1 February 2023

Case study: Gjensidige applies basic economics to net-zero

Norwegian insurer Gjensidige has been running an experimental portfolio attempting to reach carbon price neutrality. Their former CIO, now chairman of Gjensidige Pensjonsforsikring, and one of their investment analysts discuss the initial findings. Interview by Vincent Huck

In the second half of last year, Norwegian insurer Gjensidige started running an experimental equity portfolio with the objective of keeping it carbon price neutral by holding an amount of emission allowances in the EU ETS equal to the estimated net carbon price risk of each security holdings and the portfolio.

The objective is to reduce the financial climate transition risk of the portfolio and achieve a capital allocation through price signals where carbon is priced into the capital cost of companies.

Nearly four months into the experiment previous chief investment officer now advisor and chairman of the board of GPF, Erik Ranberg, and investment analyst Stian Fjellstad at the Norwegian insurer discuss with Insurance Asset Risk the 'why, how and what next' of the project.

Can you explain first why you started this experiment?

Erik RanbergErik Ranberg: Our societies are built on carbon emissions. But we know that what is needed is a transformation towards less carbon intensive activities.

To achieve that transformation there are a few major challenges. First, carbon is something that comes from more or less all activities. Arguably, some activities are more carbon intensive than others, like activities that involves combustion of fossil fuels, but most of the products we use in our daily life are linked to processes where carbon is emitted. It is impossible to make investments with no emissions linked to it.

You must also consider potential trade-offs. If a company is a high emitter of carbon but produces vital medicines, does it make sense to divest or exclude that company?

So, there is the net-zero emissions objective, but there are different approaches to it. Even so there is a consensus – amongst academics, international institutions and financial market participants - that the most efficient way to reduce carbon emission is to have an appropriate carbon price.

Stian Fjellstad: Which is what basic textbook economics tells us to do: internalise the cost of the externality to achieve the desired level of emissions.

Ranberg: Exactly, so take the example of two shoe manufacturers where one has more carbon intensive processes than the other. If you internalise the cost of carbon in your investment decision you will probably make a completely different decision than if you don't consider that cost.

The CIO has the authority to tell the asset manager that they must invest carbon price neutral. So that means the whole portfolio should be carbon price neutral and the manager can decide to invest in the higher emitting company but will have to buy EU carbon allowances (EUAs) for it and incur a capital cost.

This way we will increase the capital cost of the company that emits more and reduce the capital cost of the one that emits less. Over time, this should move capital to the companies emitting less, while we still have the products that we like to have in our society. And it's also a tool to manage our asset managers.

At the moment the approach in the market to achieve net-zero is to actively engage with leaders of companies you are invested in to reduce their emissions. This is perfectly fine and probably needed, but let's be realistic, at Gjensidige we are an investment team of 10 managing $6bn – can we meaningfully engage with all the hundreds or perhaps thousands of companies we invest in? And would they really listen to us?

On the other hand, looking at it from a carbon price neutrality standpoint I can be certain that I will treat both large and small investments the same way which is fairer to the companies.

Fjellstad: It is important to note that we do use other tools than this carbon price neutrality project in our efforts to address climate issues. We have committed to the Science Based Targets initiative and will align our work with their requirements. As part of this we have developed a framework that measures the alignment of each individual company against a global 1.5°C emissions pathway. This is aggregated to portfolio level to see where we must direct our efforts.

We see the use of EUAs as a possible alternative or complement to the active ownership approach. Meaning that while active ownership is a possible solution, it has an uncertain outcome, and it risks treating some companies unfairly.

The premise of our experiment is to say: 'It's okay for companies to have emissions, but we need to see proper risk management from the companies on how they will reduce their footprint over time to become aligned with global net-zero emissions by 2050 at latest. We believe that with the potential for higher costs of emissions in the future, lack of such plans can evolve into a major financial risk, and that risk needs to be handled properly.

In the EU, this will show up through the price of EUAs. One way to handle that risk ourselves is through holding EUAs. Instead of investing $1m in a company, we invest $1m minus X, where X represents the EUAs needed to neutralize the carbon pricing risk of the company.

By using carbon allowances in our investment risk management, we have a potentially robust and certain tool to transition the portfolio to Net Zero.

Ranberg: Of course, we know that if we do this alone, it won't work. But if the whole world is doing it then it could work. Efficient carbon market in combination with strategy to neutralize the carbon price risk should move capital in the right direction. We as investors would continue to invest into known business models instead of as we see today, a lot of capital is invested into likeable themes but very uncertain business models. Chances for overinvestment is substantial as we have seen in previous periods.

