investment viewpoints

Paris alignment: pragmatic steps for investors

Paris alignment: pragmatic steps for investors

 

The Paris Agreement sets out a global framework to avoid dangerous climate change by limiting global warming to well below 2°C. How can this be translated into meaningful goals and actions for the investment community?

 

Need to know

  • There are a number of best-practice methodologies and approaches for measuring alignment, transitioning portfolios, and taking action to drive the transition to net zero.
  • The use of forward-looking metrics provides positive answers to primary challenges for investors.
  • There is a financial risk associated with failing to take action now on expressing climate views in portfolios.

 

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The Institutional Investors Group on Climate Change (IIGCC) is the European membership body for investor collaboration on climate change. Comprising an investor-led network of over 350 asset owners and managers across 22 countries, together the body represents over EUR 39 trillion.

IIGCC established the Paris Aligned Investment Initiative (PAII) in May 2019 to explore how investors can support the key climate goal through their portfolios and actions. A series of working groups identified best-practice methodologies and approaches for measuring alignment, transitioning portfolios, and taking action to drive the transition to net zero.

“We launched the PAII to explore how you can measure alignment with the goals of the Paris Agreement and how you can take action as an investor to achieve that goal in the most effective way possible,” said Daisy Streatfeild, IIGCC Investor Practices Programme Director.

The main outcome of the project is the Net Zero Investment Framework 1.0, which has a global remit and currently covers four asset classes (sovereign debt, listed equity and corporate fixed income, and real estate). The framework has several aims, which have been designed to enable all investors to maximise their efforts and impact to achieve climate goals:

  • Translate the goals of the Paris Agreement into practical guidance for asset owners and asset managers
  • Establish a common understanding of effective approaches and methodologies to guide the ambitious action required
  • Support the decarbonisation of the real economy, help minimise the negative impacts of climate change, and seize investment opportunities

Investors are advised to use a range of top-down and bottom-up levers to achieve Paris alignment and real-world decarbonisation. The Framework identifies five components of a net-zero investment strategy, which set the direction and portfolio structure for alignment, as well as shifting the alignment of assets to meet portfolio goals:

  • Governance and strategy
  • Objectives and targets
  • Strategic asset allocation
  • Asset-class alignment
  • Advocacy and engagement

Investors are encouraged to set targets to measure their achievements in terms of those net zero-goals. From an asset-class level, bottom-up targets and objectives in line with science-based net-zero pathways are recommended, including:

  • A five-year goal for increasing the percentage of assets under management invested in assets in material sectors that are i) already at net zero, or meeting criteria to be considered either ii) ‘aligned’ iii) ‘aligning’ to net zero
  • A minimum coverage threshold of 70% of emissions in material sectors are either i) fulfilling net-zero status, ii) aligned, or subject to direct or collective engagement and stewardship actions

At a portfolio level, top-down reference targets in line with science-based net-zero pathways are also encouraged, including:

  • A <10-year CO2e emissions-reduction target covering listed equity, fixed income, or real estate
  • A <10-year goal for allocation to climate solutions representing a percentage of revenues or capex from assets under management (based on the European Union taxonomy mitigation criteria)

Investors can also play a broader role helping to drive positive change in companies and economies.

“One of the areas we really focus on is engagement and stewardship. If a company is just divested by an investor, they lose their rights to influence the direction of that company. If you have an existing holding, trying to influence that through your engagement strategy is often best for supporting that transition,” said Streatfeild.

“From an investor perspective, there are really four challenges: how do you decarbonise your investment, how do you identify the climate risks in your portfolio, how do you identify opportunities, and how do you maintain a healthy diversification of your assets?

 

Sustainability as an investment conviction

The use of forward-looking metrics provides positive answers to four primary challenges for investors, explained Maxime Perrin, Head of Sustainable Investment at LOIM.

“From an investor perspective, there are really four challenges: how do you decarbonise your investment, how do you identify the climate risks in your portfolio, how do you identify opportunities, and how do you maintain a healthy diversification of your assets?

“When we consider investment through the prism of forward-looking metrics, we can deliver positive answers to these four challenge,” he said.

Perrin stressed that investors should first be aware of the magnitude of the decarbonisation challenge, as it is one that concerns every sector, every country, and every region.

Investors should also be aware of the distinction between investing in decarbonised assets and investing in decarbonisation. The aim is to find companies that are credible in their decarbonisation efforts, those that have begun to decarbonise, or at least invest in assets and processes to allow them to decarbonise in line with Paris goals. A focus on low carbon-companies is fundamentally flawed and it is in high-emitting sectors where the issue of climate change is addressed and climate leaders are found.

