Carbon Intensity Bumps on the Way to Net Zero

Abstract

The recent update of the EU Benchmark Regulation mandates the use of enterprise value rather than revenues as the denominator for the computation of carbon intensity. The regulator’s advisers justified the substitution by its detrimental impact on the coal industry and affirmed that enterprise value—like revenues—would be applicable to both equity and fixed-income indices. However, all companies with low enterprise value to sales have suffered from the change, and enterprise value cannot be computed in the absence of equity market capitalization. Furthermore, enterprise value inherits equity market volatility, which weakens the link between changes in measured carbon intensity and underlying emissions and produces metric volatility that rewards an issuer’s market performance over its decarbonization performance. Impact-concerned investors that wish to guide portfolio decarbonization by carbon intensity should favor the use of revenues as denominator over that of enterprise value so as to encourage reductions in emissions and gains in process efficiency in the real economy.

TOPICS: ESG investing, legal/regulatory/public policy, mutual funds/passive investing/indexing, performance measurement

Key Findings

• ▪ Substituting enterprise value for revenues for the computation of carbon intensity, far from simply hurting sectors exposed to stranding risks, predictably benefits issuers associated with expectations of higher profitability, higher growth, and lower risk.

• ▪ The substitution introduces capital market volatility into measurement, which significantly weakens the link between carbon intensity and real-world decarbonization; impact-concerned investors should favor the traditional metric.