To construct the portfolios, we first set target carbon intensity at 100% of the market-cap-weighted average of the starting universe and then progressively lower the target to 50% of the universe average. In 2021, the carbon intensity of the universe, which is the reference for setting the carbon intensity target, is 164 t CO2/$M of revenues. As expected, the naïve value strategy has high average carbon intensity, at 130% of the universe average, or 209 t CO2/$M. When measured with EVIC, however, in 2021 carbon intensity is 60 t CO2/$M for the universe and 208 t CO2/$M for the naïve value strategy (3.45 times the universe). For the value strategies, the carbon intensity relative to the universe is always higher when intensity is measured as GHG Emissions/EVIC.
The 100% target is appropriate for investors who wish to preserve as many value portfolio characteristics as possible, while not producing more than the market average of carbon pollution. The universe-average targets of 70% and 50% are related to two benchmarks proposed by the EU TEG: the Climate Transition Benchmark (CTB) and Paris-Aligned Benchmark (PAB). The 70% target adheres to the CTB requirement and the 50% target adheres to the more stringent PAB requirement. The 50% target is also similar to the target level of a CTB-compliant strategy five years after inception, because the EU TEG guideline also calls for a 7% year-over-year reduction in carbon intensity.5
The iterative-weight updating process steers portfolios toward low carbon with little constraints. In theory we should be able to achieve the decarbonization targets without harming the portfolio’s valuation. Because of scarce availability of low-carbon and deep-value companies, the decarbonization bias leads, however, to impractical portfolio characteristics. These portfolio characteristics—high concentration and low liquidity—are the key drivers of the transaction costs required to maintain the value strategies.
As of March 31, 2021, the naïve value strategy had 93 effective holdings, a concentration level roughly double that of the universe. Concentration increased further with lower target carbon intensity. At 70% and 50% of the universe average (the levels required by the EU CTB and EU PAB, respectively), when we measure carbon intensity by GHG Emissions/EVIC, the effective number of holdings is reduced to only 19 and 15, respectively. In other words, allocations are limited to effectively less than 20 holdings in order to comply with the EU benchmarks, despite a starting universe of more than 600 holdings in the naïve value strategy.
The weight tilt, defined as the average deviation from the trading-volume weight of the holdings, is a measure of portfolio illiquidity and increases with higher allocations to less-liquid holdings. The universe and the naïve value strategy are weighted by market capitalization, which is highly correlated to liquidity, resulting in a low weight tilt of 1.6 as of March 31, 2021. The weight tilt increases rapidly with increasing restrictions on carbon, rising to 12.8 and 35.4 for the 70% and 50% targets, respectively, which comply with the EU benchmarks. Assuming a similar average turnover rate, the costs of rebalancing the value strategy at these decarbonization levels are 8 times (12.8/1.6) and 22 times (35.4/1.6) more costly than the naïve value strategy!6 If the expected excess return of the baseline value strategy is not more than 8 times or 22 times the expected transaction costs, the expected excess return is completely eroded by the low-carbon restrictions.7 In such a case, the investment objective and the social objective of this strategy cannot coexist.