Designing temperature alignment metrics to invest in net zero

The private sector is increasingly aware of the physical and transitional risks and opportunities associated with climate change. Implied temperature rise (ITR) metrics provide an effective means of quantifying this challenge.  

The Paris Agreement’s overarching objective is to keep “the increase in the global average temperature to well below 2 °C above pre-industrial levels and to pursue efforts to limit the temperature increase to 1.5 °C above pre-industrial levels”. However, Earth is currently on track for a 3.2°C warming by 2100, with further temperature increase thereafter, according to the UNEP.  In 2018, the Intergovernmental Panel on Climate Change (IPCC) also found that to contain global warming to 1.5°C, our remaining carbon budget sat at around 420GtCO2 (for a two-thirds chance of success). In the three years spanning 2018 to 2020, we have collectively spent nearly a quarter of that budget, according to the International Energy Agency (IEA).

Which companies are prepared for the climate transition?

Consequently, financial institutions—both private and public—are rapidly rethinking how they assess risks and rewards and are working towards developing innovative ways of pricing what we term Climate Value Impact (CVI). In essence, CVI provides a quantified notion of whether companies are likely to be positively or negatively exposed to the physical as well as the political-economic effects of the climate transition. CVI encompasses transitional, physical and liability risks. Arguably, transitional risks are, as of today, the most material to investment decision-making because of the ongoing acceleration of climate mitigation responses. These transition risks include:

•    The impact of regulation that may cause some businesses to lose their license to operate.
•    Rising capital expenditures and increased operating costs linked to the abatement of emissions through decarbonisation technologies.
•    Rising expenditures linked to carbon prices and taxes.
•    Demand destruction as consumers and businesses move away from selected products or services such as fossil fuels, air travel, combustion engines and meat.

We can distinguish three main categories of companies with respect to their CVI profile:

•    Companies insulated from carbon risks: This category includes companies in various sectors where the climate transition is expected to have limited financial impact. This includes most low-carbon sectors, where the costs of transition are generally low, with some exceptions. These companies tend to have a lower exposure to CVI. As such, investors may have a higher tolerance for companies that are not yet achieving rapid reductions in their emissions given that they are in a position to transition with relative ease (at limited costs and over a comparatively shorter time frame).

•    Companies in sectors facing market opportunities: Companies in these sectors are generally positively-exposed to the climate transition. They tend to offer products and services that stand to benefit from increased demand as the transition progresses (i.e. renewable energy companies and electric vehicles manufacturers). These companies tend to be positively exposed to CVI, sometimes significantly so. For these companies, while reducing their own emissions can unlock competitive advantages compared to other solution providers, they generally remain well-positioned in the market as a whole. 

•    Companies in sectors facing high transitional impact: This generally includes high-emitting industries which are critical to the climate transition (i.e. energy, steel, glass and cement, etc.) where climate laggards face significant risks, but where transitioning leaders may access significant market gains. These companies are highly exposed to  CVI, and whether this exposure is positive or adverse will largely depend on their transitional strategies. This is likely the most material category to meeting the objectives of the Paris Agreement, and concomitantly possibly the most important category for investors to understand.

Assessing investment climate performance

Implied temperature rise (ITR) metrics, a critical building block of CVI, are now rapidly gaining traction in the investment community. Indeed, ITR metrics have a fundamental role to play in helping distinguish climate leaders from climate laggards within individual sectors and industries. Their scenario-based analysis and assessment of companies' projected emissions is also a necessary ingredient for the subsequent analysis of exposure to abatement costs, carbon prices and other financial dynamics. Although ITR metrics are relevant to all three categories of firms presented above, they are particularly salient to distinguish between high-emitting transition leaders and laggards in order to manage the CVI of investment portfolios. 

ITR metrics allow investors to assess their investment(s)’ climate performance—be it that of individual securities or of entire portfolios—against a reference benchmark. To say a company has a 1.5 °C temperature is to say that global warming could be limited to 1.5 °C above pre-industrial levels should the entire economy undertake an equivalent level of decarbonisation. This metric brings a forward-looking perspective to carbon footprinting metrics, which assess historical emissions.  

In this paper, we first review the state of the art of temperature alignment metrics. Secondly, we formalize a theoretical framework to guide the design of ITR metrics. Thirdly, we provide an in-depth description of the fair share carbon budget approach which resolves previously identified problems in using absolute emissions versus intensity based emissions to compute temperature metrics. Fourthly, we offer a case study to discuss, in light of empirical evidence, the strengths and weaknesses of different methodological choices. To conclude, we discuss limitations and offer ideas for future research efforts.
 

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