Hedge fund discovers its carbon ‘playground’

To start today, we have breaking news. Our colleague Jamie Smyth recently wrote about the pharmaceutical companies fighting shareholder proposals that asked the drugmakers to loosen their grip on patents. The nuns who filed these petitions have argued the pharmaceutical giants are limiting cheaper access to medicine by clinging to these patents. Now, the nuns have scored wins.

This week, the Securities and Exchange Commission has ruled against Pfizer and Johnson & Johnson, meaning the patent fight will go before shareholders for a vote at the companies’ annual meetings.

And scroll down today’s newsletter to dive into the burgeoning world of environmental, social and governance (ESG) derivatives. Hedge funds are increasingly jumping into this market.

Yesterday, I stopped by an ESG conference hosted by the International Swaps and Dealers Association, the lobbying group for derivatives users. One of the big takeaways was the growth of trade volumes for ESG futures in 2022.

Early adopters for these products have been asset managers and insurance companies, typically those with pledges to cut carbon emissions who need to manage exposure, the two presenters said.

Now, commodity trading adviser hedge funds that employ trend-following strategies (think firms like AQR) are entering the market. This phenomenon brings us to our first item today about a relatively new hedge fund that is earning big returns in the carbon futures market.

I also wrote today about new ESG metrics that companies have tied to executives’ bonuses. New research shows that ESG pay metrics in the energy sector can be vague and hard for investors to understand. (And read through to the end of the item for a poll that asks whether you think these new ESG pay metrics are worthwhile or not). — Patrick Temple-West

Carbon ‘playground’ yields big returns for climate-conscious hedge fund

Standing poolside at a posh, private markets conference in Miami last month, I casually mentioned to another attendee that I write about sustainable investing.

He asked me if I had heard of the World Carbon Fund. I had not. But I was intrigued and wanted to learn more.

London-based Carbon Cap Management is a hedge fund that trades in the carbon futures market established by countries’ emissions trading systems. Its World Carbon Fund has generated more than 20 per cent annualised returns, including fees, the firm announced last week. Investors who started with the fund in February 2020 have doubled their money, founder Michael Azlen told me in an interview.

The fund trades futures markets derived from five emissions trading schemes around the world. These schemes are authorised by governments and gradually lower the supply of carbon credits that polluting companies must buy to comply with local laws. For example, heavily polluting businesses must buy allowances that permit them to emit a tonne of carbon.

The carbon allowances in the EU hit an all-time high of €101 a tonne last month. The price is rising because in recent weeks the EU has tightened rules to make the system more onerous for polluters.

Unlike voluntary carbon offsets, ETS carbon credits are regulated by governments and traded via futures contracts offered by the Intercontinental Exchange. 

Given the eye-catching returns for Azlen’s fund, I asked him how he can compete with Brevan Howard, Citadel and other hedge funds that might be interested in jumping into the market.

“For the really big players, carbon simply is not a big enough playground yet for them to make it worthwhile for them to devote the analytical resources to it,” Azlen said.

When China’s ETS ramps up, and there are 10 to 15 carbon markets around the world, bigger players might emerge, he said. “Right now, I think it is a bit too niche for them. That suits us because that means they are out of the market.”

The only competition he sees comes from “commodity-trading adviser” funds that use trend-following strategies, such as AQR, he said. They include carbon futures among up to 100 other commodities they dabble in as prices fluctuate, but their total carbon futures holdings are probably tiny, he said.

“[Azlen’s] team is deeply passionate about climate change and understands that carbon markets play a key role in decarbonising the economy,” Michel van der Spek, co-head of portfolio management at Rothschild & Co’s UK wealth management business, told me. He is an early investor in the World Carbon Fund. (Patrick Temple-West)

Gaps emerge in energy company environmental bonus provisions

Can corporate executives earn a bonus by slashing methane emissions or plastic straw usage? Yes. Increasingly, companies are adding environmental or social goals to executives’ annual bonus plans.

Last year, Starbucks joined Apple and Disney in adding new environmental and workplace targets to executive pay. At Starbucks, 10 per cent of the chief executive’s annual bonus was tied to environmental provisions, including efforts to “eliminate plastic straws” and “farm-level methane reduction”.

Shareholders have applauded companies for rewarding executives when they hit environmental or social targets. But investors have also grumbled that companies are picking targets that are virtually impossible to miss — thereby locking in a bonus without much effort.

New research from proxy adviser Institutional Shareholder Services (ISS) shows that more than three-quarters of energy companies in the S&P 500 index have added environmental or social metrics to bonus pay plans — well above the broader S&P 500.

But there is room for improvement about how specific environmental or social considerations contribute to bonuses, ISS said.

“There continues to be limited transparency around goal setting and target disclosure for many E&S metrics,” ISS said. “This impedes investors’ ability to evaluate the structure and goal rigour of the overall programme and may be especially challenging for investors who are focused on E&S metrics.”

For 2021 targets at energy companies, more than half of the environmental metric targets and 44 per cent of safety metric targets “were not clearly disclosed,” ISS said.

At least one energy company has said recently that its chief executive failed to hit environmental targets needed to earn a bigger bonus: EQT, the largest US natural gas producer, did not hit its greenhouse gas intensity goal the company said in a regulatory filing this month. Chief executive Toby Rice’s 2022 bonus was smaller and his overall pay was down for the year in part because the company missed this target.

Energy companies risk shareholder ire when they are not detailed about how environmental and social metrics are contributing to bonuses. But as the EQT example shows, climate bonus provisions can prove to be a meaningful motivator.

What do you think? Vote in our poll and we’ll report back with results on Friday. (Patrick Temple-West)

Smart read

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And vaping has rapidly accelerated into a somewhat safer version of traditional smoking. While the health concerns are still emerging, the trash piling up from vaping sticks and other products is starting to draw scrutiny too, our colleagues write in this Big Read.