This site is directed at UK Institutional/Professional Investors only. It is provided for information purposes only and should not be construed as investment advice nor a recommendation to buy/sell any products nor as an offer or solicitation to engage in any investment activity.

The role of Carbon in the Evolution of ESG Investing – Chapter 3

The Evolution of Climate Investing

As detailed in our previous chapters, there is no doubt that the highest profile issue from a sustainability perspective is Climate Change. Around the world, the questions being asked have moved on from whether Climate Change is real (and if so whether it is man-made) to what the impact will be and how governments and societies all around the world should act to mitigate it.

A look back through investment history shows that most new investment concepts are implemented first by the largest Asset Owners, before becoming mainstream and entering retail portfolios. Examples of this over recent decades include Emerging Markets, Small Cap, High Yield and Diversified Growth sectors, all of which are now fundamental parts of portfolio design for all channels. There is no doubt that the #1 issue for those Asset Owners today is ESG, and Climate Change in particular. In this case, that is coupled with a massive push from all levels of society, from government policy such as the Paris Agreement to children taking days off school all over the world to protest about the lack of progress so far. In addition, extreme weather events are clearly occurring more frequently, and increase the visibility of the Climate issue for end investors. This pressure is likely to mean that the pace of adoption is higher than we have seen with new investment concepts in the past, and will transmit quickly from large Asset Owner portfolios to portfolios designed for individual investors. This section will look at what has been done to date, and how those solutions are evolving as climate change criteria becomes embedded in investment portfolios of all kinds.

History of Low Carbon Adoption

Some of the first large allocations into ESG investing in Europe were into low-carbon products, particularly in indexed products and mandates. Index Provider MSCI launched a series of Low Carbon indices as long ago as September 20141, with backing from leading European Asset Owners AP4 (one of the Swedish National Pension funds) and FRR in France, with Amundi licensed to launch public product in both ETF and fund form.

These strategies were also successful in the UK, with adoption being led by the Local Authority sector. In September 2015, the Environment Agency invested its entire global passive equity portfolio into a fund managed by LGIM that tracked the Low Carbon Target index2, with half a dozen more Local Authorities investing over the next couple of years. One key dimension to these solutions was that they were not simply exclusion-based but aimed at a risk-controlled reduction in exposure to carbon, measured as both fossil fuel reserves and carbon intensity (which is defined as emissions relative to sales). This allows investors to maintain access to industry sectors including Oil & Gas, with a very small target tracking error of 30bps relative to the market cap parent whilst still delivering 50-80% reductions in carbon exposure.

The appeal of a strategy like this is obvious – it can produce a material decrease in carbon exposure in return for a very small investment bet, but it only addresses one aspect of climate change – historic carbon reserves and emissions.

Table 2. Case Study – Selected LGIM Product launches

Case Study – Selected LGIM Product launches

Moving on from Low Carbon

Reducing the carbon exposure of a portfolio without significantly reducing diversification is relatively straightforward, and can also be argued to be addressing two key investment risks associated with high carbon profile stocks. The first of these is so-called ‘stranded assets’ – the risk that not all carbon reserves currently held by companies will ever be able to be profitably extracted as public carbon policy changes in the coming years and decades. This is not just a potential risk to consider for future revenue streams, but is already impacting companies today. A good example can be seen in the declining fortunes of the US coal industry, which were a major issue in the run-up to the 2016 presidential election with the country’s largest, second largest and fourth largest private coal producers all going bankrupt in 2015-16. Despite President Trump’s focus on the issue this continued throughout his term, with further waves of bankruptcies in 2019 culminating in the bankruptcy of the largest remaining private producer, Murray Energy, in October of that year. This was not caused by supply issues but by a sustained reduction in demand for thermal coal, as countries and investors move towards cleaner sources of fuel. The second risk is that companies with higher carbon intensity will be more exposed to carbon pricing in future, as the coverage of emissions markets grows, the cost of emissions will rise.

However, as investor knowledge and the tools available in ESG investing have become more sophisticated, there has been pressure to move beyond simply reducing carbon exposure to address climate change more broadly in portfolios. Most obviously, this was reflected in the Paris Agreement of December 2015, when countries committed to keeping the impact of global warming below 2 degrees Celsius above the pre-industrial age average. In order to achieve this, a transition to a low carbon economy will need to be managed over the coming decades. This will require society to go beyond simply divesting in thermal coal stocks or investing in alternative energy, and impact the valuation of every company regardless of the industry they operate in.

