Targeting net zero: 5 reasons to rethink portfolio decarbonisation

 

Based on robust science, the necessity of achieving net zero has permeated the world’s most powerful institutions. The COP28 summit produced a landmark final communique to transition from fossil fuels, calling on countries to quickly shift energy systems away from fossil fuels and to hasten action this decade to achieve net zero by 2050.

In many countries, decarbonisation is already a policy imperative. 

From the US, China and Brazil to the European Union, 195 parties have committed to the Paris Agreement, placing 88% of emissions and 92% of GDP under a net-zero target. 

Impactful green industrial policy has followed. The US Inflation Reduction Act catalysed USD 110 billion in clean-energy manufacturing projects in its first year, and China is poised to surpass its 2030 target of boosting wind and solar capacity to 1,200 GW in 2025. To boost green technologies, the European Union’s (EU’s) Green Deal Industrial Plan aims to improve funding, skills, regulatory approvals and the supply of essential minerals.    

The TCFD is setting the disclosure standard

Financial regulations are also aligning to net zero. The UK, Switzerland and Brazil are among the six countries requiring specified companies and financial institutions to disclose emissions data in line with TCFD recommendations. Proposals are live in other jurisdictions, chiefly:

• The US, where the SEC is seeking companies to report a range of climate-related information, from emissions volumes to expected risks and transition plans, also in alignment with TCFD recommendations 
• The EU, in which both the range of companies captured under the Corporate Sustainability Reporting Directive and the scope of disclosures have been expanded, with frameworks like the TCFD’s required to be taken into consideration from 2024 financial year

Other markets – such as Japan, Hong Kong and Malaysia, are endorsing the TCFD framework as part of ESG reporting. Broadly, 1,539 of the TCFD’s roughly 4,000 supporting organisations are from the financial sector, according to the group’s latest status report.
 

Spotlight: Switzerland

For investors, the Swiss Climate Scores aim to promote best-practice disclosures on portfolio alignment with the Paris Agreement. The voluntary set of measures are structured as six indicators to gauge a portfolio’s:

1. Greenhouse gas emissions intensity and portfolio footprint
2. Exposure to fossil-fuel activities 
3. Proportion of companies with verified commitments to net zero 
4. Verified commitment to reducing exposure to emissions
5. Engagement and voting activity on climate issues
6. Global warming potential, expressed as implied temperature rise (ITR) 

The sixth indicator reinforces the importance of making forward-looking assessments of a portfolio’s alignment to the Paris Agreement. LOIM was one of two ITR specialists that provided input. The metric, expressed in degrees Celsius, estimates the rise in global temperature that would result in 2100 if the whole economy acted with the same ambition as a given company or portfolio.
 

Spotlight: the UK

Asset managers overseeing more than GBP 50 billion are already required to report emissions in a way consistent with TCFD recommendations. From mid-2024, those with GBP 5-50 bn must report from 30 June 2024. 

Reporting on climate risk is also a growing requirement for asset owners. Under the Climate Change Governance and Reporting Regulations, corporate pension schemes with more than GBP 1 bn must implement climate-change governance measures and publish a TCFD-aligned report every three years, including: 

 

• The impact of various climate scenarios on assets and liabilities 
• The resilience of investment and funding strategies 
• Data for scope 1, 2 and 3 emissions that are relevant to chosen metrics 
• Measure the emissions-reduction performance of the scheme relative to its targets 
• Engagement on persistent data gaps 
   

Starting next year, local government pension schemes in England and Wales are likely to be required to produce annual TCFD-aligned climate reports, which include modelling on how different climate scenarios would affect scheme liabilities. However, given the materiality of climate risks and the expectations of scheme members and the public to demonstrate how portfolios are aligning to net zero, many schemes are expected to voluntarily issue reports in advance.

 

 

 

To align with net-zero targets and disclosure regulations, investment strategies using carbon footprints as the main source of emissions data are not fit for purpose, in our view. 

As historical snapshots of emissions, carbon footprints are backward-looking. This is misleading for an investor focused on decarbonisation in the years to 2050, because a company’s targets and strategy for carbon reduction are not captured. To understand how a business’s emissions profile could change, a forward-looking approach is essential.
 

Stepping beyond

Such an approach should assess the ambition of a company’s carbon-reduction targets, and whether these encompass scope 1, 2 and 3 (upstream and downstream) emissions. Its ability to achieve them also needs to be analysed, alongside the likely impact of decarbonisation-focused regulations, technology and pressure from consumers and corporate peers. And as new emissions data become available, a company’s progress against its targets needs to be assessed.

Why is it important to understand a company’s potential decarbonisation trajectory? It helps assess exposure to transitional and liability risks – including market shifts to low-carbon products and services, forthcoming regulations to disclose progress in cutting emissions, and potential liabilities for not acting fast enough. Poor management of these risks can affect a business and ultimately its market valuation.

Looking forward to 2030 and 2050, it might become evident that companies in economically vital sectors where emissions are hard to abate – like steel and cement – are implementing effective decarbonisation plans. The carbon footprints these businesses last reported might be high, but they might be transitioning effectively – and potentially fit for a net-zero-aligned portfolio. 

