Low-Carbon Indexes Offer Fossil Fuel Divestment Alternative

Pension funds and other institutions worried about climate change are turning to equity indexes that exclude companies with carbon exposure.

Smoking vents.

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For Mats Andersson, CEO of the Fourth Swedish National Pension Fund (AP4), climate change is not only very real; it’s “the biggest risk we have as a pension fund.” Still, the $34 billion AP4 doesn’t plan to divest its fossil fuel holdings, as a small but growing number of pension funds, endowments and foundations have done out of similar environmental and economic concerns. It would be too hard to get such an extreme action approved by the Stockholm-based fund’s board, Andersson says.

Besides, he adds, AP4 has found another way to pull carbon from its portfolio that avoids unintentional tinkering with risk and return: low-carbon equity indexes that closely track blue-chip benchmarks while excluding most carbon-exposed companies in those benchmarks.

This concept is catching on with institutional investors, who are under pressure to divest from fossil fuels and educate themselves about the possibility of so-called stranded energy assets as climate protection efforts double down. In the past year index provider MSCI and U.S. asset management giants BlackRock and State Street Global Advisors (SSgA) have launched low-carbon indexes or products based on them. All three say client demand is surging.

Andersson thinks of low-carbon indexes and related investment vehicles as low-risk protection against a scenario in which high carbon exposure soon becomes a major liability for companies and their investors. “If we’re wrong about climate change, we’ll still have the same returns,” he says. “If we’re right about climate change, those companies that don’t look after their carbon footprint will be punished in terms of profits and valuation, and this will enhance our returns.”

Andersson started down the low-carbon path in 2012, when he and a few colleagues asked what it would look like to “decarbonize” the S&P 500 index. With help from New York–based BlackRock and Trucost, an environmental data provider headquartered in London, AP4 designed a customized fund that jettisoned the index’s 150 worst polluters. The Swedish firm ejected not just fossil fuel companies but also the most carbon-intensive businesses in every sector, from energy to retail to banking.

Andersson says he was surprised to discover that one year in, the low-carbon fund had outperformed its underlying index by 100 basis points. “It encouraged us to actually implement this, not only on the S&P 500 but on North America, emerging-markets and European equity mandates as well.”


Although the fund hasn’t existed long enough to convince him that it will keep beating its benchmark, so far its performance and volatility have closely followed the S&P 500, even with so many stocks excluded. Andersson notes, “One reason for the outperformance could be that companies that look after their carbon footprint seriously will probably look after the rest of their business in the same serious way.”

In the three years that 10 percent of AP4’s global equity portfolio has been directed to low-carbon strategies, that portion has outstripped its underlying indexes by 50 to 80 basis points annually.

Within two years Andersson expects that AP4 will reduce the carbon footprint of its entire equity portfolio by 50 to 70 percent. “And I see no reason long term why we shouldn’t measure the carbon footprint of every investment we do, whether that be fixed income, private equity, high-yield, whatever,” he says.

AP4’s directors have helped investors to follow their lead. “We wanted to open up these sorts of funds for other investors to come in,” Andersson says. Starting in 2012 the Swedes approached firms including BlackRock, Northern Trust Asset Management, MSCI and Zurich-based sustainability adviser South Pole Group to collaborate with them on low-carbon investment offerings.

Such efforts have paid off. In late 2013 Chicago-headquartered Northern Trust created a low-carbon equity fund at AP4’s request. Last September saw the launch of the MSCI Global Low Carbon Leaders indexes, based on the MSCI All Country World index. By the end of 2014, AP4 had invested $1.5 billion in low-carbon investment products, most of them based on the new MSCI indexes, into which the $39 billion French pension system Fonds de Réserve pour les Retraites has poured $1.3 billion.

The $52 billion United Nations Joint Staff Pension Fund and the $1.17 billion University System of Maryland Foundation had the same idea as AP4 when they put up undisclosed sums to seed the iShares MSCI ACWI Low Carbon Target ETF, launched by BlackRock’s exchange-traded-fund business last December. The UNJSPF made a similar investment in an ETF developed by Boston-based SSgA that debuted in November. Northern Trust and Standard & Poor’s Financial Services — which has offered its S&P U.S. Carbon Efficient index since 2009 — have seen much greater interest in their low-carbon products over the past year.

“Clients like that the iShares ETF meets their fiduciary obligation of being invested in the MSCI All Country World index, but it also offers them reduced carbon exposure,” says Ravi Goutam, a San Francisco–based senior member of BlackRock’s ETF institutional sales team. “It allows them to get the performance return they want while also meeting their low-carbon objective.”

The goal of the iShares ETF is not to beat its benchmark but to stay within 30 basis points of the MSCI ACWI and reduce carbon exposure by about 85 percent. Goutam says his team has mainly been targeting foundation and endowment clients in the U.S.

The MSCI Global Low Carbon Leaders indexes and products based on them strive to serve dual interests in a way that the S&P low-carbon index and fossil fuel divestment do not. They appeal to investor concerns that most untapped fossil fuel reserves could become unburnable, thanks to efforts to halt climate change, and that heavy carbon emitters outside the energy sector could suffer financially from a carbon tax.

“For each company we look at the reserves they own, to deal with the issue of fossil fuel reserves potentially becoming stranded,” says Remy Briand, Geneva-based global head of research at MSCI. “At the same time, for each company in a given universe we’re also gathering information on emissions per unit of revenue they produce, which is a measure of their efficiency in terms of carbon emissions.”

AP4’s Andersson says his support for decarbonizing equity portfolios isn’t meant to be prescriptive; he just wants investors to have another option in their struggle to balance fiduciary duty and the economic effects of a changing climate.

“As I will always say, There’s not one silver bullet. I am encouraging every move in the direction of addressing climate risk,” he explains. “I think the biggest risk is doing nothing, if you believe that climate change is real.”