Should Investors Aim for a Net-Zero Portfolio?
In 2020, Extinction Rebellion activists dug up the lawn of Trinity College, Cambridge, accusing it of being “complicit in the climate & ecological crisis” by investing £9.1 million in oil and gas companies. Later that year, the University of Cambridge pledged to divest from all fossil fuel stocks by 2030 and reach a net-zero portfolio by 2038.
And similar efforts are being made around the world. Given the scale and severity of the climate crisis, many investors consider E (the environment) as the most important of the three ESG factors. While environmental issues can span multiple dimensions, they see carbon emissions as the most important one. Like Cambridge, several aim are targeting a “carbon-neutral” or “net-zero” portfolio, in part by divesting from energy companies. The logic is that such divestment will increase these companies’ cost of capital and make it difficult for them to fund future polluting activities. (Whether it actually does will be the topic of a future post).
While the climate crisis is extremely serious, Chapters 4 and 9 of the book highlight the dangers of a blunt exclusionary approach to responsible investing. Exclusions focus on a single issue, but carbon emissions may not be the most material issue in every company. At Royal London Asset Management, we ran our portfolio through MSCI’s warming tool, which estimates the contribution of individual stocks to global warming. The worst offenders were semiconductor companies due to the emissions released in the manufacturing process. Yet, semiconductors have a hugely positive impact on society. For example, they’re used in mobile phones which can transform the lives of citizens, particularly in developing countries. In Chapter 8 I discuss how the launch of mobile money lifted 200,000 Kenyan citizens out of poverty within seven years.
Excluding Energy Firms Excludes Innovative Firms
Even if an investor considered global warming the most important issue, it’s still not clear that exclusion is the best approach. Tackling global warming involves not only reducing emissions (“doing no harm”), but launching innovations (“actively doing good”). A thought-provoking new paper by Lauren Cohen, Umit Gurun, and Quoc Nguyen find that the energy sector – typically screened out by net-zero portfolios – produce more and better “green” patents than almost all other industries.
The authors obtain data on all patents granted between 1980 and 2017, and classify a patent as “green” if it addresses environmental problems. This includes climate change mitigation, but also other environmental issues such as biodiversity protection and waste management.
Lauren, Umit, and Quoc find that the energy sector produced the second highest number of green patents, with manufacturing ranking first. Out of the top 50 green patent producers, 14% of them are energy firms: Exxon Mobil, Honeywell, Royal Dutch Shell, BP, Conoco Phillips, Chevron, and US Oil. Now, this results alone doesn’t mean that energy firms are making concerted efforts to reduce their carbon footprint. The authors carefully investigate several alternative explanations:
- Quantity over quality. The energy sector could be “greenwashing” by producing lots of low-quality patents, using sheer numbers to cover up the environmental damage caused by their core business. The authors thus study the quality of the patents generated – the number of times they’re cited by other patents, i.e. inspire follow-on innovation. They find that energy firms produce a higher quality of patents, not just higher quantity. And they produce more “blockbuster patents” (those in the top 5% of citations for a given year).
- General innovation, not green innovation. Perhaps the energy sector simply does more innovation in general, because it’s flush with cash – it doesn’t don’t care for green patents in particular? So the authors study the ratio of green patents to all patents. Across all industries, this ratio is 8.3%, but for the energy sector, it’s 22.3% – nearly three times as high. This difference continues to hold when controlling for potential determinants of the green patent ratio, such as firm age, firm size, cash holdings, and investment spending.
- Green innovation, not climate innovation. Recall that green innovation covers not just climate change, but other factors such as biodiversity and waste. Perhaps energy companies focus on these patents to greenwash without affecting their core fossil fuel business. However, the results remain robust when focusing solely on green patents that address “climate change mitigation technologies related to energy generation, transmission, or distribution”.
Green Patents and ESG Ratings
Another way to cut the data is to relate green patents to ESG ratings, rather than industry affiliation. Instead of including/excluding a stock based on its industry, some investors do so based on its ESG rating – in part, because Morningstar rates funds based on the Sustainalytics ESG ratings of their underlying holdings.
However, the authors find that ESG ratings – specifically the E component of the Sustainalytics rating – are negatively correlated with green patenting. A one standard deviation increase in the E score is associated with a 24% lower probability that a given patent will be green. Perhaps high E scores rest on their laurels and don’t feel the need to improve their E performance (of course, they could still be responsible in other ways), while it’s energy companies that feel the need to buck up.
Finally, they run the reverse analysis. Rather than studying how ESG ratings affect green patents, they investigate how green patents affect future ESG ratings. They find that the average firm is indeed rewarded for a green patent with a ratings uplift – but energy firms are given less credit. This may be due to the “halo/horn” effect, where agencies believe that an energy company is “dirty” and thus ignore their efforts to go green. (See an earlier blog for other issues with ESG ratings.)
Implications for Investors
What does this mean for investors? It certainly doesn’t mean that investors can cheerfully invest in energy stocks, ignoring their substantial carbon footprint, telling themselves “they’re generating more green patents so it’s OK”. Instead, it highlights the criticality of an integrated rather than exclusionary approach to ESG investing. Rather than excluding a company based on a single negative factor, an investor should consider a company’s positive (“actively do good”) and negative (“do no harm”) impacts cross several ESG dimensions and weight them by their materiality.
This is sometimes known as a net benefit test. A responsible company is one that provides a positive net benefit to society – i.e. grows the pie as well as ensuring that the pie is fairly divided. Loosely speaking, an energy company is a collection of “brown” assets in place and “green” growth opportunities; blanketly excluding it may deprive these green growth opportunities of capital. An investor should thus balance the damage caused by its brown assets against not only its transition plan to reduce their harm, but also the potential value created by its green initiatives.
Moreover, responsible investing isn’t just about stock selection, but also engagement – ensuring that a company fully leverages its green opportunities. One way to do so is by voting against management or undertaking public activism if it fails to do so. But it can also offer carrots as well as sticks. A significant barrier to green investment is the historically high dividend payout ratios of most energy companies. This was indeed justified in the past – firms that generate tons of cash, but have few investment opportunities, should indeed be returning capital – allowing shareholders to reallocate it to fast-growing sectors of the economy (such as tech and pharma). But the world is different now. The green revolution has presented energy companies with substantial investment opportunities. However, many investors punish companies that cut the dividend, so many are trapped into their old dividend levels. As I’ve written elsewhere, a solution is for investors to allow companies to pursue flexible dividend policies to allow them to take full advantage of these opportunities – safeguarding not only their own future but that of the planet.