 

 

 

Should an investor focused on net zero choose only low-carbon companies, with no exceptions? We don’t think so. This is because such an approach: 
 

• Limits diversification
  Focusing on inherently low-carbon sectors like healthcare, media and IT, results in portfolio diversification being constrained and concentration risk increased

• Misses opportunities
  By excluding companies whose large carbon footprints are likely to shrink as they make progress towards ambitious and credible decarbonisation targets, these strategies can omit potentially high-performing firms that are aligning to net zero

• Slows the transition
  To achieve net zero, emissions reduction in economically important but hard-to-abate sectors, like aviation and chemicals, is vital. Excluding decarbonising firms in these industries potentially slows the transition by withholding capital from them as they seek to transition
   

For LOIM, investing for net zero means forgoing the constraints of high-carbon exclusions and taking a broader, forward-looking view. 

We aim to identify financially attractive, decarbonising companies across all sectors, including hard-to-abate industries. This helps improve portfolio diversification and identify companies whose transition to less emissions-intensive business models could later be recognised by the market as it prices in the transitional, physical and liability risks of climate change. 

This also supports impactful emissions reduction, in our view, because only economy-wide decarbonisation can achieve a net-zero future. 

 

For the global economy, the road to net zero will traverse uncharted territory. Investors need to look forward, not in the rear-view mirror, to understand how transitional, physical and liability risks could impact assets – and create opportunities in the shift to a low-carbon world. 
 

Transition risk
Companies that successfully transition to low-carbon business models are likely to adapt well to shifts in demand driven by new regulations and climate-aware consumers. Those that don’t could suffer demand destruction as polluting firms are outcompeted by sustainable solutions. They might also be forced to absorb the increasing costs of carbon offsets and, if attempted, accelerated abatement measures.

 

Physical risk 
Forward-thinking businesses must plan for the inevitable increase in the frequency and severity of extreme weather events. This is necessary in mitigating the damage they cause to physical assets – like buildings, industrial operations and transport fleets – and the disruptive effects on supply chains. Adaptation strategies to cope with the potential degradation of agricultural yields, diminished water supplies and heat-stressed labour must also be implemented.

 

Litigation risk 
Given the scientific consensus on the cause of climate change and its damaging, far-reaching consequences, accountability for emissions is a pressing issue. As a result, there is potential for litigation or fines related to insufficient or delayed carbon-reduction or adaptation measures by companies. It is therefore in the interests of firms and their investors to mitigate this risk. 

 

 

With these risks in mind, a forward-looking investor can assess how well companies are adapting their business models to a low-carbon economy. In this way, they can potentially identify transition leaders that are favourably exposed to a world aiming for net zero, and avoid laggards whose unpreparedness creates risks.
 

 

Green steel 

Even in high-emission sectors, there are companies aiming to align to net zero. Using renewables energy, Norsk Hydro¹ increasingly smelts aluminium from scrap metal, reducing fossil-fuels extraction and use. In an economy aligning to net zero, where aluminium buyers are likely to be incentivised by regulatory and market forces to source low-carbon suppliers, companies like Norsk could benefit from increased market share and reduced liability risk. Such firms, in our view, are potential opportunities to be captured in a net-zero-aligned portfolio. 

 

Some of the best net-zero investment opportunities, in our view, exist among companies whose current high emission volumes contrast with genuine climate action. It follows that polluting firms with no ambition to decarbonise are the most salient risks to be avoided.

To improve portfolio alignment with net zero, investors need to keep a cool head.
 

Ice cubes and burning logs

In many hard-to-abate sectors that are vital to economic activity, like construction and shipping, cuts in emissions are most needed to reach a net-zero future. In these industries, some companies currently have large carbon footprints today, but are pursuing science-based decarbonisation targets that are aligned with the Paris Agreement and credible plans to achieve them. We call these companies ‘ice cubes’ because they contribute significantly to cooling the economy. 

For investors, they are important exposures in efforts to align portfolios to net zero. And they can also be potential opportunities for generating long-term returns, in our view. 

By decarbonising, ice cubes are aligning with the regulatory momentum and anticipated market shifts resulting from the transition. In our view, such proactive management of climate-related risks, which improves their ability to operate strongly in a world aligning to net zero, could be underpriced by the market at present, only to be realised in the future. 

In direct contrast are high-emitting companies showing no evidence of targets or plans to decarbonise. We call them ‘burning logs’ because in climate terms, they are essentially on fire, heating the economy. These companies are likely to be adversely exposed to climate-related risks as policymakers seek disclosure on emissions and markets evolve to favour low-carbon products and services.  
 

Cool analysis 

To identify ice cubes, we apply our proprietary ITR methodology to assign a company a forward-looking temperature score. This measures how effective the firm will be in helping to decarbonise its sector, and the economy more broadly, in the future – and whether it will keep to the 1.5°C -2°C warming threshold set by the Paris Agreement.

ITR is key to our TargetNetZero investment solutions in equity, fixed-income and convertible bond markets. It enables us to align portfolios to Paris Agreement, seek returns and provide diversification. This is the outcome of seeking what we believe are financially robust, decarbonising companies across the economy – even in hard-to-abate sectors. 

We believe our forward-looking approach helps identify opportunities that the market might not currently recognise, while also benefitting portfolio diversification and providing capital to decarbonising companies. The core aims of our TargetNetZero solutions are to deliver performance, provide diversification and help drive the transition.