March 7, 2020
Whilst Fairlight doesn’t market itself as a specialist ESG (Environmental, Social & Governance) asset manager, we are a signatory to the UN Principles for Responsible Investment and ESG considerations form an important part of our risk management process.
The most prominent ESG consideration in equity markets today is the corporate contribution to greenhouse gas (GHG) emissions. In the same manner that insurance companies consider climate risks when underwriting insurance, equity investors increasingly need to consider the regulatory and reputational risk of corporate GHG emissions when allocating capital.
Climate-related investment risks can largely be segmented into two categories:
Quantifying the carbon emissions of a portfolio gives insight into the exposure to the second of these risks. The GHG Protocol is the most widely used framework for measuring and reporting on GHG emissions. The GHG Protocol classifies emissions into three categories:
Data quality and availability for Scope 1 and 2 emissions is superior than Scope 3 given the significantly higher complexity of determining the emission intensities of value chains external to companies. Whilst it is conceptually preferable to include Scope 3 emissions in an analysis, at present it is difficult to do so comprehensively.
The exposure to carbon risk for an investment portfolio can be expressed in a couple of ways
1. Financed carbon emissions
The financed carbon emissions approach measures the absolute tonnes of CO2 equivalent for which a portfolio is responsible. GHG emissions are apportioned to a portfolio based on the percentage of total company equity the portfolio owns. To facilitate comparison between portfolios of different sizes, portfolios are normalised to a comparable metric of tonnes of CO2 equivalent per $1m invested.
The utilities, materials and energy sectors account for more than three quarters of the GHG emissions of the global index. Fairlight typically avoids these high emission industries because we find that companies with the quality characteristics that we desire are typically in short supply in these sectors. Whilst this sector allocation is the primary reason why Fairlight’s portfolio finances 90% fewer GHG emissions than the global index does for every dollar invested (Figure 1), it should be noted that our holdings also have lower emissions than the averages of their respective industries.
2. Carbon intensity
The concept of carbon intensity scales a company’s GHG emissions by company revenue so that small and large companies are comparable against a single metric: tonnes of CO2 equivalent per $1m of revenue. Carbon intensity is an efficiency measure that assesses how much carbon it costs to generate a unit of revenue. Figure 2 compares the carbon intensity of the Fairlight portfolio holdings with the global index. Pleasingly every single portfolio holding scores more favourably than that of the index. Somewhat surprisingly Fairlight’s portfolio has a more attractive carbon intensity profile than the vast majority of specialist low-carbon funds (a finding that explains why a common criticism of these funds is that they are often a triumph of marketing over substance).
The Fairlight View
Whilst the Fairlight investment process is primarily returns focused, a robust ESG risk assessment is performed prior to any portfolio purchase. A pleasing byproduct of a quality focused investment philosophy is a portfolio that naturally performs well across the three dimensions of environmental, social and governance issues. As a result, clients should expect the Fairlight portfolio to remain one with a low carbon emissions profile.