Integrating biodiversity into passive equity portfolios

In recent years, investors have increasingly realized that they have an important role to play in the fight against climate change. They have responded by avoiding companies with high emissions, investing in climate solution providers and supporting net-zero strategies. Many investors are now considering how they can contribute to the conservation of the world’s biodiversity.

It may not be immediately clear why conserving biodiversity is as important as minimizing climate change, but the science is clear: biodiversity loss has major consequences, including disruption to supply chains, threats to food security and increased vulnerability to natural disasters.

It also has major economic consequences – the European Central Bank (ECB) has said that biodiversity loss is a significant risk to financial stability.

With this in mind, investors are now starting to think about how they can integrate biodiversity into their investment process.

At BNP Paribas Asset Management we have been integrating biodiversity into our investment process for several years as part of the non-financial analysis and ESG analysis.¹ score that we apply in portfolio construction for most of our investment strategies. We exclude companies with the worst impact from our investment universes.

We are now moving further, with a sharper focus on biodiversity as a separate issue. Since many clients take a passive approach to investing, below we describe how we reduced the biodiversity footprint of a passively managed large-cap global equity portfolio without significantly impacting tracking error.

Determining the biggest biodiversity offenders

Our starting point is to assess which companies have the greatest impact on biodiversity.

This is easier said than done – while the concept behind measuring which companies have the biggest impact on climate change is relatively clear (the more greenhouse gases they emit, the greater their impact), measuring a company’s impact on biodiversity is less straightforward.

We use data from Iceberg Data Lab, a fintech that measures the impact of individual companies on the five direct drivers of biodiversity loss identified by IPBES (the Intergovernmental Science-Policy Platform for Biodiversity and Ecosystem Services). They are

• Land and sea use change
• Direct exploitation of species
• Climate change
• Pollution
• Invasive alien species.

It bundles them into a single benchmark: the Corporate Biodiversity Footprint.²

The data shows that companies in the basic materials and consumer goods sectors are responsible for the largest share of biodiversity loss, while companies in the IT and financial sectors have the smallest impact.

Minimizing the tracking error in a passive stock portfolio

For a portfolio with limited tracking error against its benchmark – here we use the MSCI Europe ex-UK index – we use an optimization to determine the impact of reducing the portfolio’s total biodiversity footprint by different amounts.

As Figure 2 shows, reducing the footprint by 50% does not have a much greater impact on tracking error than reducing it by 20% or 30%. However, reducing the footprint (labeled CBF in the appendix) by 70% leads to a significantly higher tracking error.

From an investment perspective, it would be undesirable to invest only in a limited number of sectors, not least because this would increase the tracking error of a passive portfolio. Accordingly, we would consider companies with a small biodiversity footprint and underweight or completely avoid companies with a larger footprint.

For example, in the consumer staples sector we would choose to underweight supermarkets, which have a major impact on biodiversity due to their exposure to agricultural supply chains.

The importance of tackling biodiversity loss

Reducing a portfolio’s biodiversity footprint is an important step that investors can take, but in itself it will not necessarily lead to much less biodiversity loss in the real world. That is why we believe that collaboration with the companies we invest in our portfolios is crucial.

In recent years we have worked with pharmaceutical companies to urge them to stop using the blood of the endangered horseshoe crab in testing for endotoxins that can cause sepsis. These actions have yielded results, with several companies pledging to phase out the use of these animals.

Other examples of our active ownership practice include submitting shareholder proposals to halt deforestation caused by the Cambodian garment industry and the degradation of Canada’s boreal forests.

Other approaches to biodiversity-related investments

In the case of the passive large-cap equity portfolio described here, we focused on minimizing exposure to companies with the worst impact on biodiversity.

Portfolios with different objectives and constraints may require a different approach.

For actively managed portfolios that are less focused on minimizing tracking error or that may invest in asset classes such as small caps, private markets and fixed income, a more flexible approach can allow greater exposure to solution providers that actually reduce biodiversity loss and potentially contribute to the United Nations Sustainable Development Goals.

Because investing in the field of biodiversity is still in its early stages, we believe it is important that investors work closely with an asset manager on their biodiversity objectives and possible solutions.

[1] ESG – Environmental, Social and Governance. ESG assessments are based on BNPP AM’s proprietary methodology, which integrates all three aspects of E, S and G.

[2] For more information on how this data is calculated and its limitations, https://docfinder.bnpparibas-am.com/api/files/60B8656F-6A6F-4A35-9244-A997DCCB59FD