What if $2T moves toward net zero emission companies every year?

Aug 4, 2021

Bill Gates’s life story rivals some of the best superhero tales out there. Imagine: a nerd with larger-than-normal glasses creates a revolutionary company that goes on to stay in the top 10 companies in the world by market capitalization every year for the past 25 years.

But the sequel in the Gates superhero saga might be as lucrative. Since 2008, Gates has turned his focus to investing in innovative research and like-minded businesses that are committed to a sustainable future.

The business mogul, who changed the world and is now trying to save it, writes persuasively in his recent book, “How to Avoid a Climate Disaster.” Gates’ well-known credo of saving like a pessimist and investing like an optimist should spark intrigue with investors around the areas he is most optimistically investing.

51 billion and zero

According to Gates, the two most important numbers are 51 billion and zero. Humans spew 51 billion tons of carbon dioxide into the atmosphere every year. We need to emit zero to avoid an irreversible and devastating climate crisis. And we need to do this by 2050.

Gates then makes the case that employing market forces – enabling investors to put capital towards companies that are committed to a net-zero future – is likely a strong approach toward solving the crisis. And his portfolio shows that he’s willing to put his money where his mouth is.

Following the money

But is Gates acting out of philanthropy, investment savvy, or both?

My colleagues and I can help answer this question in a forthcoming research paper on “Climate Alpha with Predictors also Improving Firm Efficiency.”

In an age of “snackable content,” you’ll have my deep gratitude if you read the full study when it comes out. But I’ll give you the quick hits.

Here’s our line of thinking: in a large survey of institutional investors by Krueger, Sautner, and Starks (2020), the average respondent believed that climate risk is not fully priced in market valuations. I’m likely biased since BlackRock has been particularly loud about this one, but the list of managers who share this opinion is long and reputable.

So if that belief is correct, then wouldn’t it follow that there is an opportunity to generate excess returns with strategies using climate-related data and signals?

In our forthcoming research, we found companies with low carbon emissions are positively linked to their stocks’ performance. It’s unclear whether that performance is because of the companies’ low carbon emissions – but it may be predictive of the companies’ efficiency and profitability.

Excess performance of a hypothetical portfolio that bought least emission-intensive companies and sold most emission-intensive companies

Excess performance of a hypothetical portfolio that bought least emission-intensive companies and sold most emission-intensive companies

This figure plots the cumulative log excess performance of a long-short portfolio buying the least emission-intensive companies (in the bottom 30% of carbon emission intensity) and selling the most emission-intensive companies (in the top 30% of carbon emission intensity) in the MSCI ACWI universe over the sample period from January 2010 to December 2020.

Explaining the nerdy graph

The graph shows how much better a portfolio would have performed if it bought the least carbon emission-intensive companies, and sold the most carbon emission-intensive companies across the globe from the beginning of 2010 to the end of 2020. “Excess returns” means how much better the investments would have done compared to doing nothing at all.

The yellow line shows that a value-weighted (or market-cap weighted) low-emissions portfolio could have produced around 60% cumulative outperformance over the 11-year period. (An equal-weighted portfolio could have returned about 40% for an equal-weighted portfolio, where each stock in the index has the same percentage weight in the portfolio –but a market-cap weighted portfolio is more common and relevant here.)

For the really nerdy, calculating “logarithmic returns” is an appropriate comparison method for the growth of wealth over time. All of these results come with the caveat of most research—that these numbers are theoretical, since they don’t reflect an actual real-world portfolio that executed this to a tee.

$2 trillion in motion a year

This is ultimately good news for our planet, and investor portfolios. According to Larry Fink, who spoke at the G20 Summit this year, market forces could potentially move $50 trillion in assets over the next 30 years – or $2 trillion a year on average.

Professor Lord Nicholas Stern wrote in his influential Stern Review in 2006 that climate change is the greatest market failure ever seen. What he meant is that markets had not accounted for the damage we do by emitting carbon. Markets still aren’t pricing it, at least fully.

But as the evidence mounts for the benefits of adopting green technologies, and companies move towards adopting net-zero emissions, we believe that portfolios that are positioned for this net-zero economy will win out.

For BlackRock’s part, we’re not waiting. In some of our investment portfolios, we immediately cut carbon emissions by 50% and further cut emissions by 7% year-on-year to reach Gates’s net zero number by 2050—the same level of emissions as 1850-1900 before the modern industrial world.

We maintain investments in all sectors, and emphasize companies with forward-looking green targets. We’re analyzing signals that can potentially produce “green alpha,” like quality carbon emission intensities and green patents. We use these and other green signals in our active strategies.

The (double) bottom line

The investment frontier is moving towards 51 billion to net zero emissions. But not every investor will automatically benefit. Portfolios that take into account this massive transition can both be good for the planet – and profitable.

Read about potential solutions here.