Document summary
Climate change presents one of the biggest economic and political challenges of the 21st century. While world leaders have struggled to arrive at a consensus on how to respond to issues posed by the increase in the Earth’s temperature, institutional investors are exploring the potential impact of these changes on financial assets. In particular, investors are probing the long-term portfolio implications of “carbon stranded assets” — assets that may lose economic value before the end of their expected life primarily driven by changes in regulation and technological innovation.
Up until now, much of the pressure to manage carbon stranded assets risks has focused on divesting from companies in the fossil fuel sectors. This approach effectively communicates to various stakeholders an investor’s concerns about climate change. But, from a financial perspective, the strategy is not optimal as it can create significant short-term risk by potentially deviating sharply from market risk and returns. In addition, such an approach largely ignores fixed assets from non-Energy sectors in the portfolio that are at risk of being stranded due to their dependence on burning fossil fuel reserves, such as coal-based power plants.
The shortcomings of the divestment approach have led major asset owners to seek more financially practical solutions to managing carbon risk. Instead, investors are starting to turn to strategies that re-weight the market-capitalization portfolio to effectively minimize broad carbon exposure while using optimization to reduce tracking error. These approaches take into consideration both current emissions and fossil-fuel reserves, thus aiming to capture a broader exposure to carbon-intensive companies while seeking to minimize short-term risk.
MSCI offers indexes designed to reflect divestment and re-weighting strategies to reduce carbon exposure.