In the past dozen years, many things have changed – particularly with respect to climate change, now widely acknowledged as a seminal challenge of our time.

Governments have shown up to address what economist Lord Nicholas Stern calls the mother of all market failures. According to the World Bank, more than half of all countries have committed to pricing carbon pollution and over 40 countries are already doing it. By this time next year, 90 per cent of Canada’s population will be living with a broad-based price on carbon.

The markets are beginning to reflect these changes. For the past three years, more money has been invested in renewable power generation than in fossil fuel power, according to Bloomberg New Energy Finance.

Perhaps the most powerful story is told by investment returns. Over the past five years to November 30, 2015, the FTSE Environmental Opportunities 100 Index (which tracks the 100 biggest companies with significant revenue exposure to environmental solutions) has crushed the MSCI World Energy Index (the main global index tracking 107 of the biggest oil, gas and coal companies). The FTSE EO 100 returned an annualized 8 per cent versus the MSCI World Energy Index at just 0.66 per cent.

Some market observers glibly dismiss this outperformance story as being purely based on a tough commodity market, but that is not accurate. Using the Corporate Knights Decarbonizer tool, a sector-neutral strategy that includes best-in-class companies from high carbon sectors on the S&P/TSX Composite would have beat the index by 6 percentage points over the past three years.

The attitudes of retail investors have also evolved. According to Morgan Stanley’s Sustainable Signals report, 71 per cent of investors are interested in sustainable investing.

Yet despite these developments, the total assets invested in mutual funds using environmental, social and governance criteria has grown to $8.4 billion but shrunk in relative terms to just 0.7 per cent of the overall $1.23 trillion Canadian mutual fund market.

Why is so little money being invested in sustainability-focused mutual funds and why hasn’t it grown?

A big historical reason has been the conventional wisdom of most individual investors and financial advisors that investing for good is bad for returns. But a raft of studies is serving to disprove this theory.

A recent study by Tessa Hebb at the Carleton Centre for Community Innovation comparing responsible investment (RI) mutual funds across various asset classes to comparable non-RI funds found that RI equity funds outperformed the average of comparable non-RI funds 63 per cent of the time.

The other reason is that the most responsible investment options are just not that compelling for the average investor. Most traditional RI funds hold the same stocks you would find in a regular fund, from the big banks to big oil. The differentiator is that the RI funds employ a strategy known as engagement where they work with companies on such matters as improving disclosures on climate risks and developing policies on human rights.

While this is important work, investors want to own companies whose primary activities are focused on solving big global challenges including climate change.

On this front, RI funds have been largely missing in action. There are some exceptions: the AGF Global Sustainable Growth Equity Fund has been a standout, with over 63 per cent of its exposure invested in companies providing environmental solutions. NEI Investments also recently added the NEI Environmental Leaders Fund to its offerings, which will allow investors to get exposure to companies solving big environmental problems.

The challenge for the average investor or advisor is how to make sense of which funds are leading the way. While the French government recently announced it will be introducing a label for investment funds in October 2016 to make it easy for investors to see which funds are leading or lagging the “energy and ecology climate transition,” no such scheme exists in North America.

To this end, Corporate Knights has launched the Eco-Fund Ratings to make it easy for Canadian investors to see which funds provide the best combination of economic and environmental performance. Of course, there are social factors that are also important to investors and we look forward to incorporating these factors into future ratings.

In this ranking you will see the top equity funds in four fund categories that best combine superior returns with a low carbon footprint and high exposure to companies earning revenue from the growing new energy and environmental market domains. We hope these ratings will be useful for investors looking to earn clean profits by aligning their portfolio with a better planet.

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In order to analyze the impact of both carbon intensity and exposure to green companies, we conducted explorative regression analyses using carbon intensity and exposure to green companies as variables that influence the 3-year compound return of the funds. The two environmental variables have been correlated with the financial return as single variables and in a multivariate regression that takes into account the impact of both variables in one function.

Results

The analysis for all 330 funds with a minimum 3-year history in the sample for carbon intensity suggests that the 3-year compound return is significantly influenced by the carbon intensity of the fund. A decrease of one tonne of CO2e/$m sales increased the 3-year compound return by .1 per cent. In other words, a reduction of 100 tCO2e/$m sales increased the 3-year compound return by 10 per cent. The same is valid for an increase in tCO2e/$m sales. An increase of 100 tCO2e/$m sales decreased the 3-year compound return by 10 per cent. The regression function is statistically significant and is able to explain about 13 per cent of the funds’ volatility.

We also found that expanded exposure to green companies increased the financial returns. Increasing the percentage of green companies in the fund by one per cent increased the 3-year compound return by .2 per cent.

