Over the past decade, many countries and companies have made ambitious pledges to reach net zero greenhouse gas emissions to tackle climate change. For investors, however, the implementation of similar commitments in investment portfolios has led to some unintended outcomes.
Some investors are unwilling to provide capital to high-carbon-emitting companies, even if they are in the process of decarbonizing their businesses. Divestment is the easy route for those looking to quickly get emissions off their books. But while divestment can lead to a greener portfolio, it will not necessarily result in a greener planet since it doesn’t take carbon-intensive assets offline. Investors’ net zero commitments also often have serious caveats such as excluding commingled funds – which comprise a substantial portion of global investments – rendering them effectively hollow or simply disingenuous.
Net zero commitments’ drawbacks are leading some investors to scale back or withhold commitments altogether. A mechanism to charge investors for the carbon in their portfolios – and encourage real world decarbonization – is sorely needed. The solution could lie in carbon charges for investment portfolios.
At a high level, carbon pricing offers an economic approach to paying for the externalities of carbon emissions, designed to incentivize a reduced carbon footprint and transition towards more sustainable practices. Short of a true carbon tax, which requires policy action, there are two other ways a carbon charge could be assessed and administered.
Shadow carbon charge:
The basic idea behind a shadow carbon charge is to assign a hypothetical monetary value to each ton of CO2 emitted, reflecting the environmental and societal costs of carbon pollution. By highlighting the costs of carbon emissions, a shadow carbon charge can help correct market failures and encourage the adoption of low-carbon technologies and practices. A shadow charge incorporated into capital allocation decisions leads to future capital flowing towards less carbon-intensive projects, all else equal. The term “shadow” is used when these charges are not officially implemented as government policies. Instead, they serve as indicated pricing mechanisms outside of the formal regulatory framework.
Internal carbon charge:
Unlike a shadow carbon charge, money actually changes hands within an organization when an internal carbon charge is implemented.
The concept behind an internal carbon charge is to create an internal market within a company, where carbon emissions are assigned an actual monetary value. In doing so, companies can create financial incentives for their various business units to reduce their carbon footprint and drive internal decision-making to consider environmental impacts. The pool of money generated from the internal carbon charge can be earmarked for green projects or investments.
Many companies are already incorporating these strategies in lieu or in advance of a true carbon tax or other policy solution. The companies that employ carbon charges have a head start in understanding how pricing carbon would affect their business. Indeed, companies such as Microsoft, Ben & Jerry’s, and Disney have publicly stated that they have implemented carbon charges in their capital allocation decisions.
Much of the groundwork for this approach has already been laid through the efforts of the Task Force on Climate-Related Financial Disclosures and the International Sustainability Standards Board to improve climate reporting.
For investors, implementing carbon charges in portfolios offers a similar opportunity to build carbon pricing into their investment decisions. Integrating a shadow carbon charge on portfolios helps investors understand how portfolio returns could reflect environmental costs and could provide an incentive to invest in decarbonizing companies. And adopting an internal carbon charge would go one step further to form a pool of money that could be redeployed to green investments.
In the United States, there is a ready analogy. The Securities and Exchange Commission requires that mutual funds disclose an implied after-tax return in addition to the actual pre-tax return. While this estimate may not be exactly accurate, it provides a sense of the amount a taxable investor would pay on the portfolio. This estimate also makes it easier to compare portfolio returns between funds with similar pre-tax returns but strategies that eventually lead to very different tax positions.
A shadow carbon charge can be applied in a similar manner: a portfolio could be charged an estimated price based on its GHG footprint, allowing comparison of portfolios on an implied “after-carbon charge” basis.
Such a shadow charge would provide investors with the incentive they currently lack to invest in decarbonizing today’s carbon-intensive assets. Reducing those companies’ emissions over time would drive the portfolio’s shadow carbon charges down, increasing implied returns, all else equal. Investors would also understand how much of their return is being “subsidized” by the externalities of carbon.
If such a charge were actually levied on the portfolio by an asset owner – not just as a shadow charge but as an internal charge in real dollars – it could create a pool of funds that could have a real-world impact on climate change by investing in green innovation, funding university research into green technologies, mitigating climate impact in vulnerable communities, or addressing environmental challenges in other ways.
Charging investment portfolios for their carbon footprint presents a promising approach to address the limitations of net zero portfolio commitments. Carbon charges – whether shadow or internal – present an economic pathway for investors who are serious about climate change to go beyond symbolic commitments and invest for a green planet, not a green portfolio.
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