By Josh Gregory, Founder of Sugi.
Josh Gregory, Founder of Sugi.
A new product that has recently come to market is the ‘carbon offset ETF’. These are ETFs where the carbon footprint of the underlying investments has been offset as part of the product, allegedly delivering a zero-carbon investment.
The main appeal of an offset ETF to the investor is simplicity – net zeroing a portfolio has never been easier. On the other hand, there are areas of caution: transparency around the emissions data, the offsets themselves, and inherent limitations of the strategy.
First, let’s take a look at how demand and supply have coalesced to support this new trend.
Survival of the greenest
The ETF market is crowded: globally, the number of ETFs available has risen from a few hundred to almost 8,000 in 20 years.
Hot competition drives ETF vendors to jump on every trend. The latest and greatest trend is unquestionably ESG. In particular, ESG ETFs appeal to millennials, a demographic which will have enormous buying power in the future. So the pivot to ESG by major ETF providers is not surprising. But in a crowded market, how can a new product stand out? A popular ESG theme is low carbon, and some have asked ‘why not go further?’
Wrapper’s delight
Recent years have seen the rise of ETF white-labelling platforms. These platforms allow asset managers with a great idea for an ETF – perhaps a zeitgeisty thematic – to outsource most of the practical aspects of constructing and launching that ETF. ETF platforms provide a large menu of options to the asset manager and that menu has recently been extended to include inbuilt offsets.
Although there are a couple of zero-carbon actively managed funds in the European market (see, for example, BNP Paribas’s THEAM Quant Europe Climate Carbon Offset Plan), there are as yet very few zero-carbon ETFs. The HANetf S&P Global Clean Energy Select HANzero UCITS ETF (ZERO LN), which is based on the S&P Global Clean Energy Select Index, was first to market in Europe. Then, in July, Saturna launched an actively managed carbon-neutral ETF, the Saturna Sustainable ESG Equity HANzero UCITS ETF (SESG LN).
Capturing carbon
The HANetf S&P Global Clean Energy Select HANzero UCITS ETF tracks the 30 largest companies in global clean energy. Its underlying index has a publicly listed carbon footprint of 59.15 tonnes per $1 million invested. To offset this, using an averagely priced offset, would mean an additional overhead of 7 basis points, in the context of a Total Expense Ratio (TER) of 0.55%.
But there are many ways to measure a carbon footprint. It’s broadly accepted that a full assessment of a company’s emissions should include not just the emissions associated with its operations and electricity usage (Scope 1 and 2 emissions), but also the emissions related to its value chain both upstream and downstream (Scope 3 emissions).
Many publicly listed footprints exclude all or part of Scope 3 emissions. That’s because Scope 3 is harder to measure, and there are ongoing concerns over double counting – where you also own stock in a company within that value chain.
This was a fair argument until recently. But more companies are reporting Scope 3, and double counting is only a concern in particular types of portfolios.
Counting the cost
For many companies, especially in sectors with large value chains, Scope 3 makes a big difference to their footprint. Naturally, this affects the cost of offsetting an investment product that includes those companies.
For example, offsetting a £1,000 investment in Tesco might only cost 15 basis points (£1.50) per year without Scope 3, but when Scope 3 is included, the cost jumps ten-fold to 160 basis points (£16).
The numbers become even higher when analyzing the energy sector, with its significant downstream emissions. A £1,000 investment in a global energy ETF with all of Scope 3 included would cost 13.4% to offset annually (£134). Granted, this theme has returned ~43% over the past 12 months, but offsetting would still be a significant expense and high annual returns can’t be relied on.
Compare this with tech, a low-carbon sector. It would cost just 5 basis points (£0.50) to offset a £1,000 investment in a global tech ETF, with Scope 3 included.
Armed with this knowledge, let’s go back to one of the new offset ETFs: the Saturna Sustainable ESG Equity HANzero ETF. This product has a TER of 0.75%, and its constituents are in low-carbon sectors such as tech, healthcare, and financials. Including Scope 3, a full offset would cost around 20 basis points. However, excluding Scope 3, the cost drops to 1 basis point.
A key advantage of offsetting is to allow investors to maintain their exposure to higher carbon, harder-to-abate sectors such as energy and materials; it facilitates a diversified portfolio and enables investors to support ‘transition’ companies in the process of decarbonizing their operations. But it’s misleading to think one can offset these investments on the cheap, without including some or all of Scope 3.
Nature’s fine print
It’s also important to consider the type of offsets included in carbon-neutral investments.
The cost of offsetting can be reduced through cheaper carbon credits, but these credits have limitations. They may not be independently verified to the highest standards, or they may be less effective in capturing carbon over the long term, or they may have fewer ‘co-benefits’, such as conservation and sustainable development.
