$138 billion megafund AQR shares a step-by-step guide for investors who want to reduce their portfolios' carbon footprints — and explains why this move could propel returns in the long run

  • Investors and money managers can use their dollars to reduce carbon emissions, but they need to consider solutions outside of avoiding big polluters' stocks, according to AQR.
  • Chris Palazzolo, Lukasz Pomorski, and Alice Zhao write that this approach can improve returns and environmental impact as well.
  • AQR manages $138 billion in assets, with more than $20 billion dedicated to environmentally conscious investing.
  • Visit Business Insider's homepage for more stories.

Once upon a time, the knock on socially conscious investing was that it started and ended with avoiding oil and gas companies. But a lot has changed.

As climate-themed investment strategies have taken off, not only have the investment approaches themselves gotten more complex, but advocates and investors are demanding that business leaders and money managers use the power of their dollars to encourage a greener approach — and some of them are doing it.

The environmental, social, and governance team at the investment management firm AQR is suggesting a roadmap that individual and institutional investors could use to guide their approaches and improve their returns.

AQR managed $138 billion in assets of September 30, including more than $20 billion in dedicated ESG solutions. Its ESG team is lead by Chris Palazzolo, Lukasz Pomorski, and Alice Zhao, and in a new research paper, they argue that investors large and small can employ more complex strategies to fulfill personal or corporate climate goals.

Their work focuses on reducing the carbon footprint of an investment portfolio. They find that by avoiding major carbon emitters, it's fairly easy to reduce that footprint by up to 70% without deviating very much from major benchmarks.

That simple step can improve returns by reducing the regulatory and climate-related risks their portfolios face, so it has obvious appeal. But after that 70% mark, the task becomes much harder.

And the AQR team sees trade-offs in a divestment-only approach. Once investors have dumped their shares in big carbon emitters, they lack leverage to push them to change their ways. They also can't benefit from the changes those companies do make, and today's biggest carbon emitters will probably make the most dramatic improvements.

"Investors who seek substantial reduction in emissions are more likely to exclude or hold very little in heavy emitters than be meaningful shareholders," they wrote. ""The usual approach of security selection (i.e., divesting from firms with highest emissions) can lead to a substantial carbon reduction but will not be enough for investors with the most ambitious reduction targets."

And when the biggest carbon emitters improve, it won't be as easy to de-carbonize a portfolio by avoiding just a few companies. That's another reason to try a broader approach.

What else is there?

Rather than avoiding those companies entirely, they say investors and managers could short some major carbon emitters and treat that as a way of offsetting the emissions of the stocks they are long on.

Philosophically, they say that the owners of a company's stock also collectively own its carbon emissions. If a long position on the stock is equivalent to that type of ownership, shorting the stock would be the opposite.

And the mix of long and short positions would give them more flexibility in portfolio construction and turn the companies' liabilities into positives.

"A major benefit of shorting is that it can help allocators achieve a meaningful carbon reduction without concentrating their portfolio nearly as much as pure long only security selection would," they write. "We can achieve a net zero carbon footprint by shorting just 2% of the portfolio's NAV while still being fully invested."

Thinking outside the box

While every investor wants to get a good return, there are real and non-financial reasons to take a green approach to investing. And the AQR trio says investors should consider a tactic that won't make them money, but could make it a little harder for others to pollute.

They suggest buying carbon offsets or permits. Offsets allow polluters to cancel out their emissions by paying for other activities that reduce carbon emissions elsewhere, and the permits give the buyer the right to emit specific amounts of greenhouse gases.

AQR proposes that investors simply buy those offsets and permits and never sell them. Since many companies and countries are required to offset or get permits for their carbon emissions, that will drive up the price they have to pay to pollute and could force them to work harder to reduce those emissions.

There's no financial return on that investment, but it wouldn't necessarily cost much, and in environmental terms it could deliver real bang for an investor's buck.

"If offsets can be obtained at $3/ton, the resulting "expense ratio" is relatively low for developed market large-cap indexes," they wrote. "Russell 1000 or MSCI World require offsetting 75-100 tons of carbon per $1M invested, which translates to an expense of 2-3 basis points," although that ratio add that it's higher for small-cap indexes.

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