New TCFD reports: 10 net-zero takeaways for investors

Financial institutions under scrutiny

The amended guidance released by the TCFD includes a number of meaningful changes. Among others, the revised guidance encourages financial institutions to “more explicitly address disclosure of actual financial impact” as well as key information on organisations’ plans for the transition. It also encourages enhanced disclosure of exposure to scope 3 emissions – in addition to scopes 1 and 2¹. And the guidance encourages banks to disclose emissions linked to their loan books and financial activities, plus those from their own operations.

Perhaps most notable, however, is the added recommendation that financial institutions disclose the extent to which their activities are aligned with climate change of well below 2°C by 2050. This new recommendation applies to banks, insurance companies, asset owners and asset managers. It is likely to provide a vital new insight, requiring a more forward-looking assessment – not only of emissions exposure today, but how those emissions are being managed going forward.

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Forward-looking metrics are essential

Investors will require new metrics to help them assess the alignment of their portfolios to a world limiting climate change to, or well below, 2°C. Traditional carbon footprint analysis only provides a snapshot of a company or a portfolio’s emissions today. In contrast, forward-looking metrics seek to assess the direction of travel, and to evaluate whether carbon reductions (if any) are in line with the rates necessary to limit global warming to the levels envisaged by the Paris Agreement.

The separate and independent PAT report provides guidance to financial institutions as to the best practices for designing these metrics. It offers 26 considerations highlighting key methodological choices and providing clear suggestions for preferred courses of action. Many of these considerations are highly technical but offer a guide to investors to help them assess the alternative approaches available in the market, and views on their future development.

Out with low carbon. In with transition

A key observation from these reports is that the net-zero transition cannot be achieved merely by allocating capital away from high-carbon sectors. Low-carbon strategies that divert capital to lower emitting sectors (such as healthcare or education) may achieve an artificial reduction in their carbon footprint. This, however, merely results in a virtual reduction in emissions, due only to financial reallocations, with no consideration given as to whether the emissions of underlying companies – the real-world carbon reductions that the economy requires – are actually falling or not.

The PAT report states: “The greatest financing will be needed in the highest emitting sectors, and thus a smooth transition to net-zero society will depend on capital flowing to decarbonisation activities in these sectors.” Forward-looking metrics make a key contribution to this. Such metrics assess whether a company, given the sector it is in, is a ‘climate leader’ doing enough to align itself with the transition or a ‘climate laggard’ taking inadequate action. Forward-looking metrics therefore help us identify transition champions and casualties within each sector, including in sectors that are high-emitting today.

This helps drive investment to those companies that can effectively help to decarbonise such sectors, which are often key to the economy – such as steel, cement, energy and manufacturing. Such companies are not only well prepared for the transition, but by transitioning rapidly to lower-carbon business models and product and service offerings, they may also unlock major commercial opportunities along the way. Identifying misalignment can also help to robustly engage those companies, whose decarbonisation trajectories appear to fall behind the curve.

To the fore: implied temperature rise

The PAT report observes that there are three broad categories of forward-looking tools. The simplest of these are binary measurements, such as categorising investments into companies with or without declared carbon-reduction targets. Next, divergence models assess the gap between a company’s decarbonisation trajectory at any given point in time and what it should be to ensure alignment. Finally, implied temperature rise (ITR) translates an assessment of net-zero (mis)alignment into a measure reflecting the consequences of that misalignment, using scores that reflect the level of global warming that would occur if the economy as a whole were subject to a similar level of ambition.

The PAT report notes that the latter ITR methods are more complex but avoid many of the unintended disincentives that simpler methods may introduce, if properly designed. Much of the PAT report’s suggestions relate specifically to the design of ITR metrics and offer a roadmap to their proper development. Ultimately, the report suggests that such tools should be used alongside other financial institutions’ targets to help align lending and investing with the Paris Agreement. For instance, through the use of ITR metrics, an investor may explicitly set a target seeking to reduce a portfolio’s temperature alignment from 3°C to 2°C, or all the way to 1.5°C or below, by a given year.