Success is also dependent of several other factors. We are dependent on the authorities to regulate and manage the carbon market in a proper way. We are dependent on data from companies for how sensitive they are to carbon prices.

So far, we have found sources of high-quality data. And as regards the market, I'm impressed that the politicians have managed to maintain a carbon market that has worked efficiently as the war in Ukraine is raging on.

We've only been running this for a couple of months, it takes time to implement and analyse but so far things look promising, and we have been in discussions with both academia and some international institutions – who come at it from a theoretical standpoint compared to us who are looking at it from a practical angle and putting money behind it. So far, they haven't been able to tell us that our logic is wrong.

A recent IMF working paper gave support to our thinking, where the scientists showed that there is a highly significant negative relationship between increasing prices of EUAs and the performance of equities which pays for a high share of their emissions relative to the broader equity market.

So how does it work in practice? And how did you set it up?

Stian FjellstadFjellstad: The project of the carbon price neutral portfolio is one of our projects on how to use carbon as an asset class as well as a hedging instrument.

We have entered in a partnership with British company SparkChange, which provides us with data on carbon price exposure of companies.

The data gives us an overview of the current level of emissions, historical levels and projected future emissions based on the company's decarbonisation strategy.

From there we deduct any free allowances that a company may receive, and then incorporate the carbon price components of the electricity the company use. The data also considers whether the company has banked unused allowances from previous years, revenues from selling these allowances and effects of potential hedging activities.

In a nutshell what we see from the data is the emissions a company needs to pay for both directly and indirectly and what they handle through their risk management. We are then left with what I would call a 'residual carbon risk', or an estimate of how many tonnes the company needs to cover each year going forward. This is the component that we are bringing into the portfolio.

We use the company level figure to estimate how many EUAs we need to hold per share of equity to neutralize the effects that changes in carbon price will have on the equity price. The company level figures are aggregated to portfolio level. Our aim is to end up with a carbon price neutral portfolio, which means that any net negative carbon price risk at portfolio level shall be neutralized by holding EUAs. The portfolio manager is left with the choice of either neutralising the risk by holding a company that's positively affected by increases in the carbon price against companies that are negatively affected or balancing out the residual risk through holding emission allowances.

Any surprises in the amount of EUAs you have to hold?

Ranberg: What we found is the number of allowances we need to hold is smaller than what we anticipated at portfolio level, which means companies even each other out.

Fjellstad: For some companies, it's high in the negative direction. For others, it's high in the positive direction. For example, data for a renewable utility company might say that we need to have a short position in EUAs that is more than half the size of the equity investment. While for an airline company, it might tell us that we need to hold a long position of more than half of the equity investment in EUAs. These are however outliers, so for the average company the amount would be much less than a tenth of the equity investment in either direction.

When you talk about carbon as a cost to the portfolio, who is bearing that cost? The asset owner or the asset manager?

Ranberg: The asset owner. It will always come down to the return on the portfolio. But it is important to note that those who think we can have this transition for free, be my guest. The only question is how the cost will come around.

Over the last decade or so we have seen investors making investments in green assets or projects, often while taking unknown risks and / or reducing their return requirements. We have seen this kind of behaviour before, and it has often led to poor performance and overinvestments.

What we are doing with this carbon allowances experiment is trying to understand the cost and using that cost in our risk management by taking it into account in our portfolio.

But any management of risk will have a monetary cost that you must account for.

Fjellstad: With other strategies, such as the active ownership approach, you need to use a lot of time in meetings with corporates to achieve the desired result. That has costs as well, but it will show up as an administrative cost rather a factor that affects portfolio return.

Ranberg: And again, the outcome of that engagement would be very uncertain to us, especially with the use of several external asset managers that all have different objectives and approaches to active ownership. But when we increase the cost of capital of a company, we know that they will react to it.

So yes, we are taking a cost to the portfolio upfront. But we are pretty certain what consequences it has for capital allocation, and how companies will react. And remember, we will have a hedge in our portfolio as regards carbon price risk.

However, we have an uncertainty as to whether it will materialise as a real cost going forward, because what we will probably achieve is better security selection, by having the cost upfront into our analysis and our decisions.

Again, I really want to emphasise that if Gjensidige does this alone it has very limited or no effect at all as regards pushing capital in the right direction to achieve the transition we need, because we are so small in the total capital market. But if this becomes a common way of investing in the market, then it will move capital to a large extent.

