ET Index blog series: Environmental Tracking as a practical solution to the climate crisis

The Holy Grail in the quest to tackle climate change, within the confines of the existing economic paradigm, is to place a price on carbon. In other words to make people pay for it. Within the laws of economics that govern our free market capitalist economy, the path of least resistance – cost – is king in the pursuit of profit. The ability to make the course of action that is detrimental to the environment the most expensive one, would enable us to realign the system towards a less destructive paradigm. Sam Gill, CEO of ET Index writes.

The simplest way to put a price on carbon and make companies pay for emissions would be through taxation. To some extent this happens already, e.g. fuel duty in the UK. But we do not currently have a global taxation regime whereby we have a ubiquitous and sufficiently high carbon price across all sectors and geographies. It is highly likely that we will eventually have some kind of global carbon pricing mechanism, especially with the emergence of more and more regional schemes that can be linked together. But this is still a long way off; and yet we will have blown our all time carbon budget at today’s rate within 15-20 years’ time. We need something that can start putting a price on carbon today.

The financial markets offer a mechanism through which a global carbon price can be implemented immediately. Let me explain how.

Whilst there are many different factors that influence an investor’s perception of the value of a company – e.g. the amount of profit the company made, the appointment of a new CEO, the news the company has destroyed the Gulf of Mexico etc. – the only thing that matters in determining a company’s actual share price is the supply versus the demand for its shares. Sam Gill, CEO of ET Index writes.

A company could be the most profitable company in the world, but if no one wants to buy their shares, thus killing the demand, its share price will drop. Price is always only ever a function of supply and demand.

The Environmental Tracking mechanism is designed to link the demand for a company’s shares to its environmental performance, in turn, linking a company’s share price to its environmental actions. The objective is to pioneer this approach for carbon, given the urgency of the climate crisis, before adding additional environmental indicators to the system.

Why would targeting a company’s share price be so powerful? Company management and key staff often have bonuses and compensation packages tied to the company’s share price. A suppressed share price for a company makes it more vulnerable to a hostile takeover. It also raises the cost of capital for a company. But above all every company’s raison d’être is to make money for its shareholders. If the shareholders of a company can see that the management’s actions are causing their shares to lose value, it is likely the management will be voted out.

So how can we achieve all this? The Environmental Tracking mechanism is made up of two key components. The first is a set of public Environmental Tracking Carbon Rankings (available here). Here, the largest companies in the world are ranked according to their publicly disclosed greenhouse gas emissions data. This includes their supply chain (Scope 3) emissions, which are often the most significant source of emissions. In the case of companies failing to publicly disclose data, they are awarded the same emissions intensity as the company with the highest reported emissions figure within the same sector, providing a constant incentive for disclosure. Since the ranking is relative is is designed to always push companies towards zero emissions.

The second is a series of Environmental Tracking indexes. These are stock market indexes just like, for example, the FTSE 100 or S&P 500. They contain all of the same companies as conventional market capitalisation benchmark indexes, not just those which are ‘low-carbon’. The difference between Environmental Tracking indexes and traditional stock market indexes is that they are designed to redirect capital from high-carbon to low-carbon companies. They do this by re-weighting companies according to their position in the fully transparent Environmental Tracking Carbon Rankings.

Unlike the approach of divestment, which only targets fossil-fuel companies, each and every company within the stock market is penalised or rewarded based on their carbon emissions. This is designed to push up the cost of capital for carbon-intensive companies.

This approach is the embodiment of engagement. Since all companies are publicly ranked it provides an open platform for Environmental Tracking investors to monitor progress in a transparent way and demand that companies lower emissions. For companies, the only way to move up the ranking is to lower emissions and to encourage the companies within their supply chains to do the same, in turn gaining a greater weighting in the index and therefore a greater share of investment from those tracking the index.

As any investor will know, money speaks louder than words. This is a way to use the stock market to make companies pay for the carbon they emit.

For investors who champion engagement this is the perfect mechanism on the way towards full divestment. Indeed, an investor could tell a company that unless it achieves a certain position within the ranking or clearly demonstrates a drop in emissions intensity of, say 20% per year, it will be excluded altogether.

ET Index recently produced a series of briefing notes demonstrating how investors can achieve a greater emissions-intensity reduction through Environmental Tracking than divestment alone, without compromising on returns. For investors committed to pursuing a divestment strategy, ET Fossil Free indexes offer the ability to combine divestment with Environmental Tracking, re-weighting the remaining companies in the portfolio according to their carbon emissions once fossil-fuel companies have been excluded.

Once the logic of divestment has been embraced, that shifting capital in line with emissions, can be so powerful, why stop at fossil fuel companies?