Explore the Thinking behind our investment approach

More and more countries and individual businesses are making Net Zero commitments, moving beyond carbon neutrality to removing human-induced CO² emissions from the atmosphere. Carbon neutrality and net zero emissions are often used interchangeably, but there is one key difference. Carbon neutrality can be achieved by balancing greenhouse gas (GHG) emissions with offsets via buying carbon credits. This means carbon neutrality can be achieved without reducing emissions. Essentially, net zero carbon challenges “business as usual,” while carbon neutrality allows emissions to remain the same. These commitments necessitate understanding terminology, emissions baselines, setting targets, and managing progress. The classification system for greenhouse gas (GHG) accounting, created by the Greenhouse Gas Protocol, measure carbon footprint using three categories of emissions: SCOPE 1 – Direct GHG emissions attributable to operations owned and/or controlled by a company, including vehicle fleets and facilities. SCOPE 2 – Indirect GHG emissions from purchased or acquired electricity, heating, and cooling. SCOPE 3 – Indirect GHG emissions not covered above, such as supply chain emissions, business travel via non-owned vehicles, and emissions associated with the “use phase” of products. Reporting and disclosure related to Scopes 1 and 2 is more mature. However, the deepening scrutiny associated with net zero targets means that “Scope 3 investment risks are mounting. These risks may come from new regulation of a company’s high-emission products and shift in end-product market demand driven by climate concerns.”¹ Investors have traditionally focused on Scope 1 and 2 emissions, but as the state of Scope 3 reporting improves, investors like Gitterman are looking to manage Scope 3 risks. Scope 3 is the biggest area for innovation in carbon reduction, especially because for some companies and industries, Scope 3 emissions dominate their overall carbon footprint. Seeking Low-Carbon Solutions? Our SMART Fossil Fuel Free Models were launched in 2016. They are a family of global climate aware investment allocation strategies that screen for fossil fuel and utilize carbon foot-printing tools to guide investment decisions. On the equity side of the portfolio, we use Morningstar’s Global Equity Classification Structure to identify key industries partaking in direct fossil fuel investment. The SMART Fossil Fuel Free models divest from these industries, with the exception of specific diversified water utilities. This is due to our belief that water investments have a strong sustainability thesis, specifically as it relates to UN Sustainable Development Goal #6: Clean Water and Sanitation. On the fixed income side, we carry out divestment from fossil fuel on a best effort basis, depending primarily on direct dialogues with fund managers and a quarterly analysis of bonds with fossil fuel involvement. We go beyond simple divestment of energy sector companies to understand the carbon footprint of the portfolio using Scopes 1, 2, and 3.

The U.S. is now officially back in the Paris Agreement. Messages coming from the government on climate change are strongly worded, but it’s still early days in terms of tangible actions. As The New York Times noted, “There are two immediate signals to watch for. First, how ambitious will the Biden administration be in its emissions reductions targets?” and, “…how much money will the United States provide to help poor countries adapt to the calamities of global warming and shift their economies away from fossil fuels?”1 On April 22nd, Earth Day, President Biden will hold a “Climate Summit,” which should give some insights into these questions. In the meantime, domestic climate adviser, Gina McCarthy “has pledged “the most aggressive” carbon cut the U.S. can make.”2 The White House is also working to determine the “social cost of carbon,” or SCC, which “would be considered in every rule, regulation and policy enacted as part of President Joe Biden’s “whole-of-government” approach to tackling climate change.”3 Carbon costs in other countries are running between $20-$100 per ton. Following the same method as the Obama administration could result in a cost of $125 per ton, the same value New York State recently announced as its carbon value.

