Setting Benchmarks

"There's no use running if you're on the wrong road. " - Warren Buffett

As a portfolio manager, I often felt like we were in the mud up front while our clients sat in castles miles away, obliviously sipping tea while giving us benchmarks that were out of touch with reality. They would exclude out of favor assets that offered the best opportunities while piling into flavor of the month investments that offered few. They wanted short-term results from investments that clearly required long-term time horizons. Finally, they would exclude perfectly safe investments while allowing highly risky ones on the basis of arbitrary ratings. The last one, by the way, is exactly what caused the Credit Crisis and Great Recession of 2008 -- read The Big Short by Michael Lewis. If only I could be the client...

Then I started to invest for myself. True to my wish, when I made my own direct investments, I never cared about any benchmark index. But when I invested in funds managed by others, I would compare the managers' results versus their benchmarks and fees. Sure, I took a longer perspective, took the time to understand their investment process, and looked for out of favor sectors. But if the manager couldn't outperform by at least twice their fee over a five year period, then it was time to say good bye. Eventually, I ended up replacing several actively managed funds with super low cost index funds, not because I believe markets are efficient or indexing is the best way to go, but simply because their performance couldn't justify the fees. Because even though the portfolio manager in me likes to be Hans Solo -- "Never tell me the odds"--as the client, how could I decide except by looking at the numbers?

Yet judging "by the numbers" alone could also lead to a short term, academic view of risk and return that would not only be bad for your long-term investment results but also have disastrous consequences for climate change and the economy as a whole.

This chapter, then, is my attempt to bring the two sides together. It's me the portfolio manager talking with me the client, in the hope that we could integrate long-term thinking about climate change into the investment process.

The first thing we should all do is take a look at risk. This chart shows the performance of the optimized zero carbon risk portfolio versus the Energy index from the previous chapter on Structuring Portfolios:

At first blush--The good guys won! Everything worked out. The climate aligned portfolio also way outperformed. But how does this look?

Starting in 2010, after two and a half years in mid-2012, the optimized zero carbon risk portfolio would have been down nearly -47% versus the Energy index. This was the dark valley of clean tech, after Solyndra went bankrupt and venture capital funding for clean tech practically came to an end in 2011. A Harvard Business School article put it succinctly in Clean Tech VC: A Decade of Failure: In 2016, after nearly a decade and over $25 billion invested by L.P.’s,[11] 90% of clean tech investments can be considered abject failures, and close to 100% can be considered poor investments.

Or how about now? The optimized zero carbon risk portfolio has outperformed the Energy index by a whopping 260% over the past decade. Renewable energy stocks trade at two to three times the Price/Book ratios of the oil majors:

The oil stocks are rallying again. The press is calling it an ESG bubble, because some academic research papers said that the outperformance is the result of favorable capital flows rather than fundamental.

Do you stay the course?

Warren Buffett famously said that "The true investor welcomes volatility." But he has the rare luxury of time that most do not. He invests with a faith in the long-term principles that is also backed up by a reputation and an investment vehicle that took decades to establish. Most portfolio managers and their clients, the investment officers of pension fund, endowment, reinsurer, or private banks, would not be around to see the rebound after a 40% underperformance. Even principals investing their own money usually have liquidity needs, as well as a partner who would (reasonably) question their sanity.

Yet Buffett and other great investors are right. Great investments, like the transition to a low carbon economy, take time. The path to get there could be rocky, but the long-term outcome is not in doubt. Volatility is not risk but opportunity--if you could survive the journey.

So the first important consideration is how to get there. In other words, how much volatility could you tolerate? How much of an underperformance would cause you to lose the portfolio--by getting fired or being forced to liquidate? Stop this from happening by sizing the risk properly, like we had discussed in the previous chapter on Structuring Portfolios.

Part of your decision will have to be based on actuarial analysis: How much contributions and withdrawals would be expected. Make sure you will not be forced to sell to meet those obligations. If you're making a leveraged bet on a long-term trend like climate change -- DON'T DO IT.

A bigger part, though, is one of values. Why are you making a climate-aligned investment? Do you believe some companies will outperform during transition to a low carbon economy? If so, what is the time horizon for this to happen? Five years? Ten? Twenty? Thirty years?

Or do you believe that climate change is fundamentally harmful to the well being of your constituents, so that you cannot invest in companies that contribute to climate change? In that case, then are broad market benchmarks such as the S&P 500 even relevant, since they contain companies that contribute to climate change?

Taken a step further, do your constituents agree with you? Do they want you making this decision for them? Do they agree with your analysis of which companies contribute to climate change, and which do not?

