Can You Cut Carbon Without Cutting Returns?

Can You Cut Carbon Without Cutting Returns?
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Carbon-neutral investing is a growing — and increasingly important — part of the investment universe, but not all approaches are created equal.

Climate change continues to make headlines. On November 4, 2016, the Paris Agreement — the first-ever universal, legally binding global climate deal — entered into force, with 146 countries around the world putting pen to paper. The long-term goal? To keep the increase in the global average temperature to less than 2°C above pre-industrial levels. Importantly, President Barack Obama and China’s President Xi Jinping ratified the agreement, making the two largest economies in the world key signatories and sending a strong signal to other countries to follow suit.

Notwithstanding President Donald Trump’s recent efforts to roll back some of this progress, the momentum toward a “greener” global economy remains strong. Speaking in New York on March 23, 2017, China’s permanent representative to the United Nations (UN), Liu Jieyi, reaffirmed the country’s commitment to the Paris Agreement. Its latest five-year plan, he said, has committed China to reducing its carbon intensity by 18% and to increasing the share of non-fossil energy in primary energy consumption to 15%.1 He went on to urge fellow UN delegates to honor the Paris accord, adding: “All signatories should stick to it instead of walking away. Regardless of the changes in the international landscape, China remains committed and will respond to climate change.”2

But should investors care about climate change and, if so, what can they do about it? Just as important, what are the options for generating a reasonable return on capital in what is still a nascent area of investment management? For Mellon Capital Management, it’s a question that cuts to the heart of maintaining a balance between sustainable investing and upholding fiduciary responsibility.

Putting aside for the moment any controversy over global warming as an anthropocentric phenomenon, we take the view that carbon emissions are the most immediate contributor to climate change. This is based on overwhelming evidence that temperatures worldwide are rising — and rising fast:

  • Data from the National Aeronautics and Space Administration (NASA) and the National Oceanic and Atmospheric Administration (NOAA) suggest global temperatures increased 0.99 degrees Celsius above the long-term average in 2016, making it the warmest year on record.3
  • The United Nations High Commission for Refugees (UNHCR) estimates an average of 22.5 million people have been displaced each year since 2008 because of global warming-related weather extremes.4

Given this evidence and a broad swath of similar data, the current pace of change and the likely consequences of rising CO2, we believe the argument for carbon-neutral investing is compelling. But what of the fiduciary responsibility side of the issue? Here we believe the arguments are more nuanced.

One school of thought, for example, highlights the “stranded assets” thesis — that is, to keep within the Paris accord’s 2°C commitment, only a small fraction of the world’s carbon reserves can be profitably burned. In turn, this means it might make sense for investors to divest companies that extract and use fossil fuels on the basis that their reserves

While this is a strong argument, we do view it as problematic. For one thing, there is no way of knowing how energy supply and demand could be affected by things like future regulation and innovation. Carbon capture technology, for example, could become so advanced that it would allow us to burn more fossil fuels without any accompanying rise in global temperatures. This would make some of those “stranded” assets less “stranded” and, therefore, more valuable, causing investors who had fully divested to miss out.

We also think the stranded assets argument fails to address a major challenge: As things stand, the world is so energy-dependent that an immediate wholesale shift away from fossil fuels and the technologies that use them would have a massive — many would say unacceptable — economic impact (See Figure 2).

Meanwhile, full divestment also brings with it the risk of increased volatility. Figure 3 illustrates this point. Here we view the energy sector as a proxy for fossil fuels — and have excluded it from the MSCI ACWI, a global index covering developed and emerging markets, to create a bespoke MSCI ACWI ex‑Energy Index, tracking relative returns since 1995.

While divestment from the energy sector might look smart when oil prices plunge, the same approach would have struggled to gain adherents during the strong energy run-up. Since 1995, the ACWI ex Energy Index would have returned almost 12% less than the ACWI Index. The ex-post tracking error of this ACWI ex Energy Index against its parent index from 1995 to 2016 is 1.16% per annum (the ex-ante tracking error is 0.98%). The chart below depicts how divestment costs in terms of lost returns and higher volatility.

