Most scope 1 and 2 carbon emissions are generated by three sectors: Utilities, Energy and Materials. So reducing carbon exposure is primarily achieved by stock selection within these sectors and allocating away from these sectors.
Companies in the Utilities sector generate the highest carbon emissions, with the sector having a Weighted Average Carbon Intensity (WACI) of over 2,000 in MSCI World ex Australia benchmark as of March 2021. The Energy and Materials sectors also
have high WACIs (472 and 659 respectively), both well above the overall index WACI of 97.
The global benchmark has more stocks and a broader range of carbon emissions than the Australian benchmark, making it possible to achieve greater reductions in global carbon exposure for lower levels of tracking error as shown in Figure 1.
Figure 1 - Abatement levels and tracking error
Source: MSCI, IFM Investors
The global benchmark has 27 stocks with very high carbon emissions – all have a WACI over 3,000 and the highest is over 11,0002. A small reduction in exposure to these stocks can achieve quite large reductions in carbon exposure
for a relatively small increase in tracking error. By contrast, the S&P/ASX 100 Index has only two stocks with a WACI over 3,000 and the highest is only just over 4,500. So larger active positions are required to achieve the same level of
carbon reduction in the Australian market.
In the global benchmark there are also more stocks in the high carbon emitting sectors that have very low levels of carbon emissions. This is especially true within the Utilities sector given the focus on clean energy generation. These stocks
can be held above benchmark weight, enabling a reduction in carbon exposure without sector bias.
The Australian benchmark currently lacks ‘clean’ utilities, hence allocation away from the sector is often implemented to reduce carbon exposure. So Australian low carbon portfolios end up with higher levels of sector bias, compared
to global portfolios, which contributes to higher tracking error.