So, what are the broader risks that are not being considered by the historic low carbon approaches? The first obvious one is that simply excluding or underweighting stocks with high carbon profiles ignores the other end of the spectrum – companies that are having a positive impact on carbon emissions. These can include a range of companies in differing industries, from those investing in renewable energy to battery powered cars, from Carbon Capture and Storage (CCS) technologies to reforestation efforts. Using our LGIM example, this was the first evolution with the highly publicised Future World product developed with HSBC and FTSE4, which added increased weighting in green companies to existing low carbon approaches.

A second major issue is that existing methodologies are mainly focused on Scope 1 and Scope 2 emissions (see inset). This is understandable due to the difficulties in measuring Scope 3 emissions,  but does not accurately capture the true carbon footprint of a company and its products or services, as it ignores key issues such as product disposal, logistics and employee travel. Properly assessing the full carbon footprint of a business is essential for accurately assessing the risk that future carbon policies pose to that enterprise.

Fig.1 US Environment Protection Agency Illustration of Scope 1, 2 and 3 emissions

US Environment Protection Agency Illustration of Scope 1, 2 and 3 emissions

Thirdly, carbon reserves and carbon intensity are both backward looking measures. They are accurate at a point in time, but do not take into the account how that might change in the future. Energy companies may change their mix by diversifying into renewables. Conglomerates may divest or reduce the investment in certain business lines and increase their exposure to others, and increasingly all companies are publicising their plans to reduce their carbon footprint over time. This is the fourth major risk that needs to be considered – risks from global warming and climate change are not limited to economic risks faced by firms with high emissions. A company with ultra-modern factories with a low carbon footprint are still exposed to the risks of climate change if they are all built on flood plains that could be submerged if water levels continue to rise. These physical risks – such as exposure to extreme weather events, water shortages, or rising sea levels – are not yet incorporated into most climate investment solutions, but with data availability improving all the time there is more opportunity for managers to reflect this in their portfolios going forward.

Judging how to reflect these changes to properly capture climate risks and reflect these inputs into a portfolio is the biggest challenge yet, far more complicated than a low carbon portfolio, but with more potential to improve investor outcomes both in terms of ESG profile and potentially, risk and return.

EU Climate Benchmarks - Building a Modern Climate Solution

The next stage in the evolution of product design was to address the forward-looking element and start considering how a company’s research and development, strategy and existing risks will impact their carbon footprint and exposure to carbon regulation over time. The development of carbon transition scores meant that all companies were considered for the first time, rather than simply excluding the dirtiest or overweighting the cleanest. This was a step forward in creating longer term value from an investment perspective, and relies upon company-level, bottom-up research to create value. Simply relying on survey answers is unlikely to identify the companies best or worst placed to handle a low carbon transition scenario that looks increasingly inevitable.

This was built on further with the publication of the EU’s Technical Expert Group on Sustainable Finance (“TEG”) report on Climate Benchmarks and Benchmark ESG exposures that was finalised in July 20205. The report led to the creation of a number of benchmarks by major index providers including MSCI, S&P, Solactive and FTSE to align to two different standards; the EU Climate Transition Benchmarks (“CTB”) and Paris-Aligned Benchmarks (“PAB”). The aims of both benchmarks were set out by the TEG as follows:

  • to allow a significant level of comparability of climate benchmarks methodologies,
  • to provide investors with an appropriate tool that is aligned with their investment strategy,
  • to increase transparency on investors’ impact, specifically with regard to climate change and the energy transition, and:
  • to mitigate risk of greenwashing by defining common language amongst benchmark administrators and investors.

In addition, the TEG saw four main purposes for the indices:

  • as underlyings for passive investment strategies,
  • as Investment Performance Benchmarks for emission related strategies,
  • as engagement tools and:
  • as a policy benchmark to help guide Strategic Asset Allocation.

The two indices aim to provide a set of criteria for a material reduction in carbon intensity over and above the parent benchmark, and align the portfolio with the measures required to limit global temperature increases to 1.5% degrees above the pre-industrial average, as envisaged in the Paris Agreement.

