Back to the grind: Low carbon credit performance

11 minute read

Low carbon credit relative returns have recovered after an extensive oil price rally between Q2 2020 and Q1 2021. Excess return over six years is 32bps per annum or 1.9% cumulatively, with a Sharpe ratio of 1.4.

We see this as indicative of only extremely strong price dynamics in fossils being able to counteract a secular decarbonisation trend: when such fossil price dynamics subside, low carbon credit appears to continue outperforming.

The outperformance by 1.9% in return terms may seem small in the context of other investment return prospects, but for a benchmarked real money manager, this would be considered sizable. The low carbon relative performance index is constructed by using an identical set of issuers (based on the S&P IG corporate bond index) but reweighting portfolio weights using the ECOBAR methodology and a duration and spread beta neutral weighting scheme.

The ECOBAR system is generally less restrictive and more flexible than exclusion-based ESG strategies, for example allowing traders to increase positive impact (scoring) through shorting underperformers and adjusting for term-structure effects in credit. ECOBAR scoring posits an exponential increase in scores for high-carbon emitters.