Case Study - Frontier Advisors Climate Change Hedge
In a new research paper it is circulating to clients, investment advice consultancy Frontier Advisors is exploring how derivatives could help institutional investors further hedge against the risk of climate change and the transition to a low carbon economy.
How did this come about?
Senior consultant alternatives and derivatives at Frontier, James Bulfin, first raised the idea of pursuing research into how derivatives could create an effective climate change hedge.
“We know climate change, ESG, carbon emissions and management are very important topics,” director of sector research at Frontier, Paul Newfield said.
“A lot of funds are in the early stages of what their long term strategic plan is to manage this.”
Traditionally, a fund will do a bottom-up analysis of all of their holdings and their carbon exposure in those holdings. The new Frontier research explores ways investors can use carbon derivatives to compliment this approach and manage climate change risks within their portfolio.
“It is better used in conjunction with another risk management tool,” Newfield says.
What’s the approach?
In the paper Bulfin explores three top-down strategies for hedging carbon price risk and two bottom-up strategies for reducing carbon intensity.
The three hedging strategies involve purchasing European Carbon Emission Allowances (EUAs), a blend of compliance market carbon offset credits, a derivative structured product based on the return of EU EUAs, or purchasing a blend of voluntary market carbon offsets.
The main issues with these strategies at the moment is that there is no one global approach to carbon pricing.
“It’s the fragmented nature of the carbon offset market at the moment,” Bulfin says that poses some difficulties.
“In terms of an overall global carbon price … the market doesn’t have that yet. It’s still quite a young market.”
What is the cost structure?
Frontier does a lot of work with funds on alternative strategies.
“Increasingly we are seeing funds looking at things like downside risk exposure, looking at derivatives to assist in managing climate exposure,” Newfield said.
Those funds might ask Frontier to include an ongoing derivatives retainer in their pricing structure and the climate change hedge would be included in that.
What has the interest been like so far?
“The interest is how can we use [it] to complement our existing risk management …to reduce transition risk going forward,” Bulfin says
Some funds may also consider it as an active investment strategy to gain exposure to expected higher carbon prices.
“There is a general unawareness of these types of opportunities, [we wanted to] shed some light on different avenues that funds could consider,” Newfield said.