August 17, 2021 | Documents

The integration of environmental preferences and the practice of sustainable and responsible investing are widely discussed topics among investment professionals, academics, and policy makers. Survey results confirm that more and more institutional investors commit to the integration of principles of responsible investment in their investment process. Central banks worldwide actively take part in the policy debate. The Network of Central Banks and Supervisors for Greening the Financial System (NGFS) was launched in December 2017 and currently counts 90 central banks, including the Swiss National Bank (SNB), as members or observers. The NGFS seeks to contribute to the development of environment and climate risk management in the financial sector, and recommends its members to lead by example.

Against this backdrop, the SNB has taken a passive, and for some observers unsatisfying, approach to investing its large foreign currency reserves. The SNB’s foreign currency reserves arose from the frequent currency interventions made to fulfill its monetary policy mandate since 2011, in particular during the period of the enforcement of a minimum exchange rate between 2011 and 2015. At the end of 2020, the SNB held foreign currency reserves in the total amount of CHF 910 billion. Equity investments represent 20% of the currency reserves and the SNB’s equity portfolio of approximately CHF 185 billion makes the SNB an important global equity investor. According to its annual reports, the SNB manages its equity portfolio passively, based on a strategic benchmark comprising a combination of equity indexes in various markets. It does not generally overweight or underweight particular sectors, although it does not invest in systemically important banks worldwide and in companies that seriously violate fundamental human rights, systematically cause severe environmental damage, or are involved in the production of internationally condemned weapons. Other Environmental, Social, and Governance (ESG) aspects are deliberately not considered, and the SNB is frequently criticized for the lack of a more active approach.

Two arguments point in favor of a more active exclusion policy in the current mandate of the SNB. There is a broad consensus among central banks that climate change is a threat to financial stability (Bolton et al., 2020). In particular, the transition to a low-carbon economy may imply that a large fraction of reserves of fossil fuel cannot be extracted. The resulting fall in the value of firms involved in fossil fuel extraction would severely impact the value of the SNB’s portfolio. Adopting a precautionary principle to the management of these climate related financial risks may imply the exclusion, or at least, the down-weighting of such firms in the portfolio. Second, in its 2020 annual report, the SNB has announced that it now “excludes shares and bonds of companies primarily active in the mining of coal, as there is a broad consensus in Switzerland in favor of phasing out coal.” This decision suggests that the SNB could adopt a more proactive exclusion policy if there is a sufficient consensus on climate related issues.

In this article, we do not take a stand on whether the SNB should take a more active approach regarding ESG issues. Rather, our objective is two-fold. First, we describe the different paths that a large, passive asset manager such as the SNB could take regarding ESG issues and, more specifically, carbon emissions. Second, we quantify the impact of a more carbon conscious investment approach on the portfolio’s carbon footprint and financial performance.

Large passive asset managers can pursue two strategies to change corporate policies – voice and exit. Asset managers can voice their preferences directly in individual meetings with portfolio companies or indirectly by voting on management and shareholder proposals at the portfolio companies’ annual general meetings (AGMs). Individual meetings with companies to voice concerns about certain policies require staff and are expensive, and many passive managers therefore refrain from them. While most passive asset managers, including the SNB, vote at AGMs on proposals, the number and scope of environmental or carbon-related proposals are still limited. The second channel available to passive asset managers is the “exit” channel. If institutional investors are dissatisfied with the ESG policies or the carbon emissions of some of their portfolio companies, they can sell their shares and reinvest the proceeds in companies that are closer to their preferences. If enough institutional investors do so, the exit channel could put pressure on the management of the respective companies, eventually increase their cost of capital, and lead to change.

Our empirical analysis focuses on the carbon footprint of the SNB’s U.S. equity portfolio, for two reasons. The SNB generally does not disclose detailed holdings data of its portfolio. The exception is the U.S. equity portfolio, because the U.S. regulator forces the SNB to disclose its holdings of all publicly listed U.S. companies. The SNB’s U.S. equity portfolio is valued at approximately CHF 100 billion at the end of 2019, which represents 65% of the total value of the global equity portfolio and 14% of the total currency reserves of the SNB. Although there are many different ESG issues, we focus on carbon emissions because of the climate emergency and media attention. In addition, the Greenhouse Gas (GHG) Protocol establishes a comprehensive global standardized framework to measure and manage emissions, and many of the publicly listed companies report their carbon emissions according to the GHG Protocol.

