policies incorporate various technologies that service a multitude of markets for products ranging from consumer products to electricity generation. The overriding consideration of this complex process is the destruction of harmful greenhouse gases, a real world representation of a cleaner global environment, and the basis for most environmental regulation.

How does this structured approach to evaluation of environmental criteria work in practice one might ask?

Take the example in Box 1: the listed company’s management invested in geothermal power generation. There are companies in the clean technology sector that manufacture geothermal energy production equipment or the meters and monitoring equipment required to measure the electricity production and maximize process efficiency. There are companies in the water sector that manufacture the flow control and measurement systems that move the water from the hot springs through the production system. Finally, there are carbon credit markets where the resulting offsets can be sold. These offsets are the verifiable, quantifiable units of measure or ‘environmental currency’ that captures the net positive effect of the activity of producing renewable energy from a geothermal source.

FIS Group has invested a significant amount of time and resources developing an environmental investment strategy that follows this systematic approach to selecting investments that adhere to environmental criteria. Because the opportunities are intrinsically beneficial, in most cases they address social and governance issues as well. FIS Group’s integrated approach to investing would suggest not only an investment in alternative energy companies, but also its suppliers that use environmentally sustainable activities and produce products that support sustainability. Opportunities like these are best accessed through the skill of specialist fund managers combined in an integrated, well-diversified portfolio. There are a number funds that address many of the investment opportunities available to investors, including:

• Financial products that facilitate climate change management

• Users of emissions trading systems

• Producers who lower carbon fuel use and promote renewable

• Producers of climate risk measurement systems in business decisions, financial analysis and investment valuation

• Companies that have climate change reduction targets through conservation and energy efficiency

• Companies that aim to develop renewable energy technologies, and greenhouse gas capture and storage.

These represent a small sample of the opportunities available to investors. The critical thing for institutional investors interested in ESG to understand is that the opportunities exist across all industries/sectors. Fundamentally, emissions or ‘carbon credits’ are the universal ‘environmental currency’. They reflect the value created by many of these opportunities, due to energy’s primacy to all business activity. FIS Group has the capabilities and products to help institutional investors access these opportunities within their given risk tolerances using a strategy that provides diversified exposure to emission, water and clean technology investment opportunities across sectors, along all levels of the economy’s value chain.

Roger Kenyon Senior Vice President and Portfolio Manager FIS Group, Philadelphia, PA Web www.fisgroup.com