How much have you invested so far? And in which types of companies?

Fjellstad: We have invested $5m so far, but we are building the portfolio and it is a test case. What we are interested in is the correlations. It makes no difference if it's $5m, $50m or $500m as long as it is large enough to go into our existing framework for equity investments.

The project portfolio is large enough for our framework and small enough so that there is no financial risk if it fails. It is a portfolio that will most of the time consists of 10 to 15 equities, from Northern Europe and the Nordics and a smaller amount of EUAs investments. It is important to us that the portfolio is representative of other equity portfolios we would hold as well. As of now, we are invested quite broadly in sectors such as energy, industrials, materials, automotive and financials, but there is a clear tilt towards carbon intensive sectors included in the EU ETS.

Are you currently managing it internally or with an external asset manager and if so, what was their feedback?

Ranberg: At the moment it is managed internally. If it proves to be successful, we could take it to external asset managers in a number of ways. We could use the analysis when assigning mandates. Or alternatively we could use it in discretionary mandates, giving the recipe to the asset manager and they run it on the mandate.

The most efficient way is that the manager does the carbon adjustments himself rather than we do it as an overlay. As an overlay it would probably result in us looking good and neutralising our own financial carbon price risk without much of a real-world impact to capital allocation. If the manager does the carbon adjustment themselves then she/he is steering the allocation according to the cost.

What are the capital charges implications?

Ranberg: It's an ongoing discussion with the regulator. We have an internal model and currently treat these investments as commodities, using the correlations to the underlying so we don't have the full commodity capital charge on it.

You see it is unchartered territory, we currently get a substantial capital charge for trying to bring down the carbon footprint. The capital charge at the moment makes it a bit less efficient than I would like, but I don't see it as being an impediment going forward.

What could be the perverse effects or unintended consequences?

Ranberg: When using a hedge there is always a risk of a situation where you earn money on both the hedge and the underlying investment or vice versa, that would be very perverse in this case.

Fjellstad: We may also possibly see a situation where the portfolio manager has a view that the price of EUAs will perform better than the equities in the short term and chooses to invest in the company most negatively exposed to carbon price increases within the data set only to hold allowances and speculate in the carbon market.

Ranberg: A way to handle that would be to give the manager a leeway to go short or long on carbon, so we would require a carbon price neutrality but with something like a +10% or -10% leeway. Like when you chose to be FX neutral, you always have a bit of a leeway on either side.

So how long are you planning to test it for and then what is the next step?

Ranberg: So far things are developing according to plan. We're doing some ad hoc analysis already, but in June we would have been running this for about eight months. We should then have enough data to look more thoroughly into.

If this conceptually works as planned, then we might expand and turn it into other instruments. Because this is something we can use for our fixed income investments as well.

The main consideration is that there are quite a few factors that affects the cost of carbon so we need to be sure there aren't too much residual risks that we can't control.

Fjellstad: And we look at it from two different perspectives which don't necessarily have to have the same outcome. One is the data and analysis that we do at company level and the other is whether carbon as an asset has the expected effect on individual equities in the portfolio. The other is whether the portfolio has the expected correlations to the carbon price.

But beyond the carbon price neutrality exercise presumably there is value in doing the analysis at company level?

Ranberg: Yes, that is one of the benefits we think we will get out of this, to actually have a better understanding of which companies will be more sustainable going forward and therefore which one to invest in.

Fjellstad: And regardless of the success of the experiment we are convinced that we now have a better understanding of how emissions move through the value chain from company to company and how it affects – positively or negatively – a company's revenues. Sometimes it materialises in unexpected ways.

Can you give an example?

Fjellstad: For example, you would expect an industrial company with a very good decarbonisation plan to have a very high exposure to carbon price today that will decrease in time as the plan is implemented. But in some instances, decarbonisation plans are based on an increased usage of electricity and if a company decarbonise faster than the electricity provider, well its exposure to carbon price will remain due to the carbon price component embedded in the electricity price.

What is the biggest hurdle or challenge going forward?

Ranberg: This is really a new way of trying to contribute to the transition needed for reaching net-zero, but as I said earlier if Gjensidige does it alone, it achieves nothing. If it works as we think it does and if it becomes more mainstream, then it has the potential to move a lot more capital.

Think about it this way, when you have a common target and different actors doing different things to achieve it, how do you ensure it all comes together instead of some doing too much and others too little and, further, others doing nothing?

The elegant answer is: With a market and a price.