We compare the carbon footprint of the SNB’s portfolio to that of the portfolio of the world’s largest asset manager, BlackRock. Most of the assets under management of BlackRock are in passive, index tracking portfolios and thus similarly invested to those of the SNB. We also compare the SNB’s portfolio to that of the Norwegian Government Pension Fund Global (GPFG). Also known as the Norwegian Oil Fund, GPFG is well known for its ESG-conscious approach. Using S&P Trucost data, we attribute the Scope 1-2 carbon emissions of U.S. companies to their equity investors. In terms of carbon footprint (carbon emissions per million U.S. dollar invested), the SNB’s portfolio does as well as BlackRock once one accounts for the fact that the SNB does not invest in large banks, which have low Scope 1-2 carbon emissions. The SNB’s portfolio has a significantly worse carbon footprint than the more actively managed portfolio of GPFG.

We then examine several carbon footprint mitigation strategies, based on the carbon intensity (carbon emissions per million U.S. dollar of revenue) of portfolio companies. We first show that a small subset of portfolio companies has a particularly large environmental impact. In 2019, the 13 (89) portfolio firms with the highest carbon intensity correspond to only 1% (5%) of the market value of the SNB’s U.S. equity portfolio but cause 23% (59%) of its carbon emissions.

The first exit strategy we discuss is a global exclusion strategy, in which the SNB divests the companies with the highest carbon intensity, and over-weighs companies with the lowest carbon intensity. Since many firms have a zero-carbon intensity and therefore do not contribute to the carbon footprint of the portfolio, the results are quite dramatic: In 2019, the exclusion of the 13 companies mentioned above, from a portfolio of 1,991 companies, would reduce financed carbon emissions by 23%. The exclusion of the 89 companies with the worst intensity would reduce financed carbon emissions by 59%.

The SNB’s standard reply to requests for a more environmentally active approach is that it is not its mandate. We therefore also examine two additional strategies that try to address this concern and would not disadvantage specific economic sectors. The first one is sectoral exclusion. With this strategy, the SNB would exclude the same proportion of firms with the highest carbon intensity in each sector, and reinvest the proceeds in the best-in-class companies in that sector. Such a strategy has relatively little impact on total emissions because the most polluting companies are concentrated in a few sectors (utilities, energy, and materials). An effective strategy requires the exclusion of a substantial fraction of firms in some sectors but limited or no exclusion in other sectors (such as financials, health care, and information technology).

The second strategy is global exclusion with sectoral reinvestment. With this strategy, the SNB would exclude firms with the highest carbon intensity overall and reinvest in companies with the lowest carbon intensity in the same sector. Such a strategy maintains the sectoral exposure of the portfolio and provides all diversification benefits. Following this strategy and excluding the same 13 most polluting firms and reinvesting the proceeds in the least polluting firms in the same sectors leads to a reduction of the total financed carbon emissions by 22% in 2019 (53% for the same 89 companies). The impact on the carbon footprint would be similar to the global exclusion strategy, while maintaining the same sectoral exposures as in the initial portfolio.

None of the strategies we analyze would have a meaningful impact on the overall performance of the SNB’s portfolio and hence would not impact the annual distributions of the SNB to its stakeholders. We find that the annual return differences arising from our carbon emission reduction strategies are less than 0.1%. As the list of the companies with the worst environmental footprint is also very stable across the years, and our strategies would exclude few companies, we estimate that the cost of implementation of these strategies is minimal.

Overall, exclusion strategies would be very effective at greening the SNB’s portfolio and may potentially be carried out within the current mandate. However, the SNB would execute the trades to implement its exclusion strategy in secondary markets, and hence sell the shares of high carbon intensity companies to different investors, with little immediate impact on these polluting companies. If the goal of a carbon conscious investment approach was to reduce global carbon emissions and not only the carbon footprint of its portfolio, the SNB would need to focus on putting more pressure on the most carbon intensive companies to reduce their carbon emissions rather than walking away from those companies. In the last part of the paper, we briefly discuss two such strategies and provide a rough estimate of their potential impact on global carbon emissions. These more active strategies would likely require a new mandate for the SNB.

Eric Jondeau

Rüdiger Fahlenbrach