Despite an increasingly polarized political landscape, one area where there is bipartisan support for governmental intervention is climate change. A Pew Research survey in June of this year found that “a majority of U.S. adults want the government to play a larger role in addressing climate change”, with around two-thirds saying that “the federal government is doing too little to reduce the effects.” Unsurprisingly, given the proliferation of wildfires, hurricanes, drought, extreme heat, and other impacts, most Americans “continue to say they see the effects of climate change in their own communities.” For those actively focused on climate change, the last few years have been devastating when it comes to U.S. climate policy. Pulling out of the Paris Agreement and the rolling back of regulations have put the country further and further behind the progressive efforts of other regions. However, 2020 has also brought some glimmers of hope, one being a report published by the Market Risk Subcommittee of the Market Risk Advisory Committee (MRAC) of the Commodity Futures Trading Commission (CFTC) in September. The CFTC, which regulates the U.S. derivatives market, was not the most obvious messenger of the seminal work, Managing Climate Risk in the U.S. Financial System. Jeff Gitterman recently interviewed Bob Litterman, founding partner and Risk Committee Chairman of Kepos Capital, and chair of the CFTC’s subcommittee, to discuss the process. The subcommittee, a diverse group of participants ranging from agricultural and energy companies, NGOs, academics, and financial services firms, “voted unanimously 34-0 to adopt the report” and its 53 recommendations. This bipartisan consensus was achieved by focusing on where they could secure agreement among the participants. One of the primary conclusions is the simple statement that climate change “poses a major risk to the stability of the U.S. financial system and to its ability to sustain the American economy.” As a result, the most critical recommendation is that a price on carbon that is “fair, economy-wide, and effective in reducing emissions consistent with the Paris Agreement” is the “single most important step to manage climate risk and drive the appropriate allocation of capital.” Litterman notes that carbon pricing is “an inevitable policy response” to climate risk and that once appropriate incentives are established, the financial system will go into action. However, the report did not go as far as to suggest what that price should be, as this, and the mechanics of the policy, are the role of Congress. As a risk manager, Litterman advises that “time is a scarce resource” when you’re managing risk. The longer the U.S. waits to take decisive action, the more likely it is that we face a “disorderly transition” and sudden devaluation of assets. While many would prefer climate action to be driven solely by an intrinsic motivation to steward the Earth, progress to date suggests this will never happen. We agree with Litterman that changing behavior requires changing incentives – whether those be tax credits, regulations, subsidies, or other policy levers – and we are well beyond the time to act. We hope that the work of the CFTC’s subcommittee along with positive signals from the incoming Biden Administration will incentivize climate action underpinned by an exciting new era of U.S. innovation.

Over the last several years, ESG data has become increasingly rich and sophisticated. However, the “S” has presented more challenges in terms of data as “social principles have gotten far less representation in portfolios than environmental and governance issues.” This is because the “S” covers such a wide range of topics and because broader sustainability reporting, although progressing at speed, has not yet resulted in commonly adopted standards and best practices. However, “[t]his dynamic is changing, as asset managers, advisors, and investors demand information and flex their shareholder muscle, and as more mutual funds find effective ways to sharpen a social focus.” Read more in Barron’s to learn how Jeff Gitterman and Adam Bernstein see the change in the market when it comes to the “S” in ESG, and which mutual fund families and products are leading the way.

Evidence of climate change has been growing for decades, but as physical risks manifest with more frequency and potency, the markets are fast waking up to a vastly different future. Climate change will affect all regions, sectors, and industries, albeit to varying degrees and in diverse ways. “Yet, it is still not widely considered to be a major imminent threat to portfolio success.” We foresee that climate change effects will be increasingly part of valuations as new and better data sets are created, and as market participants deepen their understanding of climate risks, specifically physical risk, and transition risk. “Advisors need to understand how climate change may affect the investments they offer to their clients, as well as how climate change may impact other aspects of a client’s overall net worth.” Read more in Forbes for tips on how to “engage with…providers and other experts to better protect client capital.”

If you are a client who lives in the state of New York and purchased a life insurance or annuity contract, on March 20, 2020, the New York State Department of Financial Services (DFS) adopted an emergency regulation that provides relief to certain policyholders who can demonstrate financial hardship as a result of COVID-19. For more information, please click here.