Mainstream ITR adoption will move markets

Mainstream adoption of ITR metrics is now increasingly likely – benefiting from guidance by the TCFD and PAT, and support from key market participants. BlackRock² in January announced it will be publishing temperature alignment scores for all its public equity and bond funds, where sufficient data are available. Axa Investment Managers already released an analysis of some of its portfolios, finding them to be aligned to 2.7°C of warming, compared to its estimate of the alignment of the wider market to 3.2°C. The use of these metrics has also been backed by members of the Net Zero Asset Owner Alliance, which now represents USD 9.3 trillion in assets under management.

As more investors adopt ITR metrics to reassess their capital allocations, many assets in the market may be repriced. A steel company might be unfavoured by the market today, by virtue of its sector’s high carbon intensity. Where such a company is rapidly decarbonising and committed to net zero, forward-looking metrics might recognise its alignment to a 1.5°C economy and distinguish it as a leader in the space, attracting investors. Vice versa, a lower carbon company might seem appealing today. Yet, if such a company is rapidly increasing its energy footprint and failing to scale up its investment in renewables, this growing footprint could align it to warming of 3°C or more. Markets will adjust, accordingly, as forward-looking insights are used broadly.

Portfolio alignment: evolving science and art

Forward-looking portfolio alignment metrics are a comparatively new development, only made possible by recent advances in climate science, carbon-data acquisition, and the understanding of decarbonisation roadmaps. As a result, there are significant opportunities for further improvement and innovation.

One example of this is apparent in the PAT report itself. The original consultation draft distinguished between two high-level approaches. The first considers whether a company’s carbon intensity is improving in line with sectoral benchmarks. This approach is simple, but can lead to skewed results if an industry’s growth in volumes is higher than anticipated and may also fail to capture volume effects – for instance, when companies focus on producing smaller volumes of higher-grade, higher-value materials, such as steel. The second approach considers a company’s absolute emissions and defines the rate at which an industry needs to decarbonise. This captures both volume and intensity-based effects but may fail to reward companies that have already decarbonised, and may introduce anomalies when companies are gaining or losing market share.

Recognising these flaws, Lombard Odier has pioneered a hybrid methodology referred to as ‘fair share carbon budget’ approach. It recognises the average rate at which given industries need to decarbonise, but recognises that a lagging company, with a higher-than-average starting carbon intensity, would need to decarbonise at a faster-than-average rate, to compensate. Vice versa, it recognises that a leading company would be able to remain within its respective carbon budget through a comparatively smaller effort, recognising the progress it has already made.³

This innovation addresses many of the respective weaknesses of the original methods. It is now highlighted in PAT’s final report as viable across all sectors, whereas earlier approaches have more limited sectoral applicability. As the science and art of portfolio alignment matures, such innovations will prove key to correcting for unintended (dis)incentives.

Best practices will improve ITR uniformity

Early reviews of industry approaches to ITR metrics noted that the use of different methodologies can lead to significant divergence in final scores. As a result, investors using separate providers, each with their unique approach, might come to different conclusions as to the alignment of a portfolio.

Many of these differences are explained by the fact that individual approaches may be looking at slightly different things. Consider the following situations:

• A methodology taking into account only a company’s scope 1 and 2 emissions will come to a different conclusion than if we progressively incorporate scope 3 emissions (as the PAT report now encourages).
• A methodology only looking at current trends in a company’s emissions will differ from one considering a company’s decarbonisation targets (PAT now encourages taking both factors into consideration).
• And, at the portfolio level, aggregating scores using simple portfolio weights may be less appropriate than weighting by owned emissions or aggregating each holding’s projected emissions and benchmarks (PAT suggests the latter approach, which Lombard Odier adopted early on, as the most scientifically robust).

The adoption of common standards on some of the key issues above would bring greater uniformity, and comparability, to these metrics. The PAT report’s suggestions represent a significant step forward in this regard and should further accelerate the mainstream adoption of these metrics – although significant changes may be required to some of the current approaches in the market to align these to the PAT report’s suggestions.

