Creating a low-carbon index was a practical way for the New York State Common Retirement Fund, the third largest pension fund in the United States with $178 billion in assets, to put its beliefs into action.
Vicki Fuller, chief investment officer of the fund, says that environmental, social and governance (ESG) considerations are integral to the investment philosophy of the fund.
“We live by them, they are firmly mentioned in our investment philosophy as a source of return and risk, this is not new for us,” she says.
“It is not new for us to be invested in renewables, solar, wind, and active managers who execute sustainable strategies.”
Now $2 billion of US equities is passively tracked to this low-emission index, which excludes or reduces investments in companies that are large contributors to carbon emissions, like the coal mining industry; and increases investments in companies that are low emitters.
The portfolio is managed by the international equities portfolio management team internally, which also manages the rest of the US passive portfolio.
In total the fund has around $50 billion in US equities, and over time plans to increase the amount in this index.
Other investors have also established low-carbon indexes to use internally.
In 2013 PGGM developed an index in house, which measures the 2800 companies in the FTSE All World Index for their environmental and social policy and good governance.
The index re-ranks the companies based on these criteria, which also include a minimum threshold. As a consequence of this, about 200 companies that don’t make it into the index have been sold by PGGM, which amounts to about 1 per cent of the portfolio.
At New York Common, the low emission index, which was created in partnership with Goldman Sachs Asset Management (GSAM), is modelled after the fund’s existing indices, which are passive investments in US companies with returns that match broad market performance.
Climate change one of the biggest risks
The low emission index eliminates or underweights stocks in some of the worst greenhouse gas emitters, based on independent emissions data reported to the carbon disclosure project, and will reduce the emissions profile within the index by up to 70 per cent.
Fuller says the focus of a long-term investor is on the strategies that manage risk, and that climate change is one of the biggest risks facing global investors across multiple sectors.
“By shifting our capital to companies with lower emissions and comparable returns, we are sending the message that our investment dollars will follow businesses with strong environmental practices,” she says.
“Environmental, social and governance is an important part of our long term strategies. Businesses which focus on the health of their companies are better to invest in. We want companies to generate long term returns into perpetuity; if there are issues causing them to be unattractive with long term returns, we want to know about it,” she says.
The fund participated in the landmark Mercer study, Investing in a Time of Climate Change, which identified the impacts that various scenarios of climate change could have on global investors. That report showed that New York Common had significant exposure to climate policy action, with almost 60 per cent of its allocation to public and private equities.
One of the recommendations of the report was re-allocating a portion of passive equity holdings into low-carbon alternatives.
“Mercer showed us how vulnerable our portfolio was,” Fuller says.
“We have a large exposure to developed countries and if there was aggressive mitigation we would be vulnerable.”
GSAM, which is one of the fund’s strategic partners, helped measure the carbon footprint of the global equities exposure.
Reducing its carbon footprint
“Our carbon footprint was 15 per cent less than the benchmark, with 75 per cent US equities and 25 per cent non-US equities in the portfolio. It set us on a quest to see what we could find,” says Fuller.
The low-carbon index was an outcome of a number of conversations with GSAM that centred around reducing the carbon footprint, which was largely determined by a subset of companies.
“Could we create a parallel index that didn’t take significant tracking error, was not different from a sector and industry perspective, but that had a lower or zero exposure to high carbon companies? We have been working on this a long time.”
Importantly, she says the focus is not just on fossil fuel companies, but on materials and industrials that also have a significant carbon footprint.
“This is why we were looking for a holistic approach. For us the approach we are taking is about the shared responsibility, it’s a problem across all industries.”
The index, Fuller says, is firmly within 25 basis points tracking error.
“That is gratifying for us because of the volatility relative to fossil fuels. We hope to increase investments in that index. We have $50 billion in US equities, about $2 billion is in the index, which is a meaningful number.”
The fund is now conducting research to determine the efficacy in applying this methodology to non-US developed equities markets. About 13 per cent of the portfolio is in non-US equities.
Engagement remains an important part of the success of the strategy to decrease the carbon footprint.
“It is very important to our success for companies to report. It is early days, but it will continue to be a big initiative to engage companies to report data to companies like the Carbon Disclosure Project.”
In addition to the low emission index, the fund recently committed an additional $1.5 billion to its sustainable investment program, bringing the total commitment to sustainable investments to more than $5 billion. Investments in this program include a wind farm in New York state and alternative energy production across the globe.
In an announcing the index, the New York State Comptroller, Thomas P DiNapoli said: “Low-carbon, sustainable investments are key to our future. Our pension fund has long supported climate aware strategies, and this expansion of our commitment offers a sensible solution that will protect the fund’s investments. It’s an approach to low-carbon investment that we can expand across all asset classes, and help spur the kind of innovation and ideas that will assist in the transition to a low-carbon economy.”