A recent trend in offsets has been to offer a ‘portfolio’ of different projects. This can mitigate the risk of project failure, as well as increase attractiveness to the investor. But, as with fine spirits, one must be cautious of the blended approach. How much of your offset is going to the attractive, expensive project, and how much is going to the cheaper ‘filler’ project?
So, are these products the Diet Coke of investing: when you want all the taste of a regular ETF, but without the carbon?
While offset ETFs are potentially guilt-free, always look at the detail about what’s being offset and how much it will cost you. And remember that someone is paying for that peace of mind…
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)
Editor’s note: Scroll down to the comments section below to read HANetf’s response to Josh’s excellent article
It was nice to read Josh Gregory’s article “Carbon offset ETFs: the Diet Coke of investing”. Most of what Josh had to say we at HANetf agree with and, in a way, it’s a nice validation. It’s also clear his critique is very similar to our thought process. Our main objective was how can one take ESG investing one step further. A low carbon investment still has a carbon footprint, and we believe if a mechanism exists today, even if not perfect, why not use it. Also, the analogy to Diet Coke is a good one. Diet Coke was first introduced on 9 August 1982 and it’s pretty clear it has improved in the last 40 years. So, by being first with HANzero™ (the brand we have given to ETF strategies that incorporate carbon offsetting) one could argue that we are still in the 1980s for carbon-neutral investing. However, we all hear, most recently in the IPCC report, 2050 is too late, so let’s act now!
Historically, carbon offsets have often been shown to be unreliably true carbon reductions. In the past, carbon offset projects have over-promised, under-delivered, and even led to worse emissions impacts. Historically, for investors looking to make positive changes with their capital, there has always been something of a ‘catch’. Like most things, they improve over time and the same is true of carbon offsets.
The rising market has attracted investor cash from a collection of emerging carbon-only investment funds that seek to profit as economies transition away from fossil fuels. Innovation is often the truest miracle of human endeavour. HANetf is always at the cutting edge of innovation in the ETF market. The management team has been instrumental in inventing various ETF firsts including the most notable physical gold ETFs. It is natural that these pioneers who have issued over 550 ETPs in their 20 years long ETF careers would innovate in this space as well. Investors are demanding action from their investment providers and HANetf is delivering to enhance the standard ESG approach through innovative features such as the HANzero™ carbon offset mechanism.
Hector McNeil, Co-Founder, and Co-CEO of HANetf, said: “ESG strategies carry a carbon footprint. They try to tilt towards companies that exhibit relatively lower carbon emissions, but there’s still a carbon footprint, nonetheless. We developed HANzero™ to offer an immediate solution. I also think product providers often wait for clients to tell them what they need, but on climate, I think it’s incumbent on product providers to be highly proactive on solutions. The funds within our stable that offer the HANzero™ functionality include the HANetf S&P Global Clean Energy Select HANzero™ UCITS ETF (ZERO), launched in partnership with Purpose Investments, which was the first to market in Europe. Then in July, we launched the Saturna Sustainable ESG Equity HANzero™ UCITS ETF (SESG), an active global equity strategy managed by Saturna Capital. The above are the first two ETFs we have applied HANzero™ to but we plan many more. We are also talking with many of our existing and new clients on our platform. We also have many more ideas in the carbon credit space as well as the offset markets. What is exciting is that many asset managers are asking us if we can extend HANzero™ and our expertise to their business either at the product level or portfolio levels outside the ETF wrapper. Clearly, there is a huge interest from investors for ESG-related strategies. Environmentally conscious investors can now focus on capital growth, and any carbon emissions linked to their investment will be offset in exciting global climate-positive projects with our partners at South Pole. Though not a glamour project by any stretch, carbon offsetting is an important tool in the fight against climate change. Our hope, in time, is that more of our partners will opt to add the carbon offset function to their ETF, regardless of thematic direction.”
As you would expect in a developing market like carbon offsets and credits, it is far from perfect. Josh’s estimates of costs are not wholly accurate, pretty close, but the principle that the costs are manageable within a product’s total fees is accurate. This means that the fees are paid out of the TER and not as an additional cost. Given ZERO is 10bps cheaper than the iShares clean energy equivalent, which doesn’t carbon offset, this should be a no-brainer for investors in our opinion.
As to whether HANzero™ goes far enough in including the full value chain impact, only time will tell. Having opened this door to investors, we will find out. Doing nothing and waiting for 2050 by offering ESG-only approaches definitely isn’t far enough in HANetf’s view.
We will leave you with a question – if all product providers calculated and offset the carbon impact of an investment and included it as standard, would the world be in a better place? If the answer is yes, then let’s do it. Currently, HANzero™ is an optional extra. Like all optional extras, they pretty much become standard very quickly. Let’s hope!