How best to measure portfolio decarbonisation?

The goal of net-zero carbon emissions is clear, but the path to get there is far less tangible for investors. There is no common framework for asset managers to measure decarbonisation in their portfolios, and there are wide discrepancies in how climate-aligned assets are selected, managed and reported on.

Approaches to decarbonisation

The Paris Aligned Investment Initiative (PAII) has outlined several approaches for tracking portfolio decarbonisation. Which approach to use is currently at the discretion of the asset manager.

The ‘self-decarbonisation’ approach involves measuring portfolio emission intensity relative to a baseline year. Another approach involves measuring portfolio emission intensity against a standard benchmark, like the MSCI World. Both of these approaches are easy to implement and to communicate to stakeholders. However, they are likely to incentivise the wrong behaviour, in our opinion, prompting investors to achieve emissions reductions through re-allocating capital to low-carbon sectors while ignoring transition leaders in high carbon sectors that need sustained financial backing.

Only the last approach – using ‘custom benchmarks’ - incentivises investing in the transition. Custom benchmarks establish what would be ‘typical’ performance for a fund, given the exact mix of industries and geographies it is invested in. For a fund just containing steel companies, this means a custom benchmark would compare the performance of the fund to that of the wider steel industry, rather than the economy as a whole. This provides a more accurate and relevant reference point than standard benchmarks.

Aligning to net-zero

At Lombard Odier, we combine custom benchmarks with forward-looking transition pathways consistent with different warming outcomes in our Implied Temperature Rise tool. This tool allows us to derive warming scores by comparing the emissions trajectories that companies and portfolios are on against the paths they must take in order to meet the goals of Paris Agreement.

To us, real decarbonisation should be about investing in companies that are contributing to the greatest reductions in emissions, rather than focusing on low-carbon sectors, where less decarbonisation is occurring. High-emitting companies on credible reduction trajectories are often neglected, but they offer long-term value opportunities, as the world transitions towards net zero.

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