The Hidden Risks in Climate-Solution Investing

New research shows that portfolios that owned companies that provide climate solutions outperformed ones that owned firms with low carbon intensity. Before you adapt that approach, however, beware that this research relies on a small sample of data over a short time period.

Interest in sustainable investing has boomed in recent decades. Responding to that demand, an increasing number of climate funds and indices have been launched, most of which seek to reduce the carbon footprint of a portfolio by excluding firms with high carbon intensity. Examples are indices such as the MSCI ACWI Low Carbon Target Index and the MSCI ACWI Climate Change Index; and ETFs such as the iShares MSCI ACWI Low Carbon Target ETF (CRBN), with about $1.3 billion of assets; the iShares Global Clean Energy ETF (ICLN), with about $4.7 billion of assets; and the First Trust NASDAQ® Clean Edge® Green Energy ETF (QCLN), with about $2.2 billion of assets (data from Morningstar as of February 2022).

While some indices and funds reduce their climate footprint by comparing firms irrespective of industry membership, others create best-in-class benchmarking, thereby allowing representation of all industries (their greater diversification reduces tracking error risk).

Along with the increased interest by investors has been increased attention by researchers on the impact of sustainable strategies on the risk and returns of a portfolio. Alexander Cheema-Fox, George Serafeim and Hui Wang contribute to the sustainable investing literature with their February 2022 study, “Climate Solutions Investments.” They began by noting that while sustainable funds do lower exposure to climate risk, they do not necessarily provide an investor with exposure to climate opportunities: “The transition to a low carbon economy requires the development, deployment, and scaling of several key new technologies, products, and services. These climate solutions range from renewable energy, electrification of transportation and processes, battery technology, energy and process efficiency, circularity, new agricultural practices, and plant-based protein alternatives to meat. These solutions should see top-line revenue growth as the world proceeds to decarbonize.”