Whatever your view of the impact of carbon emission levels on our misbehaving global climate, the UK government appears at first sight to be taking the drive to reduce the national carbon footprint pretty seriously – most significantly by penalising those companies and industries that produce the most CO2.
The 2008 Climate Change Act made Britain the first country in the world to set carbon reduction targets using legally binding ‘carbon budgets’, with the aim of cutting UK emissions from the 1990 baseline by 34 per cent by 2020, and by at least 80 per cent by 2050.
Plans are in place, through the Carbon Reduction Commitment (CRC) Energy Efficiency Scheme, for a tax on excess carbon emissions to be levied on the 4,000 highest energy-consuming companies in the UK. That is due to be introduced next April, and extended to most other FTSE 350 companies by 2015.
However, the UK’s 32 very biggest energy users – fossil fuel power stations, glass processors, steel mills and the like, accounting for around a third of the FTSE 350 by market capitalisation – won’t be included as they are already in the similar EU-wide Emission Trading Scheme.
Under this scheme, each company is given a certain number (fixed in 2006 and being progressively reduced over time) of carbon allowances per year. They have to buy extra allowances if they emit excess carbon – which can become an expensive business. For instance, in August 2008 power company Drax had to buy £232 million to cover the excess, which came out of profits and hit its share price.
Chancellor George Osborne has also introduced a second measure in the recent Budget; it has already undergone some ‘rethinks’, but is currently catchily known as the Climate Change Levy Price Support Rate. It kicks in from April 2013 and amounts to an additional tax of £4.94 per tonne of CO2 emissions for electricity companies.
The key aim is to make carbon so expensive to produce that energy companies are driven to invest in alternative low-carbon technologies. The initiative has attracted criticism – perhaps most significantly, on the grounds that the cost hasn’t been set high enough to drive much low-carbon investment by energy firms.
Nonetheless, says Fraser Macdonald, operations director of specialist investment firm Carbon Footprint Investments, the coalition appears determined to pursue the ‘polluter pays’ policy it has embarked on. ‘There is certainly a move to progress measures, as can be seen from the recent introduction of the Price Support Rate.’
He adds: ‘Additionally, changes have been made to the CRC Energy Efficiency Scheme that make it more of a penalty than when it was initially announced.’
Initially, more efficient companies could sell excess allowances and boost profits with that additional income, but now no company gets any cash back.
Firms with relatively high energy consumption are therefore set to be hit by a double whammy of carbon-related levies on top of continuing fuel price rises (Brent crude has jumped nearly 50 per cent in 2011 and there’s little indication of a long-term reversal in that trend, given increasing global demand).
According to Ralph Pettengell, chief executive of Carbon Footprint Investments, the rising cost of carbon is something that investors across the board should be factoring into their choice of shareholdings. ‘The more company profits are affected by penalties and carbon taxes, the less they will have to pay shareholders in dividends, and the less their shares will appeal to investors,’ he maintains.
Conversely, the evidence suggests that carbon-efficient companies tend to perform better than their peers. Axa Investment Managers recently used data from carbon emissions analysts Trucost to establish that across the FTSE 350 between 2005 and 2010, the top quartile of companies in terms of carbon efficiency outperformed the most carbon-intensive quartile by an average 6 per cent a year.
The research concludes that ‘low carbon strategies… have paid off over the past five years, on average, for most of the sectors exposed to carbon risk,’ and that they also tend to reduce share price volatility. This applies to industries affected indirectly, such as automotive, food and drink, and chemicals, as well as high energy consumers directly impacted by taxes and levies, such as airlines.
Institutional fund managers are starting to take notice of the climate change factor. A recent report from consultant Mercer on the implications of climate change on strategic asset allocation finds that 40 per cent of institutional portfolios should be invested ‘mindful of carbon efficiency’.
Rating agency Standard & Poor’s also plans to introduce climate risk screening for companies across all industrial sectors this summer. Incorporating carbon exposure into S&P’s credit rating methodology ‘will provide a new layer of transparency for investors seeking to incorporate the likely impacts of climate policy on corporate cashflows and creditworthiness,’ says Michael Wilkins, global head of carbon markets at the ratings house.
‘While the impact on credit ratings is likely to be limited in the short term, looking beyond 2012, stricter climate policy and tighter emissions reduction targets – especially in Europe – are likely to represent material risks for investors,’ he adds.
But the issue has so far barely registered on the radar of private investors and retail fund managers, says Pettengell. So Carbon Footprint Investments’ recently launched tracker fund is an interesting development.
In conjunction with Trucost, the firm has set up a ‘quasi-passive’ tracker fund – the IFSL Carbon Footprint UK350 Equity Index Tracker Fund – which tracks the FTSE 350 and holds every component in it, but is weighted against the worst carbon culprits. ‘There’s a direct correlation between CO2 emissions and energy consumption, so when oil prices rise the less efficient businesses will be hard hit by higher bills as well,’ explains Pettengell.
Because it can hold every company in the index, it is not classed as a green fund, ‘although it will reduce investors’ carbon footprint,’ he adds. Rather, its aim is simply to outperform the standard FTSE 350 by virtue of carbon efficiency – and that target has been achieved so far.
‘We got FTSE International to backtest the fund against the main indices’ performance, and it has beaten both the FTSE 100 and the FTSE 350 by up to 6 per cent, over each of the past three years,’ he says. The most recent results, for the year to 31 March 2011, show a more modest edge: 4.03 per cent for the FTSE 100 and 5.27 per cent for the FTSE 350, versus 5.37 per cent for the carbon-optimised index.
‘An increased concentration of investment into the more carbon-efficient companies in a sector will financially motivate and support those companies who commit to running cleaner and more efficient businesses,’ Pettengell argues.
It’s a simple but attractive proposition for anyone with a greenish-tinged investment outlook but no desire to sacrifice performance on the altar of social responsibility. But with a total expense ratio of 1.65 (reflecting Trucost’s carbon weighting input), it’s markedly more expensive than conventional trackers.
The fund is only available through intermediaries at present. Are they convinced? Martin Bamford, managing director of IFA Informed Choice, observes: ‘We are seeing increasing demand for carbon efficiency-type funds, but we are wary of them because typically it means they are limited to a smaller pool of potential companies and therefore involve greater risk. But a weighted tracker like this might well bridge the gap.’
But Julian Parrott of specialist IFA Ethical Futures is less enthusiastic. From the perspective of socially responsible investing, he argues that while a company’s carbon emissions are relevant, they’re ‘not something to hang a whole investment decision on’, and that issues such as the field of activity, management quality and financial strength are equally important. ‘I would be concerned about investing in a UK FTSE 350 tracker purely on the premise that carbon footprint will affect long-term value,’ he adds.
The carbon counting alternatives
The choices are limited. There are no other UK carbon-weighted trackers. But db-x trackers offers the S&P US Carbon Efficient ETF, which follows around 375 major US companies with relatively low carbon emissions.
You could also look at clean energy ETFs such as that from iShares, which follows the S&P Global Clean Energy index offering exposure to the 30 largest companies involved in production of clean energy.
The only actively managed direct alternatives are Deutsche Bank’s two global CROCI Carbon Funds (one long only, one long/short), which target attractive investment propositions that also have relatively low carbon emissions for their sector.
There are a couple of ‘climate change’ funds, from Virgin and HSBC, but these target businesses involved in developing climate change solutions, rather than looking specifically at greenhouse gas emissions. Parrott’s preference, meanwhile, is for broader-based ‘funds that are disciplined in their approach and have clarity about investing in solutions to climate change issues,’ notably the WHEB Sustainability fund and Cheviot’s Climate Assets fund.