Carbon dioxide and other greenhouse gases (GHGs) trap thermal radiation from the earth’s surface, sustaining natural life. However, human activities, such as burning fossil fuels, are increasing the concentration of greenhouse gases and leading to rapid increases in climate-related risks.6 Environmental impact is an important part of our sustainability analysis, and a key focus of the UN’s Sustainable Development Goals (including SDG #7: Affordable and Clean Energy and SDG#13: Climate Action7) and the data involved is complex and nuanced. Standard data disclosures like GHG emissions and carbon intensity offer important insights, particularly when combined with company-specific context and an understanding of potential future change. For example, lower or decreasing carbon intensity means that a company is generating fewer emissions per unit of revenue, which is better for the climate than higher or rising carbon intensity. The aggregate emissions data for any fund often depends heavily on sector allocation, as one would expect: Companies in utility and energy sectors inherently have higher direct emissions (scope 1) when compared with less energy-intensive sectors like healthcare or financials. When we assess potential investments in carbon-intensive sectors, a key consideration is our analysis of the rate of change in those metrics and the magnitude of improvement that we expect given individual company strategies. For the purposes of this report, we focus on carbon intensity, which measures the ratio of carbon emissions (scope 1+2) to revenues. This is one important element of environmental efficiency.
The carbon intensity measure shows the ratio of scope 1 and 2 emissions to revenues. Scope 1 emissions are direct emissions from owned or controlled sources, and scope 2 emissions are indirect emissions from the generation of purchased energy. The portfolio level score aggregates the company-level intensity measures for all held securities. This metric offers the benefit of normalizing for company size, but in doing so it necessarily obscures the absolute level of emissions, which is important when considering a company’s impact on our climate. The carbon intensity of the Sustainable Leaders portfolio is somewhat higher (more intensive) than the S&P 500, which we use as a representation of the broader market. This metric is considerably lower (less intensive) for the Sustainable Future Fund. The higher carbon intensity of the Sustainable Leaders Fund is primarily due to our investment in three utility companies, as detailed below. Additionally, the key reason this metric has increased in 2019 versus 2018 is that we added to the portfolio’s utility holdings over this time frame. Though these companies are currently large producers of hydrocarbon-based electricity, they are also leading the way in replacing hydrocarbon-derived power generation with renewable energy generation, and it follows that their carbon intensity is expected to fall in the years ahead.
Weighted average carbon intensity 2018 and 2019
Sources: MSCI ESG Research LLC data as of December 31, 2019, and Putnam analysis. Carbon intensity is measured as a ratio of Scope 1 and 2 CO2e metric tons to sales (USD millions). Portfolio carbon intensity is calculated as the weighted average of the carbon intensity for the stocks held, with uncovered assets dropped and holdings rescaled to 100%. Uncovered assets refer to cash held in the portfolio and holdings for which there is no carbon intensity score available. Uncovered assets represent less than 10% of the funds’ holdings as of December 31, 2019.
We do not explicitly exclude or screen out energy or utility holdings (which often have high carbon intensity) in our investment process, though it is unusual for companies in these sectors to meet our investment criteria. As active managers, we have the ability to selectively own and engage with companies that are committed to transitioning away from carbon-intensive energy sources. Therefore, when we assess potential investments in carbon-intensive sectors, a key consideration is our analysis for the future rate of change in those metrics and the magnitude of improvement that we expect given individual company strategies. For example, the Sustainable Leaders Fund is invested in three utility holdings: AES Corporation, Nextera Energy, and Ameren Corporation. While these holdings made up less than 5% of the portfolio as of December 31, 2019, they constituted more than 60% of the fund’s aggregate carbon intensity exposure. Said another way, if these three holdings were not held in the portfolio, the fund’s aggregate carbon intensity would be below that of the S&P 500, and would have fallen further in 2019 versus 2018.
(As of December 31, 2019, AES Corporation, Nextera Energy, and Ameren Corporation accounted for 0.00%, 1.71%, and 0.00%, respectively, of Putnam Sustainable Future Fund, and 2.01%, 1.33%, and 0.47% of Putnam Sustainable Leaders Fund. As of March 31, 2020, AES Corporation, Nextera Energy, and Ameren Corporation accounted for 0.00%, 1.93%, and 0.00%, respectively, of Putnam Sustainable Future Fund, and 2.20%, 1.33%, and 0.64% of Putnam Sustainable Leaders Fund.)
We believe that climate change is the most pervasive risk of our era, as it is inherently linked to almost all other risks. And, as noted above, fossil fuel use is a key contributor to greenhouse gas emissions and to climate-related risk. One option for investors is to avoid all exposure to fossil fuel generation and use, and this approach has some clear merits. As active managers, though, we believe that part of our role is to support the shift to renewable sources of energy. Some of the most impactful ways to support this shift involve investing in the companies, like the ones discussed here, that are most actively changing the sources of global power generation. We have three main conditions for our selective investments in carbon-intensive businesses: First, there must be a demonstrated and meaningful commitment to shift away from fossil fuels; second, there must be regular reporting on progress, with transparency on relevant metrics; and third, the company must also meet our other investment criteria.
From an analytical perspective, historical emissions data is useful, but it is inherently backward-looking, while our investment research is forward-looking. AES, NextEra, and Ameren each have meaningful strategies underway to reduce their carbon intensity, and we believe these plans represent important improvements in environmental impact, are positive for the companies’ long-term financial prospects, and are well aligned with the UN SDGs referenced above (#7 and #13).
AES Corporation (AES) is a global power company. The company has plans to reduce carbon intensity by 70% by 2030 (from 2016 levels), and recently announced that they expect to reach a 50% reduction level by 2022, earlier than initially targeted.8 In addition, the company has commercialized a “green, blend, and extend” strategy to convert customers’ coal generating assets to renewable assets. Finally, AES is a joint venture partner in Fluence, a leading global energy storage technology and services provider. Energy storage is a crucial “missing link” for many potential renewable energy projects, and solutions in this area may help to accelerate their deployment.
NextEra Energy (NEE) is a leading clean energy utility. As of 2017, NextEra had 55% lower CO2 emissions than the average U.S. electric utility. The company has lowered total emissions by half since 2001 and has committed to a decrease of 65% by 2021.9 Additionally, NextEra owns NextEra Energy Resources, LLC, which is the world’s largest generator of renewable energy (wind + solar) and a world leader in battery storage.
Ameren Corporation (AEE) is a regulated electric and natural gas utility operating in Illinois and Missouri. Ameren is retiring coal-fired energy plants and adding wind generation capacity. In total, the company’s plans should result in a 35% reduction in C02 emissions by 2030, 50% by 2040, and 80% by 2050 (all versus a 2005 baseline). Ameren’s goals are aligned with the Paris Agreement and a 2-degree climate change scenario.10
A closer examination of the high carbon intensity of these holdings illustrates our investment philosophy: We recognize that historical data is most useful when it is linked to thoughtful projections of future performance, and that engagement with companies in the midst of strategic shifts is one way for an active manager to have impact. We will selectively own companies with some poor current metrics if — and only if — our research has convinced us of the commitment to and value of meaningful positive change.
We expect to see continued improvements in the accuracy, breadth, and timeliness of environmental data, which will provide new opportunities for relevant and accurate analysis. Additionally, we are increasingly able to consider the vital metric of scope 3 carbon data, which incorporates assessment of a company’s supply chain, investments, and the use of products sold. Many companies are beginning to disclose more complete environmental metrics and to set explicit goals for improvement, while others are moving forward with thoughtful and detailed climate change analysis. All of these developments will give investors more opportunity for analysis and engagement over time.