[MUSIC] Welcome to the Crease Constituents. Today we are going to talk about the impact of climate risk exposure on security selection decisions. When it comes to selecting stocks on the basis of their carbon footprint, there are two main approaches that are being followed by investors. Approach number one is known as positive screening. Approach number two is known as negative screening, so let's start with positive screening first. Positive screening, also known as best-in-class approach, focuses on selecting the companies with the best possible score on any particular dimension of interest. Well, in this case, the dimension of interest is carbon emissions, and the best possible scores means the lowest possible carbon intensity of carbon footprint measure. So what we are going to do is we are going to hold a portfolio that is invested in those companies. Those stocks that have the lowest carbon intensity and the idea would be that by doing so, we helped those companies in the sense of decreasing the cost of capital. And also, hopefully we are holding the portfolio that is less exposed to the transition risks involved in global warming and climate exposure risks. Now the screening is often performed within a given sector or within a given region, so as to maintain some form of sector neutrality or region neutrality constraints. In other words, what we are going to do is we're not putting all the stocks in the same basket. But what we do is within each sector we are going to pick the best in class. In other words, the ones that have the lowest carbon intensity. The reason why we do so is that it helps us having a more balanced portfolio in terms of sector exposure. Now negative screening on the other hand, as one might expect, which you can think of as the worst in class approach focuses on excluding the companies that have the worst scores on any dimension of interest. So in this case, we would be focusing on, excluding from the portfolios the companies that have the highest carbon footprint or the highest carbon intensity level. Now you might wonder whether there's any difference between positive and negative screening in the end of the day. Well, if you focus on selecting the top 50% stocks on the basis of their carbon footprint, or excluding the worst 50% stocks on the basis of the carbon footprint, you would obviously get the same portfolio. Now, the reason why these approaches are actually different in practice is, of course, because investors focus on selecting or excluding not the top 50% but something like 10%, 20%, or 30%. So in the best in class approach would go for whatever, 20%, 25%, 30% of the top companies. The stocks with the lowest carbon intensity, meaning that you're excluding 75%. If you keep the top 25% you're excluding 75% of the stocks with the worst carbon intensity. When you do negative screening, on the other hand, you do the exact opposite. You're going to exclude 25% of the stock, say, 25% of the stock with the worst, the highest carbon intensity. So that explains that eventually you're left with the companies with 75% of the companies that have a lower higher performance in terms of carbon emission, in other words, a lower carbon intensity score. In the end of the day, it's not entirely clear whether you should prefer positive screening or negative screening. There are pros and cons in both cases. Positive screenings, because it focuses on very few stocks that have the highest scores, tend to lead to bigger, more substantial improvement in this dimension of interests, a bigger reduction of the carbon footprint of your portfolio. On the other hand, it tends to lead to more concentrated portfolio, which in this case, is not a good thing. In terms of the risk adjusted performance of your portfolio, you'd be better off holding a better diversified portfolio. Also, there's a good case to be made that it is easier to identify the worst in class than it is to identify the best in class. Because there's something more broad based, if you will, regardless of which methodology one would be using for measuring scope one, scope two, and scope three emissions. I mean, there are companies that are outliers if you will have very high carbon emissions, and it's pretty straight forward to identify them. Now in terms of negative screening. If you want to take it one step further, you could also implement its so called product based exclusion approach, and in this case it's negative screening not based on a continuous score but based on a more binary product based criterion. So, for example, you could decide to exclude from your portfolio any company involved in coal, because you'll be recognizing that color sets are at particular risk of becoming stranded in this forthcoming transition to a low carbon economy. [MUSIC]
