Only 1/4 of large caps are on track to meet the Paris Agreement

investment viewpoints

Only 1/4 of large caps are on track to meet the Paris Agreement

Thomas Höhne-Sparborth, PhD - Head of Sustainability Research

Thomas Höhne-Sparborth, PhD

Head of Sustainability Research
Khangzhen Leow - Sustainability Analyst

Khangzhen Leow

Sustainability Analyst
Emi Hu - Quantitative Analyst

Emi Hu

Quantitative Analyst

The United Nations Climate Change Conference of the Parties (COP) is in its 26th edition this year in Glasgow, Scotland. This is where global head of states, policymakers, and luminaries are gathering to discuss progress and actions in mitigating and adapting to the effects of climate change. COP26 is an important event, as it helps co-ordinate and concentrate global efforts in preventing and combating the disastrous consequence of climate change. In 2015, the COP21 gave us the Paris Agreement, with a stated goal to keep the rise in mean global temperature to well below 2°C above pre-industrials levels, and preferably limit the increase to 1.5°C. Almost all countries have since signed on to this.

Since then, big and small countries across the world have pledged net-zero targets and many corporates are following suit. Despite this, at Lombard Odier we estimate that only 25% of the companies in the MSCI World Index are currently aligned to keeping warming below 2°C. An even smaller percentage of 6% is already moving credibly towards 1.5°C, as of the end of October 2021. At present, the companies in the index are, in the aggregate, aligned to global warming of 2.9°C – far from the Paris Agreement goal of 2°C.

The temperature alignment of a company to the Paris Agreement may be estimated by comparing its recent and projected trend in emissions to the specific rates of decarbonisation that every industry must achieve to keep global warming below a given level. Such analyses require a careful evaluation of company commitments, recognising that not all targets may be taken at face value. As targets may be missed, or strategies may prove unworkable, the credibility of commitments may vary, leading to more conservative assessments of companies’ alignment.

In October, updated guidance by the Taskforce for Climate-related Financial Disclosures (TCFD) recommended that financial institutions disclose the extent to which financial activities are aligned to a scenario keeping warming well below 2°C. Separately, the Taskforce commissioned a report from the independent Portfolio Alignment Team (PAT) to describe how best practices for such alignment should be measured and defined. While previous estimates have been published of the economy’s and of companies’ alignment to the climate transition, Lombard Odier’s estimates of large-cap stocks’ alignment to the Paris Agreement are among the first to use a methodology close to the best practices suggested by the PAT.

To shed more light on this assessment, as of October 50% of the companies in MSCI World Index had published specific details about their carbon-reduction targets or pledges. We estimate, however, that only 19% of companies had targets that were independently validated by the science-based targets initiative, where targets are considered ambitious enough to keep the global temperature increase below 2°C while maintaining scientific feasibility. Lombard Odier’s methodology, in keeping with the recommendations of PAT, assigns various weights to company commitments depending on their credibility, with Science-Based Targets still considered among the most credible.

Aside from differences in the credibility of targets, we also note significant differences in the scope of company commitments. Among the companies having defined quantitative carbon-reduction targets, only 46% had targets covering their full upstream and downstream supply chains, many of them vaguely defined. Among science-based targets, too, many commitments on so-called scope 3 upstream and downstream emissions only include a commitment to measure and reduce these, while failing to set a specific target1.

Certain sectors within the index are moving faster towards alignment with the Paris Agreement than others. The energy sector, including oil and gas companies, remains a clear laggard. We estimate the sector to be aligned to warming of approximately 3.7°C, as companies are still failing to transition quickly enough to less carbon-intensive forms of energy, including renewables. Despite ambitious commitments declared by some major names in this sector, commitments often rely on improbable amounts of carbon offsets, lack interim targets, or cover only a portion of a company’s markets. Some companies are closer than others, but none are fully aligned.

Other sectors are moving faster. We estimate, for instance, that the average alignment of the automotive sector is now close to 2.1°C. While the sector was initially slow off the mark, more recently car manufacturers have begun to set more ambitious targets for the transition to electric vehicles. A number of clear leaders have already emerged in the industry and even if the commitments across the sector as a whole are not yet in alignment, we expect this to change in the near term as companies continue to ramp-up investment in electric mobility.

In other industries, a deep rethink is still required. In sectors such as food, household products and personal products, companies have begun to set commitments to reduce their direct and power-related emissions. These emissions are often comparatively slight, so that some of these sectors have traditionally been considered “low carbon”. However, high exposure to supply chain emissions often make these sectors anything but. For a food company to be aligned, for example, it must not only reduce its own emissions but rethink whether a transition in its product mix is required to reduce agricultural emissions. Taking supply chain emissions into account, we find these sectors to still be aligned to 3.0 - 3.3°C. of warming.

 

Zero Hour: Lombard Odier at COP26

Lombard Odier is hosting a series of events at Ardgowan House, near Glasgow, during COP26 that are focused on the role of the finance industry in assessing climate and other nature-related risks. Today, our event – the Zero Hour Sessions – features an investor workshop focused on the metrics that may be used to assess the alignment of portfolios to the climate transition.

At Lombard Odier, we have so far assessed the alignment of over 20,000 companies through the use of our implied temperature rise (ITR) metric. We use this to assess the alignment of different indices, benchmarks and investment portfolios to the net-zero transition. We believe ITR metrics are likely to become more mainstream, particularly as the best practices defined by PAT promote greater convergence and facilitate disclosures in line with TCFD guidance.

For the climate transition, the adoption of such alignment metrics is essential. Ultimately, their adoption supports the allocation of capital to transitioning leaders in those sectors where such financing is needed most urgently. High-emitting sectors such as the automotive industry, steel, cement or chemicals will remain essential to the economy – but they must transition. Rather than allocating capital away from these sectors, assessments of the alignment of individual companies helps identify which businesses within them are climate leaders.

The transition to net zero requires a comprehensive transformation of our economy across all sectors – and the right metrics to track this progress.

 

Sources

1 Scope 1, 2 and 3 emissions are broadly defined as follows:

•    Scope 1: comprises all emissions directly under the control of a company itself, and are typically linked to emissions from their own buildings, facilities and vehicles 
•    Scope 2: consists of emissions caused by the generation of power, heat, steam and cooling purchased by a company from third parties
•    Scope 3: emissions linked to the wider supply chain and lifecycle of a company’s products and services. 

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