“The problem with a lot of low-carbon strategies and methodologies that focus on the carbon footprint as it currently stands, is they are going to miss the opportunity of investing in the decarbonisation effort and will focus on companies that are not really that concerned by decarbonisation,” said Perrin

In order to construct a forward-looking metric that assesses the direction of travel of a company, and allows for investment in the transition and not just a low-carbon section of the market, it is necessary to first define the possible decarbonisation pathway of a given activity in a granular manner. This is then compared with the estimated emissions pathway of an individual company.

“When you manage the methodology, it is important to understand what the variables are and the credibility of those variables. When we look at a company’s future pathway, we are using assumptions. Those assumptions are going to be based on the company’s targets, on the company’s credibility in the past, the company’s recent emissions trajectory,” said Perrin

Perrin also noted that, while an analysis of a carbon footprint is a useful starting point, it is more important to strategically analyse portfolio temperature alignment.

“Too many investors are only looking at their portfolios through the prism of the volume of emissions it is responsible for. This is a useful starting point, and while it is necessary to calculate a carbon footprint, it is much more important in assessing a company to understand the opportunities and the risks given its temperature alignment. You look at the past in relationship to the future,” he said.

“We need to be able to identify are those companies that are risky because they are ill prepared, and not credible, which we term burning logs because they heat up the temperature of the portfolio, and distinguish them from companies which are much more credible and ready for the challenge and have already begun decarbonising. These are the ice cubes which cool down your portfolio.”

 

How can investors express climate views in their portfolios?

Moderator Thomas Höhne-Sparborth, Head of Sustainability Research, kicked off the panel session by asking if investors who are solely concerned with climate risk should simply invest in low-carbon sectors?

Perrin explained that this approach not only would create diversification risk but would cause an investor to miss out on companies which are positively aligned with the climate transition.

“Diversification is there for a reason, to reduce your risk and allow you to be exposed to the broader market. You are also going to avoid all kinds of opportunities as some companies have a positive risk and are going to benefit from the climate transition. A company that produces CO2-free steel is risk positive. Their margins are higher, they have a competitive advantage and they can sell their product higher than their competitors.”

Höhne-Sparborth asked Julius Pursaill of Cushon Adviser for his perspective on what challenges smaller players in the market have faced in terms of defining a strategy and targets.  

“We are a small player with limited resources and we have to resolve this conundrum in the context of the fiduciary duty challenges, which are significant, and in terms of cost. We have chosen to prioritise immediate reductions in our carbon footprint, and we’ve tried to combine those immediate reductions with some support for positive transition and a lot of exposure to transition upside. 

“There is no reason whatsoever why the lack of complete consensus about how one should best go about tackling climate change, and managing climate risk in portfolios, should become a barrier to taking action. Part of our policy has been to demonstrate that you can take action and make a difference while continuing to wait for refinements.”

The panel was also asked to consider timings and whether is there is a financial risk associated with failing to take action now.

Perrin noted that there is substantial risk – whether you are a credit investor or equity investor.

“Sources of ratings such as Standard & Poor's are starting to measure the lifespan of assets which are being reduced based on how likely they are to be regulated out of existence. It could also be the case that it is replaced by a better technology sooner than regulation makes it irrelevant. You have to take this into consideration, not just because it is the right thing to do, but because it is necessary to protect your own investment,” he said.  

Höhne-Sparborth also asked Sophie Chardon, Cross Asset Strategist at LOIM, for her views on the key challenges between asset classes?

“All assets are exposed to the climate risk but opportunities will differ from one to another. We do not want to exclude some asset classes because of a lack of data. We believe that with the increasing pressure coming from investors and from regulators, the quality of these data sets will improve over time.

“It is difficult in terms of methodology to get the measure of climate risk, for example, in private markets and commodities. It is difficult to measure the climate risk of copper. Copper is key to decarbonisation but at the same time the mining activity is emission intensive,” she said.

Investors have an important role to play in helping to drive positive change in the companies and economies they are invested in and engagement and stewardship are crucial in efforts to achieve this. Höhne-Sparborth asked Rebeca Coriat, Head of Stewardship at LOIM, whether engagement is still mainly restricted to equities.

“Historically, there has been greater engagement carried out in equities since you can use stewardship tools to escalate issues. Slowly, asset managers and owners are moving towards applying engagement in more asset classes,” she said.

If the priority for investors is identifying companies which are well-aligned with the goals of the Paris Agreement and the climate transition, can it be said that a well-aligned company is necessarily going to outperform a misaligned one? Perrin explained that, while there is no guarantee that better aligned companies will provide better performance for their shareholders, there is a strong indication that they will offer a lower level of risk.

Conversations regarding decarbonisation are often focused on the energy sector. Höhne-Sparborth asked whether enough attention is being devoted to non-energy emissions? Streatfeild explained that more attention should be given over to the emissions associated with food and land use.

“We could stop all emissions today and still go over the 1.5°C limit if we don’t do something about emissions connected to food and land use. It is the next frontier,” she said.

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