Sources: Mellon Capital Management and MSCI. Performance shown represents the difference in the annual return of the MSCI ACWI Index vs. the MSCI ACWI Index with the energy sector excluded. Data as of December 31, 2016. For illustrative purposes only.

Engagement, Not Divestment

Investment performance considerations aside, those divesting their holdings in fossil fuel companies lose their influence. There is also the risk that the power and influence would pass to investors less concerned with such issues. Aside from coal, which has the highest level of carbon per unit of energy and faces a range of sensible substitutes in power generation, we believe that oil and gas assets can benefit from technological advances in energy production. This motivates us to engage with companies that produce and use fossil fuels to adopt more environmentally friendly corporate policies in order to improve their carbon footprint. In addition, energy companies happen to be a very convenient target, while many companies in the other sectors — predominantly utilities, materials, and industrials — operate while ignoring or dismissing global warming. Fighting global warming is a long journey, from reducing carbon emissions in the near term to building a more environmentally friendly energy infrastructure globally. We believe that divestment is a missed opportunity to influence changes, and engagement is a better strategy.

So, is there another way? We believe fulfilling both the environmental and financial objectives in an investment strategy can be achieved by striking the appropriate balance between reducing carbon exposure and achieving suitable risk exposure as measured by tracking error. We believe a better approach to carbon-neutral investing is to consider each company on its own merits within its own sector, to rate its carbon intensity and to measure how well it addresses its carbon emissions. Not only does this process allow us to maintain proper sector exposure, but it also presents a more sensible comparison between peers. After filtering for style exposures as well as sector, country and industry biases, we can then use that information to build a portfolio that overweights the less carbon-intensive companies and underweights their more carbon-intensive counterparts within each sector.


Since 2011, the fossil fuel divestment movement has elevated awareness of global warming and its implications for investing. Combating global warming is a long journey, and taking the first step demands deliberation and planning, especially with respect to fiduciary responsibility. In evaluating an approach to addressing the issues raised by fossil fuels and their impact on global warming, investors should consider their fiduciary responsibility in tandem with their desire to decarbonize their investments.

1 Climate Change News: “This Is China’s Strongest Statement Yet on Climate Change,” March 30, 2017.
2 Bloomberg: ‘Without Naming Trump, UN Acknowledges Retreat on Climate,” March 23, 2017.
3 NASA, Goddard Institute for Space Studies (GISS) Surface Temperature Analysis (GISTEMPP) and NOAA, January 16, 2015.
4 United Nations High Commissioner for Refugees (UNHCR): “Climate Change and Humanitarian Disasters,” January 1, 2015.



All investments involve risks, including loss of principal. Certain investments involve greater or unique risks that should be considered along with the objectives, fees, and expenses before investing.


Tracking error, or active risk, is the standard deviation of the difference between the returns of an investment and its benchmark. It is measured on an ex-ante or ex-post basis. The ex-ante tracking error is a statistical measure that is defined as the forecast annualized standard deviation of the active returns of a portfolio relative to a pre-defined benchmark. Ex-post basis tracking error is more useful for reporting performance. The ex-post tracking error formula is the standard deviation of the active returns.

The MSCI ACWI (All Country World Index) is a market capitalization-weighted index designed to provide a broad measure of equity-market performance throughout the world. The MSCI ACWI is maintained by Morgan Stanley Capital International, and is comprised of stocks from both developed and emerging markets. The MSCI ACWI ex‑Energy Index is the MSCI All Country World Index (ACWI) with the energy sector stripped out. An investor cannot invest directly in any index.

Views expressed are those of the manager stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. This information should not be construed as investment advice or recommendations for any particular investment. Please consult a legal, tax or investment advisor in order to determine whether an investment product or service is appropriate for a particular situation. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. The Dreyfus Corporation, Mellon Capital and MBSC Securities Corporation are companies of BNY Mellon. ©2017 MBSC Securities Corporation, Distributor, 225 Liberty Street, 19th Floor, New York, NY 10281.