The regression analyses for the combination of both carbon intensity and exposure to green companies explained 15 per cent of the funds’ volatility. The result of the combined analysis suggests that a reduction of the carbon intensity by one tCO2e/$m and an increase of the exposure to green companies by 1 per cent increased the 3-year compound return by .2 per cent.

These results suggest a significant negative impact of carbon intensity and a significant positive impact of exposure to green companies on the 3-year compound return of the funds in the sample. However, we did find an anomaly: Canadian funds with more green exposure underperformed funds with less green exposure. This may be because the Canadian stock market has an extremely small pool of green companies (less than one per cent of its equities are classified as green), as compared to global indices that tend to have a pool of green companies five times bigger than in Canada, adjusting for size.

Conclusions

Carbon intensity and exposure to green companies influenced the 3-year compound return of funds significantly. Funds with lower carbon intensity and higher exposure to green companies had a significantly higher financial return. On the other hand, higher carbon intensity and lower exposure to green companies decreased the financial returns of equity funds.

For Canadian equity the situation was a bit different. The high carbon intensity of Canadian equity funds decreased their financial returns, but there were not as many Canadian green companies that create good financial returns (less than one per cent of the S&P/TSX Composite is comprised of green companies). This creates a dilemma for Canadian equity funds going forward: funds which decrease their carbon intensity to increase their financial returns have limited opportunities for investments in green companies.

It seems that Canadian investors are still too dependent on carbon intensive investments and that there is a need for more green companies in Canada.

Olaf Weber is a professor at the School of Environment, Enterprise and Development (SEED), University of Waterloo and Editor: Journal of Sustainable Finance and Investment.

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The starting universe consists of a total of 530 equity mutual funds classified into four distinct categories by Fundata based on the composition of the equity investments:

• Canadian Equity: majority investments in Canadian equities
• International Equity: majority investments in equities outside of Canada
• Global Equity: investments in all countries around the world including Canada
• U.S. Equity: majority investments in U.S. equities

This ranking therefore consists of four separate rankings – one for each category.

The following three quantitative indicators are employed in rating each fund. Note that a given fund is only compared against another fund in the same category, not across categories.

1. Three-year compound return, net of fees (the “Fund Return Score”): the higher are the three-year compound returns of a given fund compared to other funds in the same category, the higher is its Fund Return Score. This indicator accounts for 50 per cent of the Final Score.
2. Weighted carbon intensity (the “Fund Carbon Intensity Score”): the weighted carbon intensity of a given fund is calculated by obtaining the ratio of scope 1&2 greenhouse gas emissions (CO2e data provided by South Pole Group) to sales for a given equity multiplied by the weight of that same equity within the fund summed for all equities in that fund. The lower the weighted carbon intensity of a given fund compared to other funds in the same category, the higher is its score; scores range from 0 (worst) to 100 per cent (best). This indicator accounts for 25 per cent of the Final Score.
3. Green Exposure (“The Exposure to Green Companies”): weighted exposure companies that derive at least 20% of their revenue form environmental markets or new energy as verified by FTSE Environmental Markets and/or Bloomberg New Energy Finance. The higher the weighted green exposure of a given fund compared to other funds in the same category, the higher is its score; scores range from 0 (worst) to 100 per cent (best). This indicator accounts for 25 per cent of the Final Score.
4. The Final Score is the sum of the individual scores of the above three indicators. The top 20% of funds in a category receive a 5 Tree rating, and the next 20% a 4 Tree rating, and so on. In cases where a Fund Return Score is not available (for instance, a given fund has been in existence for less than three years), the Final Score is calculated as 50% of the Fund Carbon Intensity Score + 50% of the Fund Green Companies Exposure Score.

To enhance the validity of the assessment,we omitted any funds for which we did not have adequate (at least 2/3 of the total holdings) coverage of their securities greenhouse gas emissions data.  After applying this screen, 424 unique mutual funds remained.

Sources: The starting universe of mutual funds, fund categories and all market data such as market weights and three-year compound returns were obtained from Fundata.

Fundata combines analytics expertise and industry intelligence with the most comprehensive investment fund database in the market. We deliver robust, tailored analytics solutions to fulfill data, marketing, and compliance needs.

The weighted carbon intensity and percentage exposure to green companies were obtained from Corporate Knights’s Clean Capitalist tool. Created by Corporate Knights and powered by carbon data from South Pole Group, the Clean Capitalist Decarbonizer is an interactive tool that shows the financial implications of divesting high carbon companies in favour of those that derive at least 20 per cent of their revenues from environmental markets or new energy. The Clean Capitalist database covers 8,500 securities (comprising more than 85 per cent of global market capitalization), including all primary public equity securities with a market cap over $2 billion and/or listed on major national and global indices.

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