investment viewpoints
Measuring climate alignment, one temperature at a time
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| Thomas Höhne-Sparborth, PhD Head of Sustainability Research | Elise Beaufils Deputy Head of Sustainability Research | Barthelemy Simon Quantitative Analyst |
Decarbonisation investment strategies cover many realities on the market as building a portfolio of companies targeting net zero requires specialist analysis while lacking industry standards. What temperature alignment method does LOIM use to differentiate between companies that are on ambitious and credible decarbonisation trajectories and those that are climate laggards?
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Assessing climate exposure
Climate change is profoundly altering the investment universe as we transition towards net-zero greenhouse gas emissions. But assessing the climate exposure of a company is complex and many issues arise from the lack of data disclosure by companies and the large spectrum of industry standards.
At LOIM, we have developed a forward-looking tool, an ITR metric, to measure how well aligned a company (or portfolio) is with the goals of the Paris Agreement to hold global warming to well below 2°C. ITR compares historical and projected emissions of a company or a portfolio to the carbon budget allocated for its sector and region to remain below 2°C of global warming. It considers whether the projected emissions of a company are increasing, flat or decreasing and, if so, whether they are falling quickly enough. We translate this into a temperature-alignment score that tells us what level of global warming would result if every actor in the economy were to be managing its emissions with the same level of ambition as the company or portfolio in question.
With this metric, our goal is simple: to design TargetNetZero strategies in different asset classes that maximise opportunities and reduce climate risk in a decarbonising global economy. Rather than excluding companies point blank because they are high emitters, our approach instead seeks to identify fast-transitioning companies in vital economic sectors with credible plans to decarbonise. It’s all about mitigating transition risk, recognising that only economy-wide decarbonisation can achieve a net-zero future, and deploying capital to those most aptly positioned to make the transition happen.
What’s in an ITR tool?
Our analysis begins by defining exactly how quickly each industry can and must decarbonise as part of the economic transition to net zero. These decarbonisation benchmarks vary by industry as well as by region. In some industries, such as power, all of the technologies needed to decarbonise are already viable. In others, such as chemicals, new technologies still need to be commercialised. This influences the shape and speed of required decarbonisation for each industry. In other words, a steeper and faster decarbonisation is expected from the power sector compared to the chemicals sector.
Then, we move to company-level and project for each company an estimation of their future emissions. This projection is based on the recent trend in its carbon emissions, its decarbonisation targets, the credibility of these commitments, strategies and financing plans. These factors enable us to evaluate whether the company’s emissions are expected to fall in line with sector-specific decarbonisation benchmarks.
The figure below compares a company’s projected emissions to different industry decarbonisation benchmarks. If the company were in the industrial sector, its decarbonisation trajectory would outperform that of its industry: the company would be considered a decarbonisation leader in its sector, complying with the goal of the Paris Agreement. If the company were a power company, however, it would be underperforming and would be considered a decarbonisation laggard, not complying with the goal of the Paris agreement.
Figure 1. Company X emissions trajectory: an illustrative comparison
Source: LOIM. For illustrative purposes only.
Our ITR, expressed in degrees Centigrade of global warming, gauges:
- a company’s current and expected emissions
- how a company’s absolute emissions are expected to progress, relative to sectoral and regional carbon budgets
- the level of global warming that would result if every company were to manage its emissions with a similar level of determination
Ultimately, our ITR assesses the ambition and credibility of a company in its alignment with Paris Agreement decarbonisation objectives. It is also a first step in deciding how the company will be considered in our TargetNetZero equity, fixed-income and convertible-bond strategies.
Understanding the temperature score of all the companies in our portfolios helps to avoid exposure to crippling stranded assets and identify the most valuable investment opportunities. This forward-looking analysis also helps us to identify transitioning companies across the full breadth of the economy, improving diversification by not restricting our portfolios to inherently low-carbon sectors. Such companies, especially in hard-to-abate industries like steel and construction, are vital to the transition and their progress could be underestimated by the market, providing a source of opportunity for our strategies.
Putting ITR into action: a comparison
Two companies in the same sector can have very different decarbonisation strategies and therefore projected emissions. That helps determine if one merits a place in a climate-aligned portfolio, while the other does not.
Let’s take a look at an example in the food products industry. Company A has an ITR of 5.4°C. This means it would not be classified as a climate-aligned company. We would call this company a ‘burning log’ as it will heat up a portfolio by having no credible plans for decarbonisation.
Company B has a much lower ITR of 1.6°C. It is projected to meet the Paris Agreement goals. This means it would be classified as a climate-aligned company in our portfolios. We would call it an ‘ice cube’ because it is cooling the portfolio by plotting a credible path to meet the net-zero emissions target.
Generally speaking, we orient our investments towards ice cubes in order to differentiate, within a sector, which names are best undershooting their industry’s carbon budget benchmark and offering the most decarbonisation potential. Our TargetNetZero portfolios include issuers already targeting net-zero CO2 emissions by 2050, as well as those without such targets but which may be brought into line through regulatory action, investor engagement and market changes.
Why is a forward-looking approach necessary?
While a carbon footprint is a useful measure of a company’s emissions today, it is static and fails to quantify how a company is decarbonising or how successfully it will transition to a net-zero tomorrow. For this, a more sophisticated and forward-looking tool like an ITR is needed.
Using a company’s ITR as a gauge means moving beyond simply excluding heavy carbon emitters. This exclusionary approach often entails eliminating entire carbon-intensive sectors, or exactly where real reductions in emissions are most needed to reach net zero and where the most compelling investment opportunities arise.
By looking to the future, our ITR enables us to build portfolios that focus on real decarbonisation across all sectors by investing in companies with credible decarbonisation plans, regardless of their carbon footprint today. Ultimately, our TargetNetZero approach uses our ITR metric to help investors decarbonise, diversify, and drive the transition forward.
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