Table 3. EU Climate Transition and Paris-Aligned Benchmark criteria

EU Climate Transition and Paris-Aligned Benchmark criteria

Obviously the more stringent targets in the PAB benchmarks will cause more tracking error when compared to existing benchmarks, so the use cases for the two benchmark systems are likely to differ. The TEG envisaged that the CTB would provide the benchmark for core allocations from institutional investors. The PAB would be a much more ambitious benchmark for aggressive carbon strategies, and designed for investors who want to be at the cutting edge of decarbonising investment portfolios.

The aims of these indices are laudable, but despite being available for a number of years now they are yet to be really broadly adopted. One reason for this might be the difficulty in meeting the criteria; the world is not currently decarbonising quickly enough, making it very hard to meet the targets of the index whilst maintaining the exposures to high polluting sectors that the indices require. The EU Emissions Trading System (“ETS”) is the main policy tool of the EU to deliver its legally binding target to reduce emissions by 55% from 1990 levels by 2030 and ultimately to deliver net zero by 2050. This covers many of the highest polluting activities, including power generation, heavy industry, chemicals and some transport and agriculture. This currently reduces the supply of allowances or “permits to pollute” by a little over 2% p.a., so it can be argued to be unrealistic to expect portfolio managers to maintain exposure to these sectors while delivering 7% p.a. reductions in their financed emissions. The market has been crying out for innovative approaches that help manage the transition to this low carbon future.

The role of Carbon Allowances in Accelerating Decarbonisation

Most of the world’s biggest investors are committed to being net zero by some point in the future, most commonly either 2050 or 2045. A number have public commitments to transition activity with shorter term goals as well, for instance under the 2025 Inaugural Target Setting Protocol, 30 members of the UN-convened Net-Zero Asset Owner Alliance have published first interim targets to hit by 2025. But what is clear is that many investors don’t know how to bridge the gap between those future aspirations and today’s portfolios. If the emissions of major polluters are not coming down fast enough, how can an investor deploy capital today to accelerate decarbonisation? Investing directly in carbon-removal projects is the preferred approach of many major asset owners, but the simple fact is that there are not enough of these opportunities available today to deploy even a fraction of the capital those groups have and want to use to drive change.

One option is to invest in allowances from regulated carbon markets. In these systems governments issue allowances, sometimes known as permits to pollute, and the companies covered by the system must surrender one allowance for every tonne of CO2 that they emit. The largest and most liquid of these markets is the EU Emissions Trading System.  Allowances from this system are recognised as financial instruments under MIFID, and products that give investors access to this market are available across Europe.  A full guide as to how these markets operate can be found here.

Crucially, investors withholding allowances from the EU ETS creates environmental impact during your holding period, meaning that the allowance can still be sold later. This is in sharp contrast to the voluntary carbon credit market, where as soon as you utilise the environmental benefit of the credit its value becomes zero, meaning investing in voluntary markets is a trade-off between impact and financial returns. It also allows investors to use carbon allowances as an overlay to improve the carbon footprint of a portfolio, as a recent Whitepaper from Solactive “A Stitch in Time Saves Nine – EU Emission Allowances as a Transitory Tool for Net Zero Equity Portfolios”6 explained.

Investing in Carbon Allowances brings three major benefits:

Investment Returns – as the supply of allowances is reduced in line with the EU’s Paris Agreement goals, scarcity increases and prices are forecast to rise. A recent study estimates the current global average regulated carbon price to be a little over $5 a tonne7, but the World Bank forecast that this needs to reach $75 a tonne by 2030 to be on track for Paris agreement goals. Carbon allowances are also a diversifying asset, as correlations are relatively low relative to other major asset classes including Equities, Fixed income, Oil, Gold and Real Estate.

Hedge Carbon Risks – broad portfolios are negatively correlated with rising carbon prices, as those rising prices are costs that companies cannot pass on in full to their clients or consumers. An article in the FT last year forecast that if the World Bank global average figure of $75 a tonne by 2030 was reached, this could reduce equity markets by 20%8. Holding Carbon will hedge that exposure, and SparkChange has proprietary tools to help investors to calculate that exposure.

Generate Impact – withholding allowances from the market generates benefits from both the temporary delay to emissions (a polluter cannot utilise an allowance while it is held in the SparkChange EUA ETC) but also directly affect future supply of allowances, creating a measurable and permanent reductions in emissions. This is due to a mechanism in the ETS called the Market Stability Reserve, and the impact has been calculated by academic studies from the LSE and ICIS.

