“If you add up the [climate] policies of all of companies out there, they are consistent with warming of 3.7-3.8°C”.
- Mark Carney, December 2019
It’s not unusual that our individual actions fail to live up to our lofty statements of intent and this is a big danger when it comes to climate risk. Asset owners are increasingly in the spotlight, and so too the decision makers around them.
Back in 2015, 196 states signed up to the Paris climate change agreement, committing them to limit the global average temperature rise to well below 2°C and pursue efforts to limit it to 1.5ׄ°C. Carney has posed “a question for every company, every financial institution, every asset manager, pension fund or insurer: what’s your plan?”
Richard Curtis (a well-known film director) brought this closer to home when he launched the “Make My Money Matter” campaign in June 2020, urging individuals to demand similar questions of their savings and pension providers. I expect they will be disappointed with the answers they get. The reality is that – despite the growing talk about climate change – few investors have so far done much to address climate risks or make a real-world difference to climate outcomes. It seems that investors want to believe that climate targets will be met, yet without investing differently to make this possible.
So, how can asset owners develop an answer to Carney’s question?
To start, what does the Paris Agreement target actually mean?
The Paris targets are increasingly being interpreted as achieving “net zero” greenhouse gas emissions by 2050. There are now around 125 countries with a net zero commitment and an increasing number of companies and investors are setting net zero targets too.
This begs one big question for asset owners: how do I know if my portfolio is on track to be net-zero by 2050?
First of all, you need to know the greenhouse gas emissions associated with your portfolio today.
The task of measuring portfolio emissions is complex, but we don’t think perfect should be the enemy of the good. It’s important to get started; the approach can be refined over time. Just asking those you delegate to, whether fund manager or adviser, to provide some data is a start.
A typical way of allocating emissions is to divide each investee entity’s emissions by enterprise value, so that every equity and debt investor in the entity is deemed responsible for a share of the emissions. Emissions can be classified as scope 1 (direct emissions), scope 2 (emissions from generating the electricity used by a company) or scope 3 (downstream emissions associated with the use of a company’s product – particularly relevant for oil companies). A good starting point is scope 1 and 2, bringing scope 3 into the mix once data quality improves.
These definitions might sound theoretical, but it does matter, and it’s harder than it sounds. Take the example of a company that rents a building. To whom are the emissions related to heating the building allocated – the company’s shareholders, bond holders, the building owners or those financing the building? These parties can all influence emissions, so typically they are all allocated a share, although care is needed to understand any double-counting.
The “net” part of the target acknowledges that it is not always feasible for an entity to achieve zero emissions, even in the medium to long term, so negative emissions will be required elsewhere to balance them out. For example, sustainably managed forest and farmland can sequester carbon.
What should investors do?
To answer Mark Carney’s question: “what’s your plan?”, we suggest understanding your portfolio’s level of emissions today and then setting out a pathway – a plan with interim targets – for getting to net zero in 30 years or less. For example, the Nest pension scheme recently announced a plan to achieve net zero emissions in the portfolio by 2050, with an interim target to halve by 2030. There are readily available steps that can be taken now to reduce emissions by 50% or more in some areas, so a typical pathway has steep reductions in the early years and levels off as the reductions become harder (see chart). This helps to protect your portfolio from climate transition risks by reducing your emissions exposure more quickly.
Source: LCP chart created using data from EU Benchmark Regulations
1. To understand your emissions today, it helps to have a set of metrics that summarises key carbon measures across the portfolio. You can then explore questions such as: What are the greenhouse gas emissions associated with our current portfolio?
a. Which manager accounts for the largest share of emissions?
b. Which mandate has the highest emissions intensity (eg emissions per £m invested)?
2. For actively managed assets:
a. How does emissions intensity compare to the benchmark index?
b. Which ten positions account contribute most to that emissions intensity?
c. How are emissions impacts factored into investment decisions?
d. What steps is the manager taking to reduce our exposure to climate transition risks?
3. For passively managed assets:
a. Should we switch to tracking an index with lower emissions (see infographic)?
b. What impact might this have and what options are available?
4. What engagement is being undertaken by our managers to encourage decarbonisation? How effective is it?
Emissions intensity of some market cap equity indices
Source: Weighted Average Carbon Intensity Ratio, MSCI Inc., April 2020
The answers to these questions will indicate where you should focus your efforts and point to actions you or your investment managers could take. Reaching net zero is likely to require changes at multiple levels over many years – actions taken by the underlying companies (with support and encouragement from their investors); changes in the companies held within mandates (exiting those that are unable or unwilling to adapt); and changes in the mandates themselves (such as switching to a manager with better climate practices or making a new allocation to low carbon solutions).
A vital part of investors’ net zero approach is engagement, not only with investee companies to ensure they are on a net zero journey themselves, but also with governments to ensure they have the policy frameworks in place to facilitate decarbonisation. Ultimately, large-scale decarbonisation of the economy will be needed if you are to achieve a net zero portfolio without compromising on diversification or returns. More importantly, this real-world change is what is needed to protect your investments from systemic climate risks.
Climate change could well be the biggest single source of investment risk this century and mitigating action is needed today.
It’s also becoming increasingly clear that individuals are going to start asking questions around this as to how their money is invested – a level of engagement that should be welcomed! There are clear actions that asset owners can take to develop a plan and start implementing it.
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