Differences will – and should – remain

While the adoption of some of the best practices outlined by PAT will bring greater uniformity to these metrics, this will not mean all approaches will always lead to the exact same assessment – nor should they.

Some differences of opinion will remain. Investors may, for example, take different views as to the most likely route to decarbonisation of the economy: will it be driven more by behavioural shifts, or by technological investment? If the latter, will it be driven by energy efficiency, renewables, carbon capture, or the use of hydrogen? A number of different roadmaps remain viable and carry different implications for the timeframes of decarbonisation that different sectors must achieve. Similarly, investors may disagree on the eventual cost of a technology, such as hydrogen or carbon capture, which may in turn affect the credibility different investors may assign to a given company’s decarbonisation strategy.

This may lead one investor to adopt a different outlook on a company’s emissions trajectory than another, in much the same way that investors may diverge in their assessment of the credibility of a company’s financial projections, business strategy, and development opportunities. Here, there is no single right answer, and different investors may choose to back companies with different strategies depending on which they deem to be the most credible. 

While such cases will exist, with the adoption of the PAT’s best practices, differences should become slighter. And in most cases, investors should agree on the position of a company. All approaches, for instance, should agree in broad terms on the misalignment of an oil and gas company that is failing to decarbonise or the superior alignment of a car manufacturer rapidly transitioning to electric vehicles. Where there are differences, these should be able to be traced, explained, understood by investors and debated in and by the wider market.

Granularity matters

Finally, the PAT report makes a key observation: granularity matters. All alignment metrics work by assessing a company’s performance against a given industry benchmark, but not every sector needs to, or is able to, decarbonise at the same rate in order to achieve the  goals of the Paris Agreement All too often, however, the benchmarks used are of a very high-level, sectoral nature, which can create problems.

Consider the food industry. The Intergovernmental Panel on Climate Change (IPCC) has estimated that the food system accounts for anywhere between 21-37% of global emissions, making it a sector of focus. The differences between sub-industries, however, are significant. Emissions linked to seafood are dominated by the fuel consumption of fishing fleets. For beef, they are dominated by methane production from cows, and land-use change. Land-use change dominates the footprint of products such as chocolate, and palm oil. And for eggs, downstream processing and transport are comparatively more significant.

Given the differences in the sources of emissions and the economic levers available to mitigate them, high-level sectoral benchmarks for the food industry are of limited use. More granular approaches are needed that recognise the significant differences above. PAT argues that more granular benchmarks may be more difficult to construct, but should be prioritised where they capture meaningful differences such as the ones described.

At Lombard Odier, our approach distinguishes between more than 150 distinct sub-industries, precisely to capture the nuances above. Our benchmarks for these industries are built on sectoral roadmaps from sources such as the IPCC, but combine our in-house analysis of the respective levers available to sub-industries within each sector. In sectors such as industrials, materials and food, this is vital for reducing unintended anomalies.

As we approach COP26, the urgency of the challenge facing investors and financial institutions is clear: to assess the alignment of portfolios to an accelerating transition, and to grasp the financial risk that any potential misalignment may create.

The TCFD has emerged as a critical standard-setter for investors. Amid growing regulatory support, guidance on disclosures from the Task Force has the potential to shift the way markets view and assess climate risks and opportunities.

In this context, new guidance recommending that financial institutions disclose their alignment to keeping global warming well below 2°C is highly significant and requires new approaches. The TCFD-commissioned technical report of the Portfolio Alignment Team is a solid foundation and will support the mainstream adoption of forward-looking metrics, such as Implied Temperature Rise . As asset managers and asset owners with significant capital at stake adopt these metrics, the insights they capture will shift valuations and markets.

This makes it all the more imperative for investors to accelerate the integration of these metrics into their own analyses. At Lombard Odier, we believe investing in decarbonisation involves investing in the transition, not just the avoidance of the problem that results from allocating capital away from climate-relevant sectors.

Forward-looking metrics will play a key role in this strategy, helping us identify the leaders and laggards in key industries, and tracking their progress to net zero.