Investing in Carbon Markets can play a vital role in getting the world back on track to meet its climate change commitments.

Fig.2 Rationale for accelerating decarbonisation

Rationale for accelerating decarbonisation

As the graphic above shows, withholding allowances can create a much more realistic pathway, meaning less CO2 in the atmosphere between now and 2050, a recognition that gross emissions will not reach zero by 2050, and most importantly by accelerating the adoption of new abatement technologies that will allow decarbonisation to increase in pace. As investors delay emissions and constrain supply, prices rise and more new technologies are brought into play as economically viable alternatives to existing emissions. For example, for a steelmaker to significantly decarbonise they need to invest in a green steel plant, but they will only do this if they believe the price of emissions is high enough both now and also in the future to justify that capital expenditure. It is for this reason that the EU has repeatedly welcomed financial investors into the scheme, to provide that steady price signal that will incentivise the major investments needed to create a low carbon transition economy.

This example highlights the crucial role of carbon markets in driving change and the impact financial investors can have in accelerating progress. Critically, this impact aligns with the goals of investors whether they adopt a screening or engagement approach. For screeners, it provides a way to influence the behaviour of the biggest polluters even though you do not hold their stock. For engagement approaches, it provides a clear signal to companies in high impact sectors that the winners will be the ones who act to decarbonise fastest, and therefore are less exposed to rising carbon prices over time.

To find out more about how you can get exposure to Carbon Allowances, please contact our Sales Team via the Contact Us page


ESG Investing remains a complex topic, and not everyone will agree on how it should be integrated into investment strategies. For Asset Owners, it is about striking the right balance between reflecting the values of their underlying stakeholders whilst safeguarding their interests from a fiduciary perspective. For Asset and Wealth Managers, it is about building a coherent range of solutions that are appropriate to the client types and geographies that they wish to target. ESG is a threat to those who do not properly address it, but an opportunity for differentiation for those that do. This means not being able to satisfy all of the people all of the time. There are merits to a screening or engagement approach for instance, but it is difficult to do both.

One area where investor appetite is clear is Climate Change, and all investment strategies will increasingly be required to take a view on how to integrate it. To have a chance of achieving the net zero goals enshrined in the Paris Agreement the world needs to utilise all the tools at its disposal. This will include voluntary carbon markets and carbon removal technologies, but also regulated carbon markets. Carbon allowances from regulated markets such as the EU ETS should be part of every investor’s strategic asset allocation thinking. This will allow them to access the returns from a diversifying asset as the cost of emissions to polluters continues to rise as Emissions Allowances become increasingly scarce. It will also address the financial risks from rising carbon prices embedded in their existing portfolios, as broad equity and fixed income portfolios are negatively correlated with rising carbon prices. Crucially, holding carbon allowances will also generate much needed impact to help the world tackle the biggest challenge of our lifetimes, by accelerating decarbonisation to help fight Climate Change.

Spark Change Group Limited (FRN 944451) is an Appointed Representative of Kroll Securities Ltd. (FRN 466588) which is authorised and regulated by the Financial Conduct Authority.

Communication Disclaimers

This communication has been provided to you for informational purposes only.

This communication is not intended to constitute, and should not be construed as, investment advice, financial promotion, investment recommendations or investment research.

This communication is not intended as and is not to be taken as an offer or solicitation with respect to the purchase or sale of any security or interest, nor does it constitute an offer or solicitation in any jurisdiction, including those in which such an offer or solicitation is not authorised or to any person to whom it is unlawful to make such a solicitation or offer. Distribution of information contained in this communication may be restricted by law. Persons receiving this communication should inform themselves about and observe any such restrictions. Any dissemination or other unauthorised use of this information or documents by any person or entity is strictly prohibited.

SparkChange believes the information in this communication to be correct at the date of issue. However, no representation or warranty is given as to the accuracy of any of the information provided. Some information in this communication is based on information given/obtained from independent research providers that SparkChange considers to be reliable. Analysis provided in this communication may be based on subjective assessments and assumptions and can use one among several alternative methodologies that produce diverse results. Hence, analysis and projections should not be seen as factual and should not be relied upon as accurate predictions of future performance.

Request Full PDF Report