# Measuring the carbon footprint of an investment portfolio

## Why measure the carbon footprint of portfolios?

There is no longer any doubt for investors today that climate risk is an integral part of economic activity. As such, investors must take this risk into account in the management of their portfolios, otherwise their assets will depreciate under the impact of climate change.

Climate risk can be approached in two ways:

• a physical risk, defined as exposure to the direct physical consequences of climate change
• a transition risk, defined as exposure to changes linked to the transition to a low-carbon economy.

Calculating the carbon footprint of portfolios is not a response to physical risk. On the other hand, it helps address the transition risk. Indeed, the companies with the highest emissions risk seeing their business model questioned in the context of the transition to a low-carbon economy, and their assets (fossil fuel deposits, industrial infrastructure, for example) depreciated to the point of becoming "stranded assets".

The carbon footprint is a measure of the greenhouse gas emissions generated by the companies held in the portfolio. Emissions are understood in the generic sense, all greenhouse gases (carbon dioxide, but also methane, nitrous oxide, CFCs, etc.) taken together and are therefore measured in "Tons of CO2 equivalent", TeqCO2.

Of course, to be meaningful, the figure must be related to the amounts invested and the activity of the companies financed. This is what we will see further on, but first of all we need to look at the data necessary for this type of calculation.

## Source of the data

Before embarking on any type of calculation, it is important to have reliable quantified data, under penalty of producing irrelevant indicators, however sophisticated they may be.

Until now, investors have been used to collecting figures on companies such as balance sheets, results, market value of financial securities, etc. But the collection of GHG (greenhouse gas) emissions produced by a company is a relatively new subject. Methodologies exist, but the data itself is still not widely available.

In principle, GHG emissions are measured at the level of several scopes :

• Scope 1: greenhouse gas emissions generated directly by the company's production process
• Scope 2: indirect emissions linked to the energy consumption necessary for the manufacture of products: electricity, steam, heat, cold...
• Scope 3: emissions generated upstream (suppliers and raw materials) and downstream (product use and end of life)
GHG emissions of the U.S. Environmental Protection Agency in scopes 1, 2 and 3 (source)

Ideally, data should be available for scopes 1, 2 and 3 of all companies financed. However, this is rarely the case for several reasons:

• Scope 3 data is complicated to obtain. Scope 3 data are complicated to obtain. They are most often derived from estimates based on the companies' sector of activity. These data are still unreliable and heterogeneous.
• The risk of double counting: scope 3 covers both upstream and downstream, so there is an intersection between the scopes 3 of two companies, when one company supplies products to the other.

The data may come from the following sources:

• either directly from the companies themselves: for example those that adhere to the Carbon Disclosure Project, or based on annual reports and CSR (Corporate Social Responsibility) reports
• or from databases compiled by data providers
• or from data estimates provided by specialised companies that develop models by sector of activity

Whatever the source of the data, there are many uncertainties and inconsistencies, due to incomplete perimeters, changes in methodology from one year to the next, and so on. In particular, the calculation or estimation of Scope 3 emissions still involves many methodological problems.

Clearly, the field of extra-financial data is still emerging and there is much room for improvement. The coming European regulations will hopefully push companies to improve their reporting, otherwise investors risk turning away.

## Indicators

### Goals

To be relevant, a carbon footprint calculation must be readable and relatively easy to calculate. It can be adapted to an asset class (e.g. equities), or more generic (equities and bonds). Above all, it must enable the portfolio to be compared with other portfolios or with a benchmark, or to follow the evolution of the portfolio over time. For this purpose, it is preferable that the indicator is not sensitive to the size of the portfolio or to the volatility of stock prices.

### Variables used in subsequent calculations

 Data relating to each issuer i Value of the investment Ii Market capitalisation CBi Annual emissions Ei Annual turnover CAi Value of the company VEi Data relating to the portfolio Portfolio valuation VP

### Examples of generic indicators

#### Total carbon footprint

The total carbon footprint measures the total annual emissions "embarked" by the portfolio in tonnes of CO2. It therefore corresponds to the sum of the emissions of the companies in the portfolio, weighted by the share of ownership in the company, reflecting the portfolio investment.

T otal\ carbon\ fo otpri nt = sum_(i) I_i/"CB"_i ** E_i

This indicator shows the overall climate impact of the portfolio. However, it does not allow for comparisons because it does not disregard the overall size of the portfolio. All other things being equal, the larger the size of a portfolio, the greater its total carbon footprint.

#### Financed emissions

The financed emissions represent the portfolio's carbon footprint per million euros invested, therefore in tonnes of CO2 per €M invested. This indicator allows comparisons to be made, ignoring the portfolio size effect.