The more you are aligned with your constituents, the more they will be willing to ride through the cycles with you, and the greater volatility you will be able to bear on the road to your ultimate goals.

Assuming that you decide "Yes, this is fundamental to our investment policy," the next question is how to do it.

Do you engage or divest?

On the surface, it seems the answer is simple. As the Harvard students who wrote an open letter put it, "...engagement with the fossil fuel industry is dangerous and irresponsible. These companies are bad-faith partners in an effort towards decarbonization: their business models are predicated on continued extraction and exploitation of the world’s most vulnerable communities. They are not substantially transitioning to clean energy systems, have a record of attacking climate researchers (including Harvard’s own), and continue to block meaningful climate policy solutions..."

Yet nothing in climate change is ever simple. An article by Daniel Yergin, "Why the Energy Transition Will Be So Complicated" points out that petroleum is so embedded in our world that many parts of our lives could not go on without them, not to mention the major countries whose economies are entirely dependent on oil and natural gas exports. Articles like Why divestment doesn’t work — and just won’t die are even more blunt.

Divesting has its appeal. These companies are off your books. You send a message about doing something for climate. You could also avoid the potential losses of being caught on the wrong side of the carbon transition. If enough people do it, then the stock prices of the companies will fall and their cost of capital increase.

But perversely, then, the opposite happens: The companies look more attractive on a pure value basis. This is already happening. Look again at the relative valuations of the oil companies versus renewables:

The market is already pricing in a hefty premium for the renewables companies. Even in the course of a long transition to a low carbon world, if the oil companies just have a few "dead cat bounces," it would cause the kind of short-term underperformance discussed earlier. And what if a few of them really did change their act and became viable in that low carbon world? Removing them completely could be a costly, not to mention unnecessary, mistake.

Meanwhile, falling stock prices would make these companies attractive candidates for Leveraged Buyouts (LBO's) by private equity and sovereign wealth funds. A reshuffling of the players, but all the same questions remain. You're just paying someone else to guide them through the energy transition.

Finally, where does the divesting stop? Airlines? Utilities? Car manufacturers? Companies who use plastic packaging like Coca Cola and Pepsi? Freight carriers like UPS and Fedex? Their customers like Amazon? Amazon's customers like you and me?

It feels good to wash our hands clean and divest, but somewhere along the line, we all have to get down to the hard work:


In 2015, after trying for several years, leading UK environmentalist Jonathon Porritt wrote "It is 'impossible' for today’s big oil companies to adapt to climate change". Yet we're still trying. Last year, institutional investors of ExxonMobil banded together to elect new directors with a focus on climate change, despite intense management opposition. Meanwhile, CEO'S of major oil companies have come together under the Oil and Gas Climate Initiative with the stated aims to "accelerate the industry response to climate change" and "explicitly support the Paris Agreement and its aims."

Will this do any good? The UN Partnership for Responsible Investing's collaborative engagement between major oil companies and their institutional investors is a good summary of where the industry really is. Twenty-five major oil companies sat down with institutional investors and other groups over a two and a half year period, and

  • All the oil companies acknowledged that climate change as a significant issue for the business and have a policy commitment to act on it.

  • 16 of the 25 have improved their climate disclosures.

  • and 19 of the 25 have set long-term quantitative targets for reducing emissions.


  • 15 of the 25 companies are only committing to reducing their operational emissions from extracting and refining (Scope 1 and 2)

  • Only 5 have targeted reducing Scope 3 emissions from the use of their products.

  • Meanwhile, they all keep on drilling: "approximately 30%-40% of the engaged companies’ capex is unviable in a below 2˚C pathway."

Reducing Scope 1 and 2 emissions from oil and gas production is no small potatoes. Methane flaring causes between 265 million tCO2e of GHG emissions, more than Florida or the Philippines and five to ten times that of Bitcoin, to perhaps as much as 1 billion tCO2e, more than Germany.

But is it realistic to think that's all there is for the industry to do? I could just picture it now: A group of environmentalists go to a conference and ask an oil company to reduce their Scope 3 emissions from the use of oil and gas. The company executives respond, "You caused those emissions by flying and driving here, staying at a hotel, and using the internet to organize. So those emissions are on you." Perhaps true technically, but then what?

As countries implement carbon pricing and carbon prices rise, would there not be natural economic substitution to low carbon energy sources? Would that then reduce the demand for the output of oil and gas companies? Meanwhile, as oil companies continue to spend billions drilling for oil in the face of falling demand, they may be setting up a carbon bubble Would they then fight to keep up demand for the oil, making climate change worse? Or would they have to write off their assets, costing you billions in losses? Or both?

