Reducing an equity portfolio’s exposure to carbon emissions is an increasingly common investor goal. Doing so requires many decisions, including how and where to take active risk relative to a benchmark. In this paper, we examine emissions concentration, style factor exposure, and portfolio construction as key elements in that decision-making process. We argue that a thoughtful approach to these elements can help investors reduce unwanted active risk and factor exposure, freeing risk budget to add value beyond carbon reduction objectives.
A preliminary step when seeking to reduce a portfolio’s carbon exposure involves deciding how to quantify carbon emissions. In this paper, we focus on one common carbon metric: carbon footprint. This measure divides a company’s metric tons of carbon dioxide-equivalent emissions (tCO2e) by its market capitalization.
Carbon Emissions Concentration
Some sectors are “cleaner” than others, and the distribution of carbon emissions across sectors differs markedly from the distribution of market capitalization. Figure 1 presents carbon footprint and market capitalization data for Russell 1000® Index sectors from 2013 through 2022 (in descending order by market capitalization, with the largest sector on the left).
Figure 1: Average Proportion of Russell 1000® Index Market Capitalization and Contribution to Index Carbon Footprint by Sector 1/1/2013 – 12/31/2022
Sources: London Stock Exchange Group; MSCI; the D. E. Shaw group. All sector classifications reflected above are proprietary classifications developed by the D. E. Shaw group. Sector contributions to weighted average carbon footprint for sector S and benchmark B are calculated as (ΣiϵSwiCFi)/(ΣiϵBwiCFi), where wi is the benchmark weight of company i, and CFi is its carbon footprint.
As can be seen, emissions are concentrated in a handful of relatively small sectors. This presents a potential opportunity to substantially reduce exposure to carbon emissions by underweighting or omitting entirely, for instance, the utility or energy sector. But that approach may not align with an investor’s economic objectives or investment policy, and can also lead to taking active risk. Consider the example of the energy sector, which returned 64.36% in 2022 compared to -19.13% for the Russell 1000® Index as a whole—even a moderate underweight position in the sector might have had meaningful return implications. The same logic holds when investors contemplate applying overweights to relatively clean sectors like technology and telecom or health care.
Similarly, there is significant concentration of emissions at the individual stock level. Figure 2 plots each constituent in the Russell 1000® Index by relative size and carbon footprint. The size of each bubble represents the stock’s contribution to the index’s total carbon footprint (the product of its index weight and carbon footprint).
Figure 2: Russell 1000® Index Constituents by Market Capitalization and Carbon Footprint, with Observation Size Scaled to Reflect Contribution to Total Index Carbon Footprint As of 12/31/2022
Sources: London Stock Exchange Group; MSCI; the D. E. Shaw group.
We see that the size of the bubbles increases non-linearly as we approach the right-hand side of the chart, meaning that a relatively small number of companies (the larger bubbles) account for a sizable share of the index’s carbon footprint. Conversely, companies at the top left represent a relatively large amount of market capitalization and few emissions. Overweighting the stocks of those large cap firms might materially reduce measured carbon emissions, but exposure to concentrated single-stock risk could also have adverse consequences. Consider, for example, Apple Inc. or Tesla Inc., which fell 26.40% and 65.03%, respectively, in 2022.
More generally, to the extent that the relationship between market capitalization and carbon emissions correlates to certain other variables, decisions to actively weight certain stocks have the potential to introduce additional biases, such as industry group effects, even after controlling for sector. For example, carbon emissions are concentrated among a small number of names within the consumer cyclical sector, but simply reducing or omitting those names would lead to a large underweight of the airline industry group as compared to other industry groups in the sector.
There are also tradeoffs to consider regarding portfolio sensitivity to emissions data estimates. Because a given company’s emissions data are estimated by either a data provider or the company itself, an investor seeking to exploit concentration when targeting reductions in emissions exposure might place too much confidence in a small number of estimates. This creates the potential for a “single point of failure” problem if revisions are made to estimated data.
Carbon emissions concentration, therefore, presents both opportunity and risk in the form of economic and portfolio exposure tradeoffs. We believe that thoughtful portfolio and risk management, discussed later in this paper, can lead to more robust outcomes in light of these considerations.
Style Factor Exposure
A second and perhaps less well understood aspect to consider in reducing a portfolio’s measured carbon emissions centers on exposure to traditional equity style factors. As one illustration, Figure 3 shows the value factor exposure (y-axis) and carbon footprint (x-axis) of each Russell 1000® Index constituent as of year-end 2022.
Figure 3: Value Factor Exposure and Carbon Footprint of Russell 1000® Index Constituents As of 12/31/2022
Sources: London Stock Exchange Group; MSCI; the D. E. Shaw group. All measurements of equity style factor exposures referenced in this document are proprietary values developed by the D. E. Shaw group.
The data indicate that value exposure is positively related to carbon footprint with a high degree of statistical significance (t-stat = 13.68). This makes intuitive sense because value companies tend to have high present-day levels of physical assets (e.g., as measured by book value) and fundamental economic activity (e.g., as measured by sales or earnings) relative to their market capitalization, characteristics which correlate positively with high present-day carbon emissions relative to market capitalization.
We separately find that the relationship between value and carbon footprint for the Russell 1000® Index constituents has remained relatively stable since 2013 and holds within many sectors. All else equal, this suggests that an investor seeking to reduce a portfolio’s carbon footprint might unknowingly introduce a negative value tilt. The observed stable relationship between value and carbon footprint over the past decade also suggests that relative exposures to value exhibited by many stocks were not heavily influenced by flows into ESG-focused investment products.
The link between a company’s carbon emissions and its exposure to equity style risk is not limited to value. Figure 4 shows the cross-sectional correlations of additional style factor exposures to carbon footprint.
Figure 4: Correlations of Select Factors to Carbon Footprint for the Russell 1000® Index As of 12/31/2022
Sources: London Stock Exchange Group; MSCI; the D. E. Shaw group. All measurements of equity style factor exposures referenced in this document are proprietary values developed by the D. E. Shaw group. Each factor shown represents the cross-sectional correlation coefficient between factor loading and log(carbon footprint) for individual companies in the Russell 1000® Index as of December 31, 2022. The carbon footprint units reflected are log(tCO2e/$mn). Factor loadings are normalized z-score values.
In most cases, the relationships are statistically significant. These correlations indicate that investors seeking to target a reduction in an equity portfolio’s carbon footprint could inadvertently introduce negative tilts to a host of style factors in addition to value, as well as positive tilts to size and volatility.
Building on the data from Figure 2, Figure 5 highlights stock-level exposure to the leverage and volatility style factors, showing that many individual stocks with a high carbon footprint also have exposure to certain style factors.
Figure 5: Russell 1000® Index Constituents by Market Capitalization and Carbon Footprint, with Observation Size Scaled to Reflect Contribution to Total Index Carbon Footprint and Highlighting Exposure to the Leverage and Volatility Factors As of 12/31/2023