Phil Maymin: Welcome back to a very special episode of the Myron Scholes podcast, On Time. Chief Investment Strategist at Janus Henderson, Professor of Finance at the Stanford Graduate School of Business, and Nobel Laureate in Economic Sciences, among many other accomplishments and responsibilities that would take way too long to list. Myron shares his unique insights with us here. These podcast episodes are aimed at sophisticated investors and those who wish to be sophisticated investors and are intended to be thought provoking and perhaps even controversial. We hope you leave each episode with more questions than you started, and we invite you to send feedback or questions to Myron at askmyron@janushenderson.com.

Today’s episode is specifically about decarbonization of portfolios, to coincide with the publication in the Journal of Investment Management of a paper by Myron and Ashwin Alankar on carbon emissions and asset management. But more generally, it’s about the role of innovation in finance.

Myron Scholes: Time and uncertainty are linked to new ideas, ventures, innovations, and their development. A key economic observation is that infrastructure to support innovation must follow innovation. There is an old adage to not put the horse before the cart. Seldom would a war general, for example, order the ordinance to the front line and then follow with his troops moving forward. The same is true with financial innovation or innovation generally. Innovators go first, followed by infrastructure to support only the successful or seemingly successful innovations. Infrastructure includes all of the support and control functions of the activity. And the pace of implementation and infrastructure support are uncertain, sometimes going faster, and other times slower, given market forces. Under uncertainty, this makes sense. If a valuable innovation were a sure thing, it would already have been implemented successfully. Many innovations fail, however, either because they were too early, or their value was overestimated, and demand was insufficient to sustain it.

We have heard that the early bird gets the worm. The counter-adage, however, is that the early bird gets frozen to death. With uncertainty, innovators move forward with implementations without building out all of the infrastructure to support their ideas. With failures, the expected cost would be too great to do so. Time unfolds, providing more information as to potential success. With partial successes, more infrastructure is built to support innovations and cement in success.

Along these lines, I discuss a paper written with my colleague Ashwin Alankar, Head of Asset Allocation Strategies at Janus Henderson. The paper is entitled “Carbon Emissions and Asset Management,” published in the Journal of Investment Management in its 2022 fall issue. The innovation described here is for portfolio managers to buy carbon credits to neutralize the CO2 emissions of their investment portfolio securities. We have heard the complaint that the carbon credit market is new and that some credits are suspect, although we believe that this perception has come from documentation of the actions of a few bad actors or carbon credit projects that fail. This market is growing and becoming important for those buying or selling carbon offsets as the world transitions to a greener economy. With the growth in the carbon credit market comes new infrastructure support to solidify and sustain it. The market is thickening, becoming deeper, and is used extensively by major corporations and intermediaries. This is exactly what we would expect with increasing demonstrated demand and value over time. Success stimulates the development of infrastructure to support the market. As uncertainty as to value is resolved, infrastructure is built to complement and solidify innovations.

Two major current approaches that portfolio managers use to be active in reducing CO2 emissions given the ESG movement in Europe and the United States are, first, to exclude firms or underweight firms with poor ESG scores, such as coal, oil, and gas producers from their portfolios. The hope is that this increases the cost of capital to these firms by reducing their stock prices. But we are not clear as to what increasing the cost of capital would achieve in reducing net carbon emissions in our global society. The second approach is to engage with firms and cajole them to decarbonize and reduce carbon emissions. Passive investment managers take this approach for they are constrained to stay at the benchmark or the index, which includes retaining positions in carbon emitters. This approach has vague and uncertain outcomes as well.

As already noted, we propose and model a third approach. The portfolio manager optimizes the portfolio to select investments to maximize the expected return in the portfolio for a given level of risk, or a given objective, passive or active, and then buys carbon credits to offset the carbon emissions of the components, the companies in the portfolio. The portfolio becomes carbon neutral; the contents of the portfolio do contain carbon emitters. The goal of society is to reduce net carbon emissions globally. CO2 emissions do not stay in the U.S. or in Asia, they enhance global warming.

Maymin: Myron, what would it cost to make an index fund carbon neutral by buying carbon credits?

Scholes: The market prices of carbon credits exist and are traded in the act of secondary market. Market prices determine the cost to be incurred by portfolio managers to make their portfolios net carbon neutral. Today’s prices to offset the carbon emissions of the S&P 500 portfolio costs about 7 basis points per year. This is a known cost. For less developed market portfolios, the cost would be upwards to 35 basis points per year. The portfolio manager could offer two portfolios to its investors: One optimized, but without any carbon offsets or any carbon considerations, and the other a clone that differs from the first portfolio and buys credits to offset entirely the carbon emissions of the second portfolio for a known cost.

Maymin: What’s the benefit of providing one portfolio that’s carbon neutral and the other that doesn’t buy carbon credits?

