2016 Women’s Economic Round Table Prize-Winning Essay: “When Quants Take on Climate Change”

This year’s WERT prize, a $2,000 award for the best essay written by a current or former Knight-Bagehot Fellow, focused on climate change. Specifically, entrants were asked to write about on an aspect of the climate issue that has been overlooked and to explain how the press could foster a more intelligent discussion.

Sara Silver’s meticulously reported winning entry, When Quants Take on Climate Change, identifies a change that can be a key driver in fostering a sustainable environment: how financial innovation is making green investments pay off.

The WERT prize is funded by a bequest made by the Women’s Economic Round Table to Columbia University’s Knight-Bagehot Fellowship in Economics and Business Journalism.

Each year since 2008, the Knight-Bagehot Fellows, a group of mid-career journalists, have visited AIER as part of their all-expenses-paid year studying at Columbia.  The Institute has published the winning WERT essay since the prize’s inception in 2014. 

Sara Silver is a member of the Knight-Bagehot class of 2000. Her winning essay is below.

When Quants Take on Climate Change
By Sara Silver

Financial engineering, which drove the global economy into crisis in 2008, is now being used to steer investors away from greenhouse gas emissions. Quants have managed to design low-carbon investment products that match the returns and risk of the S&P 500 and other benchmark indexes. In effect, these products—offered by the world’s largest asset managers including BlackRock, Goldman Sachs, State Street Global Advisors, and UBS—let investors have their cake, while eating half as much carbon.

This financial innovation has created a new, more profitable wave of green funds, overturning the long-held belief that sustainable investing comes at a cost. Research from Harvard Business School—backed by a welter of investment data and a decade of corporate disclosures—shows, in fact, that companies with superior environmental, social, or governance (ESG) records produce greater long-term profits and returns. While active investors have for years used ESG themes, these new funds make it possible for passive investors to do so as well.

The New York State Common Retirement Fund, the third largest pension plan in the U.S., in December put $2 billion in a Goldman fund that cuts 70 percent of the greenhouse gas emissions from its portfolio. “By shifting our capital to companies with lower emissions and comparable returns, we are sending the message that our investment dollars will follow businesses with strong environmental practices,” said Vicki Fuller, the fund’s chief investment officer.

The business press has paid scant attention to these developments, even as climate has moved into the headlines with the Paris summit, China’s national cap-and-trade system, Volkswagen’s efforts to evade pollution regulations, and charges that Exxon misled the public about the harms of climate change.

In addition to explaining how the quants have made green investing more profitable, financial reporters could point to asset managers like Fuller rewarding companies that cut emissions.

There is also news of a trend: Low-carbon investing is moving into the mainstream. The world’s largest ratings agencies and index designers are using the tools developed for green products to rate the ESG impact of vanilla corporate bonds, stock indexes, and mutual funds. Since 2013, the credit rating agency Standard & Poor’s has been quietly downgrading companies with poor environmental records and upgrading those preparing for a low-carbon economy, such as Tenneco, a maker of auto filters. This year, MSCI began releasing the carbon footprint of all 160,000 of the indexes it designs, and Morningstar started assigning ESG grades to all the mutual and exchange-traded funds it rates.

When financial products display carbon emissions data the way food labels carry nutritional information, consumers will be able to choose products based on their environmental as well as financial performance.  This represents a third-generation of green investing and potentially the most important.

The first generation of low-carbon products “screened out” fossil fuel companies on ethical grounds, but missed big swings in energy prices. It also offered a supply-side solution—don’t hold oil stocks—to a demand-side problem created by consumers driving SUVs, living online, and air-conditioning desert homes.

Second-generation products “screen in” or include more of the most energy-efficient companies in each sector—knowing they tend to be more profitable. Carbon efficiency is defined by the amount of emissions produced per dollar of revenue, and removing the worst 10 percent of companies in each sector can eliminate 50 percent of emissions. 

The quantitative insights behind these products came from sifting through masses of emissions data. “In the pre-high tech days of finance, you couldn’t get your arms around a dataset,” said George Calhoun, director of the quantitative finance program at Stevens Institute of Technology. “Now you can much more easily interrogate the idea that carbon-efficient companies perform better than others.”

In March, Morgan Stanley concluded that “sustainable investments have usually met, and often exceeded, the performance of comparable traditional investments … on both an absolute and risk-adjusted basis, across asset classes and over time.”

Improved products and algorithms were key to the 2014 decision by the Rockefeller Brothers Fund, whose $867 million in assets sprung from the Standard Oil fortune, to eliminate fossil fuels from its holdings.

Board member Hugh Lawson guided Rockefeller’s efforts to keep the fund’s moral stance from exacting a financial cost. In June, Goldman Sachs appointed him head of ESG Investing and the next month acquired Imprint Capital, a boutique impact investing firm.

M&A is sweeping the ESG industry. This fall, governance watchdog Institutional Shareholder Services bought the Scandanavian firm Ethix SRI Advisors and research provider Sustainalytics bought Zurich’s ESG Analytics.

MSCI has acquired four companies since 2009 to build a powerhouse 220-person ESG team to calculate current and future emissions from reserves and tools to assess the long-term carbon risks and opportunities in portfolios.

Such long-term thinking is key to avoiding the “tragedy of the horizon,” of short-term investing, according to Mark Carney, chairman of the Financial Stability Board, which has identified climate change as a major threat to the world economy. Assessing those risks depends on better disclosure from companies worldwide, clear prices on carbon, and better stress-testing, Carney said in September.  

In late October, the Obama administration opened the door to sustainable investments in U.S. retirement plans. Labor Secretary Thomas Perez repealed 2008 guidance for the main U.S. pension law, known as ERISA, discouraging fiduciaries from considering factors other than risk and return, saying it had a “chilling effect” on ESG investing.

He credited changes in the financial markets, particularly improved metrics and analytical tools with enabling the growth of the ESG market. “It’s become quite mainstream,” he said.