investment viewpoints

A net-zero solution is more than a low-carbon strategy

May 10, 2021

Yannik Zufferey, PhD

Chief Investment Officer, Core Business

The race is on. What we are confronting is a new industrial revolution, unfolding at the speed of the digital age, and one that will generate immense opportunities and risks in fixed-income markets.

To convey the scale of the net-zero challenge, Bill Gates uses the analogy of a bathtub slowly filling up with water. Because the effect is cumulative, even the slowest trickle will cause the tub to overflow eventually. At the current rate of emissions – 52 Gt CO₂e each year – we have less than 10 years before we breach 1.5° C of global warming, a level judged as vital if we are to limit catastrophic environmental, social and economic damage¹.

To be on track for achieving net-zero emissions by 2050, we have nine years to reduce emissions by 50%. This urgency is therefore driving action by policymakers, companies and consumers for rapid decarbonisation. As investors, we must rethink our portfolios for this profound economic transition.

Problems with low-carbon strategies

Today, bond indices carry an immense amount of climate risk that we believe is not accurately priced in. For fixed-income investors with sights on net zero, the obvious question is: how should carbon risk be managed?

Historically, many investors have responded by adopting low-carbon strategies that exclude sectors and companies with high emissions in favour of low emitters. In our view, this approach is flawed, for a number of reasons:

•   Missed opportunities: By ignoring companies with large carbon footprints but credible decarbonisation trajectories, it prevents investors from accessing climate-transition opportunities
•   Slowing the transition: By excluding essential companies – such as steel and cement businesses – that are truly decarbonising and whose progress is vital achieving net zero, it slows the pace of the transition
•   Concentration risk: By significantly restricting the investible universe, low-carbon strategies can reduce diversification and therefore increase concentration risk

In our view, investors seeking to capture opportunity and avoid risk in the net-zero transition should take an economy-wide, forward-looking view that extends far beyond current carbon footprints.

Ultimately, they must identify companies – which, irrespective of their sector or current carbon footprints – are executing credible plans to reduce their emissions in alignment with a net-zero future.

We call this investing in the transition.

Cooling portfolios, cooling the economy

Investing in the transition requires stepping beyond carbon-footprint analyses and gaining a clear sight of companies’ decarbonisation trajectories. By doing so, investors can judge whether businesses are transition opportunities to be captured or risks to be avoided.

With this forward-looking view, we believe that some of the best net-zero opportunities exist among companies whose current emissions would exclude them from low-carbon strategies but, due to their action on achieving carbon-reduction targets, indicate that they are on viable decarbonisation pathways. Their potential to thrive in a world aligning to – and achieving – net zero could be underpriced by the market.

We define these transition opportunities as ‘ice cubes’ because their progress on reducing emissions is helping to cool the economy. In direct contrast, what we define as transition risks or ‘burning logs’ are the heavy emitters with no apparent plans to decarbonise. They are doing nothing to advance the transition and will likely become casualties at or on the way to net zero.

FIG 1 Ice cubes and burning logs: illustrative examples

Towards a net-zero solution

We do not expect the net-zero transition to be smooth. Instead of targeting low-carbon sectors today, or managing to a climate benchmark with step-change reductions in emissions, we aim to adapt to changes in emission levels and reduction targets at the industry and company level. At LOIM, our sustainability team has developed forward-looking, science-based carbon expertise that underpins our net-zero investment approach. Broadly, it consists of four steps:

We assess the overall CO₂ exposure of a company in terms of scope 1, 2 and 3 emissions². This goes further than most climate-risk models on the market, including the European Union Climate benchmarks, which is delaying the inclusion of scope 3 emissions.
We assess the company’s expected rate of decarbonisation and performance against the level required for its industry to become aligned with a net-zero world.
We consider the impact of emissions-curbing regulations and peer pressure created by decarbonising competitors, and identify opportunities to drive change through stewardship.
Combining all of this information, we assess how closely a potential investment’s emissions trajectory is declining to 100% decarbonisation by 2050, validated by interim targets.

Targeting net zero in fixed income

In fixed-income markets, the universe of net-zero-aligned companies is limited. A truly net-zero portfolio of corporate bonds is therefore currently impracticable – although we expect this to become possible in the coming years as the transition accelerates. But our conviction in investing in the transition compels us to seek ice cubes, avoid burning logs and engage to accelerate progress in achieving net zero.

In doing so, we look forward and across the entire economy – not restricting ourselves to low-carbon sectors – aiming to decarbonise, diversify and drive the transition.

Sources

¹ The Greenhouse Gas (GHG) protocol identifies Scope 1 emissions as direct emissions from company facilities and vehicles; Scope 2 emissions as indirect emissions from energy supply; and Scope 3 emissions as indirect emissions from a company’s overall supply chain.

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