Scholes: Investors would choose a convex combination of these two spanning portfolios to satisfy their own utility or preferences as to decarbonization, given the known cost of credits and the prices they are willing to pay to reduce the net CO2 emissions of their investment. Firms move to decarbonize by producing their own carbon offsets – so-called white carbon – by changing production methods, inventions, etc. This takes time and will not occur instantaneously. There are failures and successes that are revealed in time. To wean ourselves off of coal, oil, and natural gas, is likely to take multiple decades.

With increasing demand to decarbonize, new innovations are a growth engine for the global economy. Other firms might invest in producing offsets by planting forests or expanding the use of plants in the ocean – so-called green and blue carbon credits – that sell as carbon credits to others. Not all of these are successful projects; many will fail. Successful offsets will sell through the over-the-counter credit market. Although a young market, amazingly 350 million metric tons of carbon credits were sold in the voluntary market in 2021. These credits theoretically would neutralize $4.3 trillion of investment in the S&P 500. Although carbon credits are only band-aids as a transition to a greener economy moves forward, credits are a necessary band-aid that will slow down the bleeding dramatically. The band-aid might be a competing solution to move to slow down global warming by capturing carbon emissions. When the price of carbon credits increases, more credits are produced, and companies are incentivized to move more quickly to decarbonize. This is exactly what society wants to achieve.

Maymin: Isn’t excluding a firm from a portfolio costless and produces a better result in our fight to limit global emissions?

Scholes: Excluding firms from a portfolio is not costless or cost effective. Constraints are costly if they have value; they will produce loss returns or increase volatility because of reduced portfolio diversification. Over the last 15 or so years, the annual loss return of the S&P 500 ESG portfolio constrained to hold higher-scoring ESG firms was over 1% per year less than the unconstrained S&P 500 itself, and this ESG-constrained portfolio is higher volatility. This might be a spurious result, however. The timeframe is short, and it is hard to measure differences in returns.

The main point is that, unlike carbon credits with a known cost to achieve net carbon emissions, the benefits of exclusion are uncertain and are unknown. Portfolio managers can build net carbon neutral portfolios with known costs because the market prices of carbon credits exist. They can assess the quality and manage the credits that they acquire for their investors; this is a function they can perform. And given the cost, each investor can decide how much they would be willing to pay to produce a net carbon benefit. A portfolio exists, and then their investors in the portfolios can make their own decisions. Investors will know the cost and will assess their own benefit to reduce the CO2 emissions of their portfolio and do so cost effectively when compared to other alternatives. Why? Because carbon credits are priced in the market.

Maymin: Some argue that buying credits is slippery and investors would reject it. Aren’t carbon credits a bad solution to the problem of reducing global emissions?

Scholes: The complaint, however, that I often hear with this approach is that the portfolio will still hold, for example, horrible polluters such as coal mining companies. No one who cherishes the environment would hold such companies. Although the portfolio is net carbon neutral, the contents are awful for society. If we take the portfolio view, however, it is carbon neutral. Portfolios can also be made carbon neutral by excluding net carbon emitters such as the coal companies. Holding only companies that are carbon neutral or fudging to some extent by buying companies with relatively good ESG scores has a cost in lost diversification and possibly lost returns with uncertain benefits. Excluding some firms means that someone else has to hold them. Do index funds hold them? Do those who care less about the emissions hold them? Or are they sold to foreign investors who are unconstrained and don’t invest in reducing carbon emissions at all? Exclusion is an unknown event and will not necessarily result in the desired result at all. Companies generate their own offsets now and are given credit for these offsets by reporting their net carbon emissions. They buy credits produced by others who are more efficient at producing carbon offsets; this is just a division of labor. Portfolio managers could do the same. Net emissions are important in society to gauge global warming. Gross emissions are secondary in the global fight to reduce our net carbon footprint. Encouraging the generation of new credits in the green or blue carbon market benefits the global economy and encourages innovation. Global warming does not score any form of carbon offset differently, and throwing out U.S. coal companies from portfolios, thereby increasing their cost to capital, might lead them to give up the business to coal producers in other countries that use cheaper energy sources to compete against U.S. producers while still emitting CO2 into the atmosphere. This is a global problem. We do not claim that the portfolio method is the only method. We think that it is cost effective, and its value is known; its cost is known. Credit markets are surviving and growing. This is the proof of concept that an innovation is succeeding.

Maymin: I have read that the carbon credit markets are full of false claims and invalid credits.  Do you agree, and what does the future hold for this market?

Scholes: Another complaint we hear is that the carbon credit market is inefficient, and credits are spurious or sold multiple times. This relates back to our innovation discussion. Innovations must lead infrastructure. Successful innovations lead to more infrastructure and control. The carbon credit markets are growing. Infrastructure is weeding out bad actors and attracting participants who value the carbon credit approach as a bona fide mechanism to capture carbon globally and to reduce the net emissions of CO2 into the atmosphere.

