Environmental risks have taken a strong hold in the developed investing world. Until a few years ago, it resided in the domain of do gooders and tree huggers seeking to make a better world.
So, what has changed so much that it is now taking roots in mainstream investing? By and large, environmental issues have been able to make the move because of some very serious concerns. And these have been backed by legitimate data around environmental degradation worldwide, its impact on humanity, communities, countries and also its economic effect in the form of damage to properties and loss of man hours in the wake of environmental disasters coming at a pace not seen before.
The damage extends to business activity, leading to loss of revenues and higher cost of insurance.
As the thesis of reining in environmental damage with a framework of 2 degree alignment for climate change has spread, it behoves major institutional asset owners with large monetary assets at their disposal to become part of the movement. Since no government can alone afford to finance this mammoth effort, it is increasingly apparent that private funding has to step in through innovative ways.
One way is to invest the large funds in a manner that sends a message that companies willfully polluting with no sense of corporate citizenship need to be punished by not buying their stock. They are the ones that do not invest in clean power or processes, which in turn causes severe environmental damage.
This process of underinvesting or excluding certain types of stocks from investment portfolios has gained a lot of popularity in recent times.
Specialised data vendors, including Trucost, measure the carbon footprint of a company with a fair degree of accuracy. The data are then used to create indices or investment portfolios, which deliberately underweight polluters and overweight the companies that are making an active effort to keep their pollution levels low.
This process of penalty in an investment framework, which keeps the risk return tracking error for the investor fairly limited, has gained a lot of popularity. It is like buying a free option on the carbon penalty. The index is designed to overweight clean companies at the expense of the dirty ones within each sector.
This means the risk return profile of the company matches that of the underlying beta index. Yet, the asset owner is then able to engage companies and send a powerful message that this is an important aspect for them to address. Globally, billions of dollars of institutional asset owner money have moved to carbon efficient indices to indicate strong support for good environmental practices.