Sustainable Portfolios That Internalise CO2 Emissions

    Stockholm (NordsIP) – Understanding how investors can manage their CO2 emissions through portfolio allocations can be instrumental for sustainable finance to tackle climate change and facilitate the energy transition. However, this is not always a simple process.

    To help investors navigate this task, Schroders unveiled its carbon framework for sustainable investing in the middle of May. The framework was authored by Schroders’ Lesley-Ann Morgan, Head of Multi-asset Strategy, Ben Popatlal, Multi-asset Strategist, and Charlotte Smith, Graduate Trainee. The asset manager takes a four-pillar approach to the investment economics of carbon that considers the impact of fiscal and central bank policy tools, as well as market mechanisms such as carbon allowances and carbon offsets.

    Carbon Taxes

    On the fiscal front, Schroders’ Carbon Framework focuses on the role of carbon taxes. The asset manager makes the economic externality point, which argues that carbon taxes allow governments to assign a price to carbon emissions on the assumption that the market is too myopic to internalise the public costs of CO2 emissions correctly.

    According to Schroders, carbon taxes are difficult to navigate because of their complexity. On the one hand, even within the EU, carbon taxes vary widely in terms of tax rates, which range from $0.05 in California to $137 per metric ton of CO2 emissions in Sweden, as well as in terms of scope. While Singapore only taxes the direct emissions of its 50 top emitters, it manages to achieve an 80% emission coverage. Meanwhile, Spain’s carbon tax only applies to fluorinated gases, giving it a minimal 3% emission coverage.

    Moreover, carbon taxes also differ in terms of their sectoral effects. Schroders points to the experience of the UK where carbon taxes were an incentive for electric utility companies to drastically decrease their emissions, an effect which was not as strongly present in other sectors.

    This heterogeneity of carbon taxes ultimately appears to be an excuse for many countries to lag behind, according to Schroders. “To reach the target of 2˚C for global warming by 2050, our analysis shows carbon prices will have to be far higher than recent levels, reaching over $100/tCO2e. Carbon Value at Risk shows almost half of listed global companies would face a rise or fall of more than 20% in earnings if carbon prices rose to $100/t,” the asset manager warns.

    Asset Purchases and Scenario Analyses

    Carbon emissions feed through to central bank policy and henceforth to portfolio analysis via asset purchases and stress testing. The authors of the Carbon Framework focus on the different approaches of the ECB and the Federal Reserve System.

    The ECB has started to make moves toward internalising climate change considerations in its asset purchases programmes by excluding high-emitting issuers from its market intervention. Investors should be aware that while this creates incentives for such companies to mitigate their carbon footprint, it can also add instability to financial markets.

    Including the effects of physical and transition risk on company-level entities, the ECB’s stress tests have also been able to provide an overview of the potential impact of climate change on European banks’. The Federal Reserve has traditionally been less keen to embrace such a macroprudential approach.

    Carbon Allowance Markets

    In contrast to CO2 taxes, which price carbon emissions without affecting their supply, emissions trading schemes (ETS) fix the volume of allowed emissions and let the market determine the price of those emissions. In this sense, the schemes create a market for carbon allowances. The largest such system is the EU’s ETS, followed by California’s Regional Greenhouse Gas Initiative (RGGI). “Today 16% of global greenhouse gas emissions are covered by emissions trading systems, with an additional 8% covered by carbon taxes,” the Schroders report argues.

    Carbon allowances are a commodity and as such can be traded and included as part of an sustainable investment strategy. “We believe there is both an investment and sustainability case for using carbon allowances within portfolios. The investment rationale is based primarily on policy and societal pressure for decarbonisation, combined with the powerful tailwind from a falling supply of allowances. This is reflected in the forward curve for European carbon allowance futures. In April 2022 the spot price of European carbon allowances was €80 and the forward curve suggested a price of €104 in Dember 2030, suggesting a forward-looking annualised return of around 3%,” the report continues, before warning that EU carbon allowances are less risk-efficient than most other asset classes due to their volatility.

    Carbon Offsets

    Schroders also points investors towards carbon offsets. These are “instruments which reflect an emissions reduction of one metric ton of CO2” and include “emissions-reduction (polluting at a lower level), emissions-avoidance (stopping an activity that would have released emissions), or the removal of CO2 from the atmosphere (such as planting trees which sequester carbon naturally).” Afforestation is a common example of a carbon offset project.

    Carbon offsets allow investors to voluntarily pay for the cost of their portfolio’s emissions but the prices will vary widely, depending on the nature of the project, whether it focuses on removal or reduction, how liquid the offsets being traded are or the age of the project.

    “We believe the sustainability rationale is strong, but the investment rationale depends on the stage of the lifecycle that the investor is involved. There is an investment case at the project development level for those that can take on the size and illiquidity risk, but for investors buying offsets later in the lifecycle, we think such purchases should be made outside of portfolios, and the outlay regarded as a cost, rather than an investment,” the Schroders report concludes.

    Filipe Albuquerque
    Filipe Albuquerque
    Filipe is an economist with 8 years of experience in macroeconomic and financial analysis for the Economist Intelligence Unit, the UN World Institute for Development Economic Research, the Stockholm School of Economics and the School of Oriental and African Studies. Filipe holds a MSc in European Political Economy from the LSE and a MSc in Economics from the University of London, where he currently is a PhD candidate.

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