Portfolio managers, in our view, have another approach to consider reducing net carbon emissions in their portfolios, and it might be a superior approach to exclusion or to cajoling companies to reduce their carbon exposures.

Maymin: Could you comment on your idea of infrastructure following innovation in the context of other recent financial novelties like cryptocurrencies or NFTs, non-fungible tokens?

Scholes: Yes, this is a good question. Many previous financial market crises have occurred because innovation was too far ahead of infrastructure. There is a balance that must be maintained between too-cumbersome an infrastructure and too far-ahead innovation. For example, in October 1987 the market collapsed and fell over 20% in one day. The New York Stock Exchange Commission claimed that this was because of portfolio insurance and lack of regulation of futures contracts. The Chicago Mercantile Exchange Commission, on the other hand, which I was on, claimed that most likely the crash resulted from a lack of infrastructure of the New York Stock Exchange to handle the increased volume of trades that occurred around that time, and that Congressman Rostenkowski stated a few days earlier that he proposed to tax mergers and acquisitions, and the market sold off dramatically in these stocks, resulting in a cascade of selling in the marketplace.

For example, the 2007-2008 crisis resulted from a lack of infrastructure to support the explosive growth of securitization of subprime mortgages and the lack of concern of the banks about the credit risks of the more secure securitized pools. With cryptocurrencies, the problems are obvious. Hackers are stealing currencies. Cyber controls are weak. Credit risk monitoring is weak. Algorithmic stable coins at $1 collapsed because of ill-conceived infrastructure to support the claim of a stable currency. There are many who write about and teach about these infrastructure risks and the lack of infrastructure development, but experiencing loss is a way to really understand risks. Old warriors retire or quit after experiencing losses. New entrants don’t have any experience. They might learn about it through books, but they don’t have the experience to really internalize it and understand it. War generals know this and always send fresh troops up the hill to attempt to take the hill once again.

Maymin: That’s great. Okay, well, then let’s go back to carbon, and the earth, and the planet. As investors in funds, let’s suppose they all start to begin decarbonizing their portfolios in the way you described. What effect do you think that would have, or what do you expect that would have, on new carbon offset projects, and registries, and maybe even ultimately on the environment as a whole?

Scholes: If the price of carbon offsets sold as credits increase go up, new projects will be developed and stored credits from older projects will be sold. Increases in prices result in more carbon capture and reduction of global warming. These new carbon capture projects reduce net carbon in the environment. This benefits society. Increasing carbon credit prices, however, could lead to the production of spurious credits. Obviously then, as new projects come online, additional policing and controls become necessary to validate the increasing supply of credits.

Maymin: Makes sense. It’s funny, in environmental discussions, there’s often a prevailing notion of people versus nature. But your approach here is one of people acting together with nature, through the power of markets. What is it about markets that allows them to solve such enormous problems in effective ways?

Scholes: Great question. Behind markets are prices. Prices allow entities to make tradeoffs. Those entities that are decarbonizing through producing white solutions use market prices to determine the speed with which they will invest and develop new technology. Moreover, prices are key to determine the effects of actions on outcomes. The carbon credit market provides signals as to the price that clears the market for offsets. Entities use these prices to decide whether to use or trade their own offsets. Portfolio managers do likewise. For those with skills to generate additional carbon credits, price increases signal them to produce additional credits to sell to others. This is another example of the division of labor, or skills, in our society. In ESG discussions, how do we value or price societal or governance issues at firms? Yes, profit-making firms take these into account. But without market prices, it is difficult to weight them. With market prices, portfolio managers or corporations can buy credits, or depending on internal values versus external, market values do not depend on that. In other words, with market prices, portfolio managers or corporations can buy credits or not, depending on their internal values versus external market values.

Maymin: Awesome. One last question. Regardless of anything, there will always be some, maybe even many, investors who say that polluters like coal companies, they should just be excluded from the portfolio. Regardless of cost or carbon credit availability, no matter what, even to make the portfolio net carbon, they don’t care about that. They just want to exclude. What’s your response to these investors?

Scholes: If an investor values the exclusion of coal companies much more than the cost of carbon credits and the cost of exclusion, I will argue that they should exclude them from their portfolio if they can, or short them if they want to go to the extreme and buy carbon credits to decarbonize the remaining part of their portfolio. But the point is, depending on their preferences, sometimes the cost-benefit calculator is dominated by personal preferences.

Maymin: Thanks, Myron. And thanks to our listeners for joining in. If you’d like to listen to any other episodes in the series or explore our other podcasts you can subscribe at Spotify or Apple Podcasts or, I don’t know, wherever you listen to podcasts. Also, check out the Insights page on JanusHenderson.com for additional timely content from our investment experts.