How difficult is it to achieve a net zero investment portfolio?
On the face of it, the trend is favourable. BlackRock's CEO Larry Fink has warned companies that they face increased scrutiny of their carbon-cutting plans and US president Joe Biden has outlined $2tr of commitments in support of climate action at a time when thousands of businesses and scores of national governments are unveiling net zero strategies. The EU is pushing ahead with its broader plans for a more sustainable finance sector, while it and other G20 members, including China, are already committed to bolstering financial stability in the face of escalating climate impacts, primarily through the widespread adoption of corporate climate risk reporting in line with the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations.
The investment industry has responded with hundreds of banks, asset managers, and pension firms around the world unveiling ambitious new targets in recent months that commit them to both decarbonising their own operations and delivering net zero emissions across their own portfolios by mid-century at the latest. Organisations such as the Net Zero Asset Managers and Net Zero Asset Owners Alliances already boast memberships that manage or own trillions of dollars of assets, and they are still growing fast.
However, setting a net zero portfolio goal is the easy part. For various stakeholders - policymakers, investors, insurers, the man or woman on the street - the simple question of how to deliver on that promise leads to all manner of challenging answers.
Consider, for example, the news in February that German energy provider RWE is suing the Dutch government through the International Centre for Settlement of Investment Disputes (ICSID), seeking compensation for the decision to phase out use of coal in the Netherlands. RWE has criticised the Dutch legislation, comparing it to similar German legislation, where operators of coal power stations are being given billions of euros to avoid similar legal action, according to one Reuters report on the matter.
But this is where things get complicated for investors. Back in 2019, the Financial Times was reporting on RWE's pledge to go carbon neutral "by 2040". Before that, in 2018, Greenpeace was urging Norway's Government Pension Fund Global to ditch RWE because of its reliance on coal. The fact that a sovereign wealth fund founded on oil wealth is petitioned to ditch a holding in a company using coal to generate energy, which has committed to cutting its emissions to 'neutral' but is in turn suing a national government seeking to stop coal use as part of its legal obligations under the Paris Agreement, illustrates the complex nature of transitioning to a net zero world. Moreover, it indicates how there can be reasons why, seen from the outside, the actions of companies in response to climate change related risks may be seen as contradicting to their commitments to net zero.
Staying with the example of energy companies, consider the findings of the Transition Pathway Initiative's (TPI) review of 132 of the world's largest publicly listed energy companies. As recently as 2019, it suggested that "only 20 per cent of companies explicitly acknowledge the need for net global CO2 emissions to reach zero in order to stop global temperatures from rising. Most importantly, only 13 companies out of 132 had made net zero commitments in relation to their own emissions at the time of the analysis".
Since then more energy majors have come forward with net zero targets, but have their long term investment strategies changed that much? The latest TPI report this month warns that despite net zero pledges from a growing band of the oil and gas majors the industry will need to scale back investment in new fossil fuel infrastructure much faster than currently planned if warming is to be limited to 1.5C. "Gas consumption, considered by the industry to be a "growth engine", must begin to decline by 2030," the report concluded. "Most European oil and gas companies have responded to investor pressure by updating their emission targets, describing them as being consistent with Net Zero. Research shows that this is not the case… oil and gas companies will have to go much further to genuinely claim 1.5C/Net Zero alignment. For most, this is likely to require a substantial scaling back of investment in exploration and production activities, particularly for oil."
Such a change would clearly have implications for portfolio managers. BP and Shell are key FTSE 100 oil and gas stocks as of the December 2020 index rebalancing. But so too are companies linked to coal mining, such as Anglo America, BHB, and Glencore.
Many of the world's most carbon intensive companies have responded to concerns about their long term viability in a decarbonising world by announcing new net zero goals, but questions remain about the credibility of their climate strategies. Meanwhile, despite the surge in the number of companies setting net zero targets they remain in the minority on most of the world's top exchanges. According to the South Pole report Crossing the Line to Zero: The state of Net Zero Commitments - which included research into the views of executives who attended the first Net Zero Festival in October 2020 - some 35 per cