Anna Bernasek: I'm Anna Bernasek, head of thought leadership at State Street, and I'm talking today with State Street's Alex Cheema-Fox and Harvard's George Serafeim. Alex and George have teamed up on a number of research projects and delivered award winning papers and insights. One of those papers We’ll always have Paris is the inspiration behind the State Street S&P Global Institutional Investor Carbon Indicator. It's great to be talking with you, Alex and George today. Can we get started and just jump right into the title? It's a great one. It's like one of the best titles I've read recently for a research paper. Can you tell us the story behind it and why it’s that significant?
George Serafeim: Well, Alex chose the title, so he should be able to speak to it and how he came up with the title.
Alexander Cheema-Fox: So the subtitle is How Institutional exposures to Carbon Emissions have Evolved since 2015, 2015 being the year of the Paris Agreement. Now, I am a fan of Humphrey Bogart and of Casablanca. Call me basic. So I just wanted to reference Bogie's farewell statement to Ingrid Bergman as she got on to the plane in that movie.
Anna Bernasek: I love it. So what questions, Alex, did you actually set out to answer in this paper?
Alexander Cheema-Fox: We always follow a very fact based approach in our research. And here we just wanted to gauge whether or not institutional investors had really altered their exposure to carbon risk after all of the discussion around the Paris 2015 agreement. Now, in order to do this, at State Street as a custodian, we serviced trillions and trillions of assets, as researchers, we examined this data set and tried to glean some information from it in a very aggregated, anonymized and controlled fashion. Just to understand what, if any, broad institutional trends there may have been in response to the Paris 2015 agreement.
Anna Bernasek: George, how did you actually set out to answer those questions?
George Serafeim: Well, Anna, it's actually a complicated process. The first one, as Alex mentioned, we need a very large data set of institutional holdings. The research has been able to be pursued and completed only because we have had this access to highly anonymized data on institutional holdings. The second element is that we need data on carbon emissions, of course, and that data is not as widely reported or as comparable and reliable as one might want. So we need to be able to actually do a lot of data analysis and cleaning and processing in order to be able to have that data. And then lastly, we need to be able to merge those data sets. We need to be able to merge the institutional holdings data with the carbon emission data in order to be able then to analyze at the portfolio level and the aggregate level the carbon exposures of different institutional holdings.
Anna Bernasek: Alex, why do we even care about the carbon emissions in investor portfolios?
Alexander Cheema-Fox: There are two reasons. One is call it a more ecological reason, which is as institutions are tilting away or towards higher carbon assets, they may affect investment decisions and thus how the real economy evolves. The second is from the perspective of those institutions themselves. Carbon is a risk like any other risk, and if institutions are heavily exposed to high carbon assets and there are changes, whether they be policy changes, regulations, carbon taxes, they are bearing up on risk that will affect their investment returns by their carbon exposure.
George Serafeim: If you actually take a step back and you go back to 2015 and you observe 196 nations coming together and reaching a global agreement that basically says we need to reduce carbon emissions fast, and we need to do that at a global level. And you are asking yourself, what are the kinds of risks and opportunities that is being created by this global agreement and by the determination of governments all around the world to reduce their carbon emissions, of course, at a different pace and with different methods because it reflects their own unique circumstances. But those risks and opportunities are very real. Risks are being created by regulations, for example, such as carbon taxes, and opportunities are being created by new technologies that are emerging, giving rise to new companies. And as a result, you take a step back and you say, well, this really matters to me, both from a risk and an opportunity perspective.
Anna Bernasek: Alex this paper is pretty technical. Are there certain? Concepts that a reader needs to understand.
Alexander Cheema-Fox: Yeah, I'd say there are three key ones. One is how we measure and define carbon risk itself. One is how we define portfolio exposures. And the third would be how those portfolio exposures actually evolve through time. Now, in terms of carbon, the first item, we define carbon risk in two different ways. One is through emissions. That's just what it sounds like how much carbon a company emits in its operations. Now the other notion is one of intensity. Intensity is a kind of carbon efficiency measure. It is emissions scaled by revenue. It's how much carbon it costs a company to earn a buck of revenue. And these two often are similar. For instance, energy companies tend to have high emissions and high intensity, but emissions sort of scales with company size, while intensity being an efficiency measure need not. Now the second idea here is portfolio exposures, and this is a very general idea that we're applying in the carbon space. You can think of it in the context of beta of a portfolio. If you have an asset in your portfolio that is 10% of your fund and that that asset has a beta of two, then this contributes a beta exposure of 0.2. If you want to know the beta exposure of a fund, you would sum across all the assets in the fund to get the fund's beta. We apply this idea to carbon risk to give an idea of a portfolio. In this case the aggregate institutional portfolio intensity and emissions exposure overall. Now that's a snapshot in time. It tells you where things stand at one moment, but it's also interesting to understand how these exposures might evolve. Now an exposure is effectively two pieces. One is the company characteristics, say the company's carbon intensity, and the other is the weight that it holds in the portfolio at hand. So the weight of a portfolio evolves for three reasons. 1. is stocks earn returns positive or negative, positions grow or shrink 2. as investors buy or sell assets, positions grow or shrink. And3. , as companies increase or decrease their carbon emissions or intensity, then the carbon component will grow or shrink. We disaggregated the evolution of exposure into these three components to understand what's really driving the changes that we see in aggregate institutional carbon exposure.
Anna Bernasek: George, you explained the how in the process. I'm wondering along the way whether you encountered any roadblocks or challenges. After all, this is really unique analysis, so just wondered if you could let us know what those challenges might be and how you overcame them.
