investment viewpoints
Temperature alignment: how we capture it to benefit investors
Transition vision: anticipating climate risk in the sustainability revolution
As an investment firm, our core belief is that we are at the beginning of a profound economic transition. The prevailing growth model upon which our society has relied has become unsustainable and a shift to a new paradigm is occurring. Decoupling growth from negative environmental and societal footprints is becoming ever more realistic as businesses find solutions that create value by delivering greater circularity, more leanness, more inclusivity and cleanness. We call this transition the shift from a WILD (Wasteful, Idle, Lopsided and Dirty) economy to a digitally enabled CLIC™ (Circular, Lean, Inclusive and Clean) economy, and we believe our fiduciary duty is to help our clients mitigate the risks and capture the investment opportunities associated with this transition. Our investment philosophy recognises that this new economic revolution is similar in scale to the Industrial Revolution, but is sweeping across the business world with the speed of the Digital Revolution, and represents the most significant investment opportunity of our time.
We are committed to constant innovation so that we may enhance our capabilities to enable clients to navigate this shift and achieve their long-term financial return objectives. The transition to a low-carbon and climate-resilient economy is one of the most important cross-cutting features of this CLIC™ economic transformation. Decarbonisation commitments are increasingly enshrined in law by many countries and are being adopted directly by companies. This is consistent with the reality of the transition to net-zero emissions, which will require concerted action across all sectors of the economy. It is, however, remarkably complicated for asset owners to invest sustainably because of a lack of standards and definitions, incomplete disclosure of data and nascent understanding of the decarbonisation pathways that are particular to individual industries and geographies.
We believe forward-looking measures are vital to assist investors in understanding the transition pathways of assets in order to avoid exposure to stranded assets and identify valuable opportunities.
LOPTA: our forward-looking view of climate risk
We believe it is vital to quantify the temperature trajectory of individual companies within our investment universes. This means assessing the degree of alignment of companies to the decarbonisation pathways implied by the goals of the Paris Agreement, which seeks to limit global warming to 1.5-2°C. For example, a company that is on a trajectory more aligned to a 3°C outcome might be cutting its direct and indirect CO2 and greenhouse gas emissions to some extent, but is not decarbonising itself at a pace sufficient to meet the goals set by the Paris Agreement. This may lead to, inter alia, more stringent operating circumstances, loss of competitiveness, restricted growth prospects and asset stranding; all having a negative impact on future profitability.
This analysis will allow us to align portfolios with the companies best-positioned to capitalise on the full quantum of the investable opportunities represented by this transition and identify specific and systemic risks for those companies which have not understood the urgency and nature of the transition. The Lombard Odier Portfolio Temperature Alignment (LOPTA) framework allows us to strategically analyse temperature trajectories across all portfolios.
We believe forward-looking measures are vital to assist asset owners and asset managers in understanding the transition pathways of their investments as the economy shifts as a result of the climate transition. It is also vital to understand the trajectory of all companies in our portfolios in order to avoid exposure to crippling stranded assets and identify the most valuable investment opportunities. Stewardship and engagement will play a vital role in this process.
This new forward-looking data point will become critical as there are many examples of strategies that have delivered consistent risk-adjusted excess returns over the years and have impressive track records but are fundamentally poorly positioned for a future which will look radically different, as the climate transition’s powerful feedback loop of regulatory and market forces creates, shifts and destroys value across nearly all sectors and industries. We believe regulatory pressure to report temperature alignment is now also inevitable. We think it is necessary to precede such requirements and report portfolio alignment to the Paris Agreement as quickly as possible, given the urgency of the net-zero transition.
Science-based approach to understanding portfolio temperature alignment
World leaders agreed as part of the 2015 Paris Agreement to keep the temperature rise this century well below 2°C above pre-industrial levels and to pursue efforts to limit the rise to 1.5°C. This trajectory is built on the scientific basis established by the Intergovernmental Panel on Climate Change (IPCC) and its grim verdicts on impacts and future risks, as well as options for adaptation and mitigation. This basis has been widely adopted in the finance industry, from asset owners through to central bank governors at the Financial Stability Board and represents the impetus for all future climate-related legislation. At a recent Treasury Committee hearing in the UK, United Nations special envoy for climate action and finance Mark Carney stated that “if you price the capital markets…all of the assets are probably north of 4°C.”1 A warming level of 4°C would put the world on a trajectory consistent with catastrophic global heating and could drive losses in income to the global economy of over USD 23 trillion each year, or roughly one-third of current global GDP.2
We believe we must allocate capital not only to low-carbon solution providers but also towards carbon-intensive, hard-to-abate industries which are fundamental to the economy but where there is an urgent need to transition to a more sustainable model. By providing a transparent metric to gauge the temperature alignment of a portfolio, and whether it is aligned with the Paris Agreement and a net-zero economy, we will be able to understand which areas of our portfolios are on the right decarbonisation pathways and those which are lagging behind. In this way, we will be able to identify future investment opportunities in the climate space and avoid exposure to stranded assets and other economic risks.
We report one transparent number – Portfolio Temperature Alignment – providing full insight into the complex underlying analysis of company pathways to decarbonisation.
Lombard Odier’s proprietary approach
At Lombard Odier, we have built a proprietary framework to analyse portfolio temperature alignment. To date, companies have not reported in a consistent way on how to manage the transition to a net-zero emissions world. There are third-party tools already available to analyse the temperature alignment of asset portfolios but existing tools are inferior and present significant flaws.
We believe the strength of the LOPTA approach lies in the breadth of its coverage and its granularity – rather than looking at the required transitions through the lens of a handful of broad sectors, we have defined the pace and shape of the necessary rate of decarbonisation across 160 industries and 6 regions. This leads us to a more nuanced and accurate temperature analysis of 15,000 companies (and over 100,000 when including industry-estimates). We analyse the full range of decarbonisation measures available to each industry, ranging from demand-side changes (including lower meat consumption and less air travel) to technology-led solutions (such as electrification, efficiency improvements, fuel substitutions and carbon offsets or capture). After building the industry decarbonisation pathway by region, we compare each company’s actual footprint and temperature trajectory to its specific industry pathway to calculate a company-level temperature outcome. This, in turn, is used to calculate a portfolio-level temperature outcome.
We are able to report one transparent number – Portfolio Temperature Alignment – while providing full insights into the complex underlying analysis of company pathways to decarbonisation and the interaction between different industry trajectories, geographies, and abatement costs. We believe that no third-party data providers currently offer this level of granularity or a transparent methodology which is fully adjustable for different pathway assumptions.
Conclusion
Our objective through this approach is to help our clients understand the decarbonisation target and pathway of their portfolio companies through a single and easy-to-use metric. This should provide them with a stronger base to engage with companies or adjust their portfolios.
sources.
1 Mark Carney (15 October 2019). Oral evidence provided to the House of Commons Treasury Committee.
important information.
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