Member Musing: Three principles of climate investing
As investors and owners of firms, whether as principals or fiduciaries, we are responsible for addressing the varied potential impacts of continued greenhouse gas emissions. The projected cost of climate change is significant, affecting individuals, society, the environment, and the companies operating within it.
While we all might agree to these essential facts, they do not help us define the best methods to achieve our desired climate outcomes. Over the last decade, Scientific Beta has been integral in the development of a carbon transition framework in Europe. What we have learnt can be distilled into three core principles of climate impact investing; shun the alpha-washing trend, utilise divestment as a powerful capital allocation tool, and fund the transition to a low-carbon future.
Principle 1: Green alpha is just an illusion
Generating alpha from climate investing is a green-washed illusion, and strategies that focus on this imagined return driver put at risk both their true alpha drivers and their climate impact objectives.
We have shown that the trend towards investment strategies promising to deliver alpha through their climate portfolios is supported by poor (and in many cases reckless) investment science.
First, investment theory contradicts the notion of higher return for lower risk, stating instead that lower-risk portfolios should logically yield lower returns (in accordance with the ‘return for risk’ principle). At the same time, empirical studies have revealed a lack of alpha across the entire ESG data universe when properly accounting for spurious exposures.
We have shown that ESG strategies promising excess returns have selectively chosen favourable time periods or concealed underlying factor exposures. We can call these non-robust representations of a climate investment strategy ‘alpha-washing’, and it should be considered as pernicious as other more well-known forms of portfolio greenwashing.
Principle 2: Maximise your impact objectives
Utilising divestment as an arrow in the arsenal of climate impact investing is essential to its overall success. Engagement with the management and board of a firm is a powerful means to influence their decisions, but to ensure that our impact objectives are reflected in our approach to climate investing, our investment decisions need to support our engagement activities.
Real change will occur when a firm’s management observes a clear link between their actions and the investment response of climate-engaged investors. The strength of engagement lies in the potential for divestment, giving the investor leverage to drive change and shape a firm’s actions.
Principle 3: Don’t let your impact be greenwashed away
Ultimately, investors play a significant role in the economy by controlling the supply of capital. This is no truer than with the capital allocation necessary to fund the transition to net-zero carbon over the next quarter-century.
Therefore, climate investing is more about facilitating a carbon transition rather than merely punishing current high-carbon industries by denying them capital. We need our investments to be channeled towards firms that are making progress within the high-carbon industries, and this will provide real incentives for high polluters to improve their practices.
Any climate impact investment strategy should focus on its core non-financial goals to maximise its impact on firms. If you wish to read further, the Scientific Beta White Paper, The Three Principles of Climate Impact Investing, explores these approaches in greater detail. We provide a guide to help assess a climate impact strategy for potential greenwashing risk and impact success.
Mike Aked is a Senior Investment Strategist for Scientific Beta. At Scientific Beta, Mike undertakes Australian-based research on ESG and investment factor-based topics. Mike was previously Partner, Head of Research – Australia and Global Head of Asset Allocation with Research Affiliates. He has also worked with the University of Virginia Investment Management Company (UVIMCO), Sunsuper, and UBS Global Asset Management across the US, Europe, Asia and Australia. Mike has a wealth of academic and practical experience in fundamental, quantitative and factor investing across both single and multi-asset class frameworks.