George Serafeim: Many roadblocks Anna. I think the most significant one relates to carbon data. Carbon data is not reported by all companies, and even when it is reported, it is reported in an incomplete way. And what do I mean by that? For example, when not all companies are reporting, what data providers are trying to do is estimate the carbon data, using for example, environmentally extended input output tables to estimate some of that data. Of course, that estimation as every estimation comes with a degree of error and we need to actually try and account for that and try to be mindful of that. The second element that is challenging is that not all companies and even the companies that report, they do not give data on the full scope of emissions. What do I mean by that? Not all emissions are reported in the same degree and with the same degree of accuracy. For example, in our research we use the most reliable data that relates primarily to scope one and scope two emissions. Now you will ask me what are those? Well, scope one emissions are emissions that are produced directly from the assets that you own and control. Think about, for example, a manufacturer and the heating that is actually being consumed as part of the manufacturing process. Or think about you own your buildings and then the heating and the emissions that are generated from the heating in the buildings that you own or from the vehicles that you own as a company. Scope two Emissions are emissions that are generated from the electricity that you purchase and when the electricity is being generated. And that data is also tending to be more widely available, but also more reliably calculated because they're easier to calculate. But now think about scope three emissions and scope three emissions come in two flavors one upstream in your supply chain. Think about a food company and all the emissions that are generated by agriculture upstream in their supply chain. Or think about downstream emissions. For example, if you are a car manufacturer, when your customers are actually driving those vehicles and they are generating emissions, those emissions tend to be much less widely available. They are also less reliably reported and calculated. And as a result, right now, we haven't been including them in our work and our research also, because when we go back in one of our papers, we found that that kind of data was not as helpful from a risk return reward perspective, primarily when they tended to be more noisy.
Anna Bernasek: So after all that work and thinking, what did you actually find? Alex, can you take on that question?
Alexander Cheema-Fox: Certainly, we looked at this in a global sense. We also looked at this regionally and we also disaggregated the various drivers of how these exposures evolved. So if we if we think about that, very broadly we did see that investors reduced to their exposure to carbon risk after the Paris 2015 agreement, there was an overall trend of carbon reduction. That varied a lot across regions and sectors for instance, European assets saw their exposures decline pretty quickly. However, US assets really didn't seem to move much until around 2019 when they started to decline. Now, much of this decline really was driven by variation in exposures to the highest carbon sectors like energy and utilities. And some of this has seen the declines retrench a bit particularly in the emissions exposure in the past two years or so, we have seen energy companies rally a bit. It's been something of a renaissance for energy stocks and that has led to institutional portfolios which hold energy stocks seeing their emissions exposure largely rebound from some of the lows during the COVID era. While intensity exposures, which are those efficiency measures, they've bounced back a bit, but far less so as economic activity has picked up, emissions exposures have increased and though not entirely back to where they were, intensity exposures have remained relatively low. So that that is something of a positive story of carbon efficiency even as overall emissions have continued to rise.
Anna Bernasek: And George, were you surprised by any of these findings?
George Serafeim: I don't know if surprised is the right word, Anna, but I think it's very, very interesting, Right. So take, for example, what Alex just mentioned. And if you observe an overall, for example, decline in carbon exposure, you might attribute that to the fact that investors might be trading right? There might be a flow effect. And as a result, this might be generated. But actually the analysis shows that it wasn't really a flow effect. In fact, it was a price effect, meaning that there was a repricing of stocks, basically. And in the last almost decade we saw that in general, low carbon exposures had a better returns and as a result, a price effect. While in the last two years it was the opposite and it has reversed. And also we saw that when it comes to carbon intensity, there was a company effect, meaning that many companies have been reacting to the technological changes, to the regulatory changes, and they have been reducing the carbon to a dollar of revenue ratio that Alex was discussing about before. I think when you actually start to decompose some of those effects, you're peeling the onion a little bit and that gives you deeper insights about what is exactly going on. Is this a price effect? Is this a flow effect or is this a company effect?
Anna Bernasek: Alex, what then would the key takeaways from your work be for institutional investors?
Alexander Cheema-Fox: Well, very broadly, once again, carbon risk is a risk like any other that institutional investors have to be aware of, have to decide how they want to manage. And similarly, on the other side of that carbon, a carbon reducing economy also creates opportunities that institutional investors ought to be aware of. So to me, this is just another key risk that needs to be considered as investors make their decisions as to how to manage risks and chase returns. What is valuable about what we're producing is that it gives investors a sense of where the community at large stands and context is king it's always very useful to understand where the world is going when you're making your own decisions as a particular investor within that world. Do you want to follow the herd? Do you want to avoid the herd? Or you just want to understand what pitfalls may be rising from the herd going in a particular direction?
Anna Bernasek: George, a final question for you. You're a prolific researcher and writer. What are you working on now?
George Serafeim: I'm very, very excited about what Alex mentioned in terms of the opportunity side of the equation. And actually just last year, Alex and I published a new paper on Climate solutions investments. And what those are, are basically companies. that are producing those types of technologies, innovations that you observe everywhere around the world from heat pumps and how you use actually to heat your home to electric vehicles, to batteries, to renewable energy, to new forms of agriculture, to applications of artificial intelligence in agriculture and industrial production and grid optimization. And we're asking ourselves the question about what is the revenue potential of that new economy and those climate solutions, what is the profitability potential, what is the growth potential? And at the end of the day, also what is the valuation upside when you are looking at it from an investment perspective? And I'm and I'm very, very excited about this new wave of innovation and technology that can bring prosperity to the world.
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