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Donald Sze

Donald Sze

Executive Director, MSCI Research

Guillermo Cano

Guillermo Cano

Executive Director, MSCI Research

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Portfolio Intelligence Through a Carbon-Efficiency Factor

  • Carbon emissions are an important attribute for determining a company’s exposure to the risk associated with the transition to a low-carbon economy.
  • In addition to measuring a portfolio’s carbon footprint, investors may also want to understand the carbon emissions of their investments relative to sector peers.
  • We introduce a carbon-efficiency factor to help investors understand company and portfolio-level exposures to carbon efficiency and their potential impact on portfolio returns.

The transition to a low-carbon economy may trigger a major transformation of the global economy, generating significant risks and opportunities for companies and investors. Traditionally, climate-aware investors have used weighted average carbon intensity (WACI) to measure their exposure to carbon-intensive companies and reduce their carbon footprint, but they may not all be able to achieve a “low” carbon footprint. Since every sector needs to decarbonize to limit climate change and carbon intensity, investors may benefit from understanding the carbon intensity of their investments relative to sector peers. However, carbon-intensive firms, on average, will be more impacted by the low-carbon transition.


Two approaches to a low-carbon allocation

From a sector-positioning perspective, there are basically two approaches for constructing low-carbon portfolios: sector allocation and security selection. The sector allocation approach involves reallocating capital from carbon-intensive sectors such as energy to carbon-efficient sectors such as information technology. Simply underweighting or divesting from carbon-intensive sectors, however, would deprive them of capital that is critical for transitioning to a low-carbon economy. The security selection approach, on the other hand, does not take sector tilts but, instead, invests in companies with lower carbon intensity than their sector peers. This approach recognizes that every sector needs to decarbonize for the low-carbon transition. By investing in the low emitters of each sector, investors potentially incentivize companies across sectors to decarbonize through their capital allocation decisions.


Introducing carbon efficiency

But how can investors measure relative carbon efficiency? We examine the utility of a carbon-efficiency factor to help investors understand portfolio exposures to carbon-efficient stocks and their potential impact on portfolio returns.1

We measure the “carbon efficiency” of a stock by comparing its Scope 1, 2 and 3 emissions intensity against its sector peers.2 Simply, a stock is “carbon efficient” if it has a lower intensity than its peers. To further explain the concept, let’s relate it to car shopping. Buyers can easily compare automobile fuel efficiency across different makes and models by using a miles per gallon (MPG) metric. Many energy-conscious consumers desire a higher MPG, as fuel-efficient cars are more environmentally friendly, and have the added benefit of lower fuel costs. In a similar fashion, climate-aware investors may consider the emissions intensity of companies to reduce exposure to transition risk and potentially contribute to the decarbonization of the real economy. Just as no one would compare the fuel efficiency of a large delivery truck to that of a compact sedan, we also measure carbon efficiency on a sector-relative basis to account for the difference of emissions intensity across sectors (as shown below).


Emissions intensity varied across and within sectors

A graphic that shows how the intensity of emissions varies across and within sectors.

Scope 1+2+3 emissions intensity of the constituents of the MSCI ACWI Investable Market Index (IMI). The boxplot reflects the first, second and third quartiles (box) and fifth and 95th percentiles (whiskers) of emissions intensity. Data as of Aug. 3, 2022.


Carbon-efficiency factor illustration

To analyze how a carbon-efficiency factor may help investors measure the degree of security selection with respect to carbon emissions, we consider four hypothetical low-carbon portfolios based on the MSCI ACWI Index (as shown in the exhibit below). The first portfolio represents the sector allocation approach by excluding stocks from the three most-carbon-intensive sectors: energy, utilities and materials. The other three portfolios implement the security selection approach to various degrees: taking positions in the bottom 75%, 50% and 25% of firms by carbon intensity in each sector, respectively, but do not take any active sector tilts.4

The traditional WACI metric shows that all four portfolios had a lower carbon footprint than the MSCI ACWI Index. However, it does not differentiate between the first and third portfolio (which have similar levels of carbon intensity) because WACI does not account for the sectoral variation of carbon intensity. In contrast, we found that the exposure to the carbon-efficiency factor increased with the extent of security selection in the hypothetical portfolios. This simple analysis illustrates how the carbon-efficiency factor may complement WACI as investors construct low-carbon portfolios.


The carbon-efficiency factor revealed the extent of security selection in low-carbon portfolios

A bar chart that illustrates how the carbon-efficiency factor may complement WACI as investors construct low-carbon portfolios.

The WACI and carbon-efficiency factor exposure of the MSCI ACWI Index and four hypothetical low-carbon portfolios. WACI was calculated as the weighted average of Scope 1+2+3 emissions intensity relative to EVIC. Data as of Aug. 3, 2022.


An increased focus on climate-risk exposure

In the coming years, investors are likely to pay even greater attention to climate risk, as extreme weather events become more commonplace and the window for limiting global warming closes.4 Thus, investors have become engaged in trying to understand their exposure to the different aspects of climate risk. In this blog post, we introduced the notion of a carbon-efficiency factor and showed how the metric revealed the approach used for constructing low-carbon portfolios.



1The carbon-efficiency factor is included in MSCI’s next-generation equity risk models.

2We use scope 1+2+3 emissions intensity relative to enterprise value including cash (EVIC). By including scope 3 emissions, the factor accounts for all direct and indirect emissions of companies across their value chains. The carbon-efficiency factor is first computed as the negative log of scope 1+2+3 emissions intensity. The resulting value is then subtracted by the cap-weighted sector mean.

3To construct the portfolios that model the security-selection approach, we begin with the MSCI ACWI Index weight for low-carbon companies in each sector. We then renormalize the stock weights in each sector such that their sum equals the corresponding sector weight of the MSCI ACWI Index.

4According to the MSCI Net-Zero Tracker, as of June 2022, there are 57 and 248 months left to keep warming below 1.5 and 2°C above preindustrial levels, respectively.



Further Reading

The Role of Capital in the New-Zero Revolution

Managing Climate Risk in Investment Portfolios

Net-Zero Alignment: Objectives and Strategic Approaches for Investors

Net-Zero Alignment: Portfolio Construction Approaches for Investors