To be viable long-term, these companies must address more than just Scope 1 and 2 emissions. They must address the Scope 3 emissions in a way that is acceptable globally, not just in the host countries where the companies operate. Otherwise, they will all be much smaller as rising carbon prices, not to mention consumer boycotts, will cause the utilities to switch to renewables, airlines to switch to alternative fuels, and car manufacturers to switch to electric vehicles.

As investors, then, you must make a call here--it's your job. Do these companies in fact have a viable business model?

  • Could they invest the cashflows from legacy oil and gas businesses in renewable energy successfully?

  • Could they create a low or zero carbon energy product, using carbon capture and sequestration technology, hydrogen, or carbon offsets, that will be acceptable in enough markets around the world?

  • Is there another use for their output, such as plastics, that will also be acceptable to the general public?

  • Failing all of the above, will they reduce capex and return capital to shareholders?

If they do, then engage with them and help see these strategies through. Perhaps it will happen in stages, and eliminating those methane flares would be a good first step. But we also need to move quickly and cannot stay there. Nobody--not the general public, the companies, and least of all us investors--have decades to wait passively any more. As the investor, you need to act like a coach and not a buddy. You need to do more than just say "Great job" and actively understand the companies' strategies and monitor their progress. If you realize there is no viable strategy, or the companies are not following through with them, then you must think about whether it would be better to divest after all. You can at least save your own investment if not the world. But if the companies are pursuing a viable transition strategy, then be their champion as well. Make them see that doing the right thing will reward them with higher valuations, stock prices, and bonuses, rather than fall prey to buyouts and layoffs.

This is what is really hard about engaging right now. It's easy to jump on the divest bandwagon. You've sold your shares, announced it to the public, and you're one of the good guys. But if you're engaging, how does anyone know that you're really working through the carbon transition with your companies, instead of just greenwashing? What do those of us who choose to engage rally around? It requires many stakeholders to work together: investors, the companies, the general public. Could we agree on what the goals of the engagement should be? Could we agree on what the metrics of progress should be?

One possibility is to rally around the Science Based Targets Initiative (SBTi)'s commitment to a 1.5 degree transition. Amazingly, there are nine oil and gas companies that have signed up for it, including oil exploration companies like Schlumberger and Halliburton:

But what have they committed to? Unfortunately there's no more information available on the SBTi website.

In conclusion, divesting and engaging should not be opposites but rather two sides of the same coin. Think of it as "selective engagement." Some companies you would engage with, and some you would just have to divest. To divest alone would not have much impact in the real world. To engage without the prospect (threat?) of divesting would probably achieve very little as well.

Now that you've made the important long-term decisions, the next step is to work out a set of benchmarks for your portfolio managers.

The benchmark should reflect your long-term climate strategy into a neutral index so that your portfolio managers would manage (and hopefully outperform) against it. It should include the amount of climate-aligned difference or "tilt" versus standard indices such as the S&P 500 or MSCI World. If you choose to divest from oil companies, they should not be in the index. If you choose to engage with them, it should include only the companies that qualify for your engagement strategy.

You could construct a benchmark yourself, or you could choose from one of many that's being pumped out to support the boom in ESG investing. There are, for example:

  • The S&P Paris-Aligned & Climate Transition, or PACT™, Indices, which "are designed to measure the performance of eligible equity securities from an underlying benchmark index, selected and weighted to be collectively compatible with a 1.5ºC global warming climate scenario and to meet several other climate-themed objectives at the index level, as of each rebalance."

  • The MSCI World Climate Change ESG Select Index, which excludes companies engaged in Nuclear Weapons, Tobacco, Thermal Coal, Nuclear Power and Unconventional Oil & Gas, companies which are "not in compliance with the United Nations Global Compact principles", and companies which are not "rated B and above." (A "B" means "laggard" and is probably a company in the lowest quartile compared to its peers.)

  • Finally, for hard core divesters, there's the S&P 500 Fossil Fuel Free Index , which is simply "companies in the S&P 500 that do not own fossil fuel reserves. Fossil fuel reserves are defined as economically and technically recoverable sources of crude oil, natural gas and thermal coal."

But how good are these benchmarks in real life? With colorful titles such as The ESG Mirage and The Trillion Dollar Fantasy, critics have pointed out the key problems, some of which we've already discussed, with using ESG-based indices for climate investing:

  • The ESG ratings only incorporate direct Scope 1 (on site) and Scope 2 (purchased electricity) emissions, not the much larger and harder to measure Scope 3 (supply chain) emissions.