Fi nanced\ emissions = (sum_(i) I_i/"CB"_i ** E_i) / (VP) ** 1000000

This calculation method is suitable to equity portfolios. For a bond or diversified portfolio, the market capitalisation can be replaced by the valuation of the company calculated from balance sheet data, for example net assets :

Fi nanced\ emissions = (sum_(i) I_i/"VE"_i ** E_i) / (VP) ** 1000000

This indicator allows comparison between portfolios, or of the portfolio itself with a benchmark, or a monitoring of the portfolio's carbon footprint over time.

On the other hand, since it does not take into account the volume of business activity of the companies, it does not give an indication of the operational efficiency of the companies financed.

#### Carbon intensity

A company's carbon intensity is measured as the ratio of its total emissions to its total turnover. At the portfolio level, the total emissions of the portfolio are calculated as a ratio of the total emissions of the portfolio to the total turnover of the portfolio. This gives a carbon footprint in tonnes of CO2 per M of turnover.

Carbon\ i ntensity = (sum_(i) I_i/"CB"_i ** E_i) / (sum_(i) I_i/"CB"_i ** CA_i) ** 1000000

As before, in this type of formula, the market capitalisation can be replaced by the company's valuation:

Carbon\ i ntensity = (sum_(i) I_i/"VE"_i ** E_i) / (sum_(i) I_i/"VE"_i ** CA_i) ** 1000000

This indicator is dependent on the size of the companies financed.

#### Weighted carbon intensity

Weighted carbon intensity measures the portfolio's exposure to the most carbon-intensive companies, therefore in tonnes of CO2 per €M of turnover, while disregarding the size of the companies financed. It consists of calculating the sum of the carbon intensities of the companies financed (total emissions per €M of turnover), weighted by the weight of the company in the portfolio:

Weighted\ carbon\ i ntensity = sum_(i) I_i/(VP) ** E_i/(CA_i)

Carbon intensity measures the portfolio's exposure to regulatory risk such as a carbon tax. It does not take into account market capitalisation and is therefore not impacted by price volatility.

Carbon intensity, whether total or weighted, does not take into account a company's positioning. For equal emissions, a company with a high-end positioning, and therefore a high margin, will have a lower carbon intensity than a company with a lower margin. To ignore this bias, it would be necessary to perform an analysis at the production level. For example, for a car manufacturer, relate CO2 emissions to the number of units produced.

#### Special cases

The indicators described above are well suited to portfolios of listed securities of private companies. In particular, the use of company value in the denominator, instead of market capitalisation, makes it possible to calculate an overall carbon footprint for a diversified portfolio containing equities and bonds.

However, there are many types of investment portfolios, just as important for the economy, for which these indicators are not relevant.

## Sovereign bonds

In the case of sovereign bonds, a method is needed to estimate the State's overall carbon footprint. Should only the public sector be taken into account, or the whole economy? In the latter case, however, there is a risk of double counting if the portfolio also contains bonds of large private companies.

Another approach consists in not directly calculating a carbon footprint, a risky exercise anyway, but rather to follow a risk-based approach. State policies to reduce their carbon footprint can be assessed, for example through Intended Nationally Determined Contributions (INDCs).

## Private Equity

In the case of unlisted companies, extra-financial reporting is generally absent. It is only through direct contact and dialogue that the investor can convince the company to calculate and track its carbon footprint. This is part of the so-called "engagement policy", which is very much in favour among SRI investors.

## Infrastructure and project financing

Here again, a figure can only be obtained prospectively and based on modelling, since, by definition, the asset financed is not yet in operation. Methodologies are proposed by specialist firms such as Carbone 4.

## Real estate

It is relatively easy to calculate the carbon footprint of a property asset in CO2 equivalent per m², based on the technical characteristics of the building. However, the portfolio's investment strategy must be taken into account. If this strategy consists of buying buildings to renovate them before reselling them, the portfolio's carbon footprint may be poor overall, although the end environmental impact is actually positive.

## Critical analysis

The carbon footprint is a good tool for monitoring a portfolio globally over time, and at the level of each company to engage in a dialogue and measure its emission reduction policy.

However, there is a huge quantitative bias that institutional investors are very conscious of: a portfolio of low-emitting tertiary sector stocks will necessarily have a much better carbon footprint than a portfolio of industrial stocks. However, it is the latter that hold the most promising solutions for decarbonising the economy.

As part of a genuine policy to support the economy in the energy transition, other types of indicators must therefore be taken into account. These include the following:

• The "green share" of funded activities; as such, the European taxonomy is a valuable tool.
• The calculation of avoided emissions compared to a reference scenario. This indicator makes it possible to identify the "good performers" in a given sector of activity.
• The "portfolio temperature" which - using a complex and constantly evolving method - makes it possible to measure the alignment (or distance) of the portfolio with a +2°C scenario in 2050.

Furthermore, the comparison between portfolios, particularly those of different asset management companies, is made very difficult by the differences in methodology.

In conclusion, the carbon footprint, like all numerical indicators, is a useful tool in which one should not be locked in, however, as it can be falsely reassuring.

1. Valuation calculated from balance sheet data
2. Sum of the market values of the positions held