The carbon footprint fallacy
Why green investors need to get their hands dirty
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Describing the financial industry’s attempts to help investors allocate capital on the basis of ESG as “an unholy mess that needs to be ruthlessly streamlined”, The Economist magazine once argued that ESG should be boiled down to the letter E for environment.
The author of the piece goes further and argues that even within ‘E’, investment screening should focus on one simple measure: emissions. As the magazine goes onto suggest, the regulatory burden is already moving in that direction anyway, while improved transparency will help investors avoid being exposed to carbon intensive companies:1
“Investors and regulators are already pushing to make disclosure by firms of their emissions more uniform and universal. The more standardised they are, the easier it will be to assess which companies are large carbon culprits—and which are doing most to reduce emissions. Fund managers and banks should be better able to track the carbon footprints of their portfolios and whether they shrink over time.”
Warren Buffett once said, “In the business world, the rear view mirror is always clearer than the windshield.” When a company reports its annual emissions to the regulator, or publishes the data in its annual report to shareholders, the data is akin to looking in the rear view mirror. Real-time emissions monitoring, such as that increasingly carried out by drones and satellites, is akin to looking out the side windows. For investors, what really matters is what’s coming up the road ahead. What path is the company’s carbon footprint going to take, why will it take that path, how much is it going to cost, and how sustainable is the drop in carbon intensity?
Short term emissions trends don’t tell the whole story
In April the Financial Times (in partnership with Statista) published Europe’s Climate Leaders 2024, the fourth edition of the data set which ranks European companies in terms of who is doing best at cutting emissions. The research primarily focuses on those companies that have a) reported the largest reduction in Scope 1 and 2 emissions intensity (tonnes of CO2e per £ million in revenue) over a 5-year period (2017-22), and b) made further climate related commitments, such as being a signatory to the Science Based Targets initiative (SBTI) or collaborating with the CDP. Each company is then assigned a score based on these factors plus a few other emissions-based metrics (see Carbon intensity: The key to an economically sustainable green transition).2
This leaves much to be desired. The score doesn’t factor in the industry in which the company is operating in (i.e., on what scale are emissions hard-to-abate?), how far along it is in cutting emissions (i.e., have the ‘low hanging fruit already been picked?), nor the method or reason by which emissions have been cut (i.e., is it due to a drop in demand, or a decision to outsource production?).
The permanence of the emission reductions is important, and you can only gauge that if you understand the underlying reasons. If the drop followed a series of investments in new technology or energy efficiencies that ensures emissions stay low in the future, then a company really should receive a much higher score than one where the emission cuts are merely due to transitory factors. In short, it’s hard to separate the signal from the noise.
Short termism, avoided emissions, and unlikely beneficiaries
A focus on short-term emission reductions could also discourage investment in more sustainable long-term solutions. For example, it’s not hard to imagine that a company active in the cement business might avoid investing in new but perhaps speculative technology, and instead focus on known iterative measures. Focus on the former and they might be downgraded in the eyes of myopic ‘E’ focused investors. Far better to incentivise a culture of innovation in which the impact of new technologies can percolate through the rest of the cement industry.
The same principles apply to innovation where it leads to decarbonisation in other often unrelated industries - so called ‘Scope 4 emissions. These are the ‘avoided emissions’ resulting from the production and use of more carbon efficient products, or the employment of services such as energy efficiency that avoid carbon emissions. As I explain in Scope 4 emissions: Unlocking low-carbon innovation, if “all the incentives are focused on individual companies bearing down on their Scope 1, 2 and 3 emissions then we may be missing out on innovations that, while far from optimal at the individual firm or industry level, could have much larger net emissions benefits for the global economy.”
The carbon footprint of a company can also give a misleading picture of its exposure to carbon pricing. The key factor is cost-pass-through, in this case the degree to which the carbon price is transmitted along the value chain. Economic theory indicates that cost-pass-through is likely to be very high in markets where demand is highly price inelastic and consumers have little choice but to pay up. Market power tends to weaken the incentive for cost-pass-through as an individual firm might fear it will lose market share to a rival, while more fragmented markets tend to result in higher levels of cost-pass-through.
Jan Ahrens from SparkChange uses the example of Engie, the French multi-national energy company, as a business who benefits from higher carbon prices even though it emitted almost 25 Mt CO2 in 2023, “In their most recent annual report, Engie states that an increase of EUA prices by €2/EUA would INCREASE pre-tax income by €12m. Engie will thrive in a high carbon price future.” In addition to high levels of cost-pass-through in the EU power market, Ahrens highlights Engie’s generation portfolio (significant renewable capacity and low carbon intensity fossil fuel assets), suggesting that as carbon and power prices rise, its generation costs won’t increase as fast.3
Investing is more than just ‘green’ versus ‘brown’ stocks
The debate over whether carbon footprint is the correct measure or not goes to the heart of the issue for many climate orientated investors. Analysis published in 2023 by the University of Hamburg found that ‘green’ stocks (as measured by firms own reported carbon intensity) generally delivered higher returns than ‘brown’ stocks during the period 2012-2021, across all G7 countries with the exception of Italy. Although the pattern did reverse somewhat as the energy crisis took hold during late 2021 and into 2022. As the report notes, other researchers who have examined this relationship have often come up with conflicting conclusions.4
Ok, there’s some evidence - albeit inconclusive - that screening out ‘brown’ firms might improve returns for investors. But will it actually result in improved environmental outcomes, or is it just a means of reducing the stranded asset risk that could come with exposure to carbon intensive companies? Conventional thinking based on the power of divestment suggests that by not investing in ‘brown’ companies, investors are somehow starving them of capital, and in turn forcing them to either clean-up, or close down. However, as this article has demonstrated, focusing too narrowly on recent trends in a company’s carbon intensity can be misleading, and potentially damaging.
An alternative approach involves ‘tilting’, or otherwise investing in a ‘brown’ firm if it has taken corrective action to decarbonise, thereby rewarding a firm for investing in cutting its carbon intensity. The research, published by the European Corporate Governance Institute (ECGI) in 2023 suggests that the optimal strategy is to tilt if the investment in cutting emissions offers high return (tonnes of CO2 per $ invested). This is especially the case where managers have a strong stock option incentive in place, and where news of the company’s investment in decarbonisation is public knowledge.5
It may seem that divesting your capital from carbon intensive firms is the most responsible investing strategy as it hinders ‘brown’ firms from expanding, and reduces your exposure to climate transition risks (i.e. high carbon prices, stranded asset risk). However, being willing to provide capital to ‘brown firms’ that are best-in-class will encourage such companies to reduce their emissions.
The upshot is that there is too much focus on rewarding ‘green’ firms where the opportunity for gains in cutting emissions is marginal. That’s the carbon footprint fallacy. The much bigger prize comes from getting your hands dirty and investing in those ‘brown’ firms who have made a clear and transparent plan to decarbonise, and are incentivised to deliver.
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https://www.economist.com/leaders/2022/07/21/esg-should-be-boiled-down-to-one-simple-measure-emissions
https://www.ft.com/climate-leaders-europe-2024
https://www.linkedin.com/posts/janahrens1_carbon-eua-activity-7178417697641099265-19G5/
https://www.brookings.edu/wp-content/uploads/2023/01/WP83-Bauer-et-al_1.12.23.pdf
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4093518
Excellent post, agree on the reflections.