The Earth’s climate is approaching a dangerous turning point. Left unchecked, climate change could have catastrophic environmental and financial consequences. According to the UN Intergovernmental Panel on Climate Change (IPCC), tackling climate change will inevitably call for a quick and full decarbonization of the world economy by mid-century.

As governments and regulators brace for this low carbon world, new risks to companies and markets will come to bear. Climate-aware institutional investors are increasingly taking steps to lower their exposures to fossil fuels and CO2 emissions in order to mitigate carbon-related risks and better position themselves for the low-carbon transition.

With this in mind, the Quantitative Investing Team at TD Asset Management Inc. (TDAM) recently authored an article titled Quantitative Equity - Low Carbon and Low Volatility that discusses whether a low volatility strategy can meaningfully shrink its carbon exposure, without compromising its defensive qualities.

Low carbon and low volatility

The carbon footprint of a given portfolio is highly contingent on its exposure to the Energy, Materials and Utilities sectors. Though traditional low volatility strategies typically have limited exposure to the first two sectors, the same cannot be said for Utilities. Utilities is a low risk, non-cyclical sector that is often the largest overweight position in many low volatility strategies.

How does the Utilities sector stack up against the other sectors from a carbon intensity standpoint? Not very well. The most carbon intensive companies are found in the Utilities, Materials and Energy sectors with the Utilities sector showing the largest dispersion in carbon intensity values.

Does low carbon affect portfolio risk and performance?

From a low volatility perspective, the more we constrain the carbon exposure of the low volatility portfolios, the more we constrain the weight of Utilities. Fortunately, the reduction in carbon intensity (and therefore in the percentage invested in Utilities) has virtually no bearing on the overall risk profile of the low volatility strategies, at least over the period considered.

While we do see a positive relationship between risk reduction and relative carbon exposure, the relationship is remarkably weak. Moreover, lowering the carbon intensity of the various low volatility strategies helped risk-adjusted performance as many carbon intensive stocks (Energy stocks, in particular) posted relatively low returns over the simulation period.

Managing exposure to Utilities is key to decreasing the carbon intensity of low volatility portfolios. Ultimately, we find that the carbon intensity of a low volatility portfolio can be reduced sharply without materially sacrificing the defensiveness of the strategy.

TDAM launches TD Emerald Low Carbon / Low Volatility Global Equity Pooled Fund Trust

As climate change awareness continues to grow, investors are increasingly looking to decarbonize their portfolio to align with their commitments and/or to reduce exposure to transition risks from high-carbon-emitting companies, while ensuring their investment objectives are met.

At TDAM we are committed to serving our clients' investment objectives to achieve sustainable long-term risk-adjusted returns. To demonstrate this ongoing commitment, we are pleased to announce the launch of the TD Emerald Low Carbon / Low Volatility Global Equity Pooled Fund Trust.

For more information on the features and benefits of the new Fund please contact your TDAM Relationship Management Team.