  • They incorporate a broad range of criteria, so improvements in employee diversity or governance policies could cause ESG ratings upgrades even for a company with high climate risks.

  • They try to measure the impact of climate and environmental risk on a company's business risk profile, rather than its total social risk profile. In doing so, they could underestimate the long-term climate risk of the company.

  • They are graded on a curve, relative to other companies its own sector. So a company with high climate risks that is marginally better than others would still receive higher ESG ratings.

As MSCI succinctly puts it in What MSCI’s ESG Ratings are and are not, "ESG ratings are not climate ratings." Yet many investors act like it is, or at least it's better than nothing. But it may not be. With an incorrect benchmark, you could be giving the wrong instructions to your portfolio managers. You might think you've reduce your climate risk, when in fact the index is giving them marching orders to keep investing or even adding to high risk industries.

There's a relative easy way to check on how good a benchmark is for climate investing: See how it compares to the market's view of climate risk. Unlike rating agencies, the market relies on the collective wisdom of all the investors out there, and they're not paid by corporate issuers. Even if a small number of them understand the true climate risks of a company, their trades could push the prices in a way that reflects them. To see if your benchmark is "aligned" with the market's view of climate risk, you can perform an analysis similar to what we did in the chapter on Analyzing Investments. You can follow these steps based on [our paper]( for a benchmark you constructed yourself or one constructed by an ESG ratings service:

  • Set up your climate-aligned benchmark as the Green portfolio and its matching index as the Brown portfolio

  • Calculate a Brown Minus Green (BMG) series

  • Regress the returns of the industries in a major market index such as the MSCI World against this BMG series to get its BMG factor loadings. These are the market implied climate risks of the industry sectors.

  • Run rolling regressions of the stocks in the index against this BMG series to get their BMG factor loadings. These are the market implied climate risks of the stocks.

  • Now look at those market implied risks, and ask yourself: Do these make sense?

  • Is your BMG series, based on your climate-aligned benchmark, identifying statistically significant climate risk sensitivities in the industries and the stocks?

  • Are those sensitivities relatively stable over time, which makes sense since climate risks don't change much in the short term? Or do they drift up and down?

  • Are those climate risk sensitivities logical? Do they agree with the fundamental research on climate risk?

These questions may be hard to answer if you're just looking at one benchmark index, but when you compare it with others that we've analyzed, you'll be able to see a pattern. For example, we did identify that the market priced the climate risk of the oil and gas and renewable energy stocks correctly. Using the open climate investing project's default BMG factor, you can see that only the energy sector has a significant number of stocks with market-based climate risk:

These are the energy stocks that have significant market-based climate risks:

When you look at a particular stock, it should have a market-based climate risk that is relatively stable and trending over time:

So if your climate-aligned benchmark does not identify statistically significant climate risks in the same stocks, then it's not in sync with even the market's analysis of climate risks. Similarly, if your benchmark thinks that many high climate risk stocks have little or even negative climate risk sensitivities, then there's probably a problem with your benchmark.

And finally, one last question: Should portfolio managers vote proxies?

A strangely interesting and difficult question to answer. Let's let the provocatively titled Could Index Funds Be 'Worse Than Marxism'? be the starting point. It suggests that since so many stocks are owned by the major index funds (and the author didn't even count the closet indexers -- Yes, we know you're out there -- disguised as active managers), the true owners of public companies have little incentive to make companies, well, do anything. As a result, academic papers have found that industries including pharmaceuticals, banking, airlines, and even commodities markets have become less competitive. Of course, the asset managers disagree, with BlackRock's white paper and The Brooking Institution's working paper challenging the methodologies of the research and therefore their conclusions.

So, let's see: If the Workers invest in a mutual fund managed by BlackRock based on an index published by Standard & Poor's, and the mutual fund owns shares in a public company regulated by the SEC -- Do the Workers then Own the Means of Production? Or must they rise up against the shackles of oppression -- but from whom?

Meanwhile, how is this for a reasonable proposal:

  • Portfolio managers have shorter tenures compared to the long-term returns of the fund.

  • Therefore, many proxy decisions, especially climate-related ones, have impacts longer than the expected tenure of the portfolio manager. These should be decided on by the ultimate asset owner.

  • Some proxy decisions, however, could affect the immediate prices of the companies. Portfolio managers are therefore right to say that a proxy vote affects their results (and bonuses.)

  • Therefore, portfolio managers should have input on how to vote on proxies.

In the end, we come full circle. Asset owners and portfolio managers are really part of the same time. How about let's try to work together?

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