How can investors align to net zero?

 

Financial institutions are committing to decarbonising their lending, investment and insurance activities. But understanding the impact of this new way of allocating capital requires new analytical tools. What are the emerging best practices in measuring real emissions reduction, and how should investors implement them?

 

Need to know Portfolio-alignment metrics, such as implied temperature rise (ITR), add value and help understand existing challenges. Capital deployment is needed to expand beyond green capital to making infrastructure we already have fit for purpose. Physical risks presented by climate change are an important consideration but the market is underappreciating the scale of liability risks.

 

 

In the first of LOIM’s Zero-Hour Sessions, Tanguy Séné, Manager at COP26 Private Finance Hub and member of the Portfolio Alignment Team, explained how portfolio-alignment metrics add value and help understand existing challenges, such as:

• Current emissions from a given counterparty do not provide a full picture
• Not every counterparty needs to, or is able to, decarbonise at the same rate in order to achieve the goals of the Paris Agreement
• Divestment alone is unlikely to achieve sufficient real-world decarbonisation to achieve net zero

These metrics are also integral when it comes to helping apply the updated Task Force on Climate-related Financial Disclosures (TCFD) guidance for the financial sector, which is that all financial institutions should describe the alignment of their activities with global warming of well below 2°C by 2050.

The TCFD commissioned the Portfolio Alignment Team (PAT) to write a report on best practice and identifying future areas for research. The PAT report supports the development of portfolio-alignment tools by tackling key challenges such as:

• Inconsistency in the outputs of different portfolio-alignment tools
• Gaps in the data and analytics environment that prevent portfolio-alignment tools from reaching their full potential
• Opacity in methodologies

“We want to open the black box, showing the trade-offs and explaining the choices that have to be made, [to see] what is going on under the hood,” Séné said.

 

 

On the rise: temperature alignment

Séné outlined the three categories of portfolio alignment metrics, and their pros and cons.

• Binary target measurement is the simplest model and focuses on the percent of investments or counterparties with declared net-zero targets.
• Benchmark divergence model measures forward-looking performance against normative benchmarks.
• Implied temperature rise (ITR) metrics are emerging as insightful new means of screening portfolios, and allow for more detailed emissions-trajectory analysis of companies.

“[ITRs] translate the alignment – or maybe the misalignment – only on the basis of a temperature. If the global economy was behaving like my investment portfolio, what would be the likely degree of global warming? This method is very intuitive and can be compared to various scenarios such as the Paris Agreement or the business-as-usual scenario,” Séné said.

 

 

Séné also shared a number of recommendations from the report on key design judgements and best practice. For example, the PAT recommends building granular decarbonisation benchmarks to capture real differences in expected emissions reduction across industries or regions.

PAT also promotes the inclusion of scope 3 emissions¹ for sectors where reducing supply chain or consumption-driven emissions is essential, such as autos, and expanding scope 3 coverage as better data become available.

“When we face so many challenges, it is worth pursuing the development of these kinds of metrics because these are the only tools which can give you a realistic, science-based dashboard for the pathway to net zero. Ultimately, they help financial institutions do what matters most to fight climate change – which is driving down emissions in every sector and in every location,” Séné said.

 

Hard truths in the race to net zero

In the following panel discussion, moderator Chris Kaminker, Group Head of Sustainable Investment at LOIM, asked: what type of convergence is likely if all of these recommendations are adopted? Séné explained that the PAT report represents a stepping-stone toward learning through practice.

“It is about convergence, not harmonisation. There is a lot of scope for providers to have different approaches that are just a little more comparable than they have been. Methodologies today are very hard to compare on the market. We hope that methods will converge and force the development of these tools, while allowing a degree of innovation,” he explained.

Richard Manley, Head of Sustainable Investing at the Canada Pension Plan Investment Board, highlighted the benefits of such convergence: “The ability to have an audited appraisal of a company’s proven, probable and possible ability to decarbonise over the long term would allow us to move the debate from ‘are you aligning?’ to ‘how and when are you going to deliver on what you can do?’”

Kaminker also asked the panel for its assessment of the current net-zero alignment of the real economy.

Paul Bodnar, Global Head of Sustainable Investing at BlackRock, said capital deployment needed to expand beyond green capital to making infrastructure we already have fit for purpose.

“I think that every sector and every region is moving in the right direction. The fundamental challenge we have is pace and speed,” Bodnar said.

“Getting to net-zero involves turning over the physical asset base of the economy. The issue is that these assets were designed to have long lifetimes. Achieving this transition is about more than re-investment. We cannot build a green economy on top of a dirty one and hope to succeed. The solution also involves figuring out what to do with the legacy assets in each of these sectors.”

The panelists were also asked to consider whether the prospect of limiting global warming to below 1.5°C was still possible.

Bodnar said that obstacles remain to this outcome: “There are two types of gaps. There is a gap between the level of pledges by governments and companies, and the 1.5°C goal. The second gap is between promises and implementation. We are on a current trajectory of 2.7°C. These are the gaps we have to fill – and do so quickly.

“If the real economy is not aligned, you cannot align portfolios at scale. If you looked at a broad-based index and at the investable universe, and you only had to pick from companies today that are Paris-aligned, you would be cutting out about 65% of the investable universe. It is about engagement and creating a triangle of ambition and action of governments, finance and corporates.”

Kaminker also asked the panel whether there were any ‘silver bullet’ decarbonisation solutions?

Thomas Höhne-Sparborth, Head of Sustainability Research at LOIM, said there is a huge amount of uncertainty about how the world achieves net zero.

“We can reach net zero through a range of measures, including aggressive investment in electrification, carbon capture or the hydrogen economy. We can debate which scenario is the most likely but we don’t need to agree on it. What we need to do is stress test our portfolios against all of those scenarios.”

Kaminker also asked the panel for their views on the extent of physical risks presented by climate change.

Höhne-Sparborth said: “Even if we get to net zero by 2050, physical risks are still very much an issue. What is being overlooked are liability risks. Physical risks provide one component but the market is underappreciating the scale of liability risks. We are already seeing cases of companies being sued over a failure to adapt their infrastructure. We’ve seen companies being sued for historical emissions. We are only coming to grasp the potential scale of liability risk and we believe this is a major blind spot and it is a key area of focus for us.

The panel were also asked explain what, in their view, is the opportunity set for funding green investments?

Höhne-Sparborth said: “These metrics we’ve been talking about measure how quickly a portfolio’s own emissions are falling. When you have a solution provider making wind turbines, you might have a company with emissions that are increasing quite quickly. If we are going to produce a hundred times as many wind turbines, the making of them will produce more emissions. That doesn’t make those companies a bad choice and we want to invest in these companies because they help to decarbonise the rest of the economy.

“To make this transition happen, we need to radically scale up investment. We need to make sure we are allocating sufficient capital to those solutions.”

 

Sources

¹ Scope 1, 2 and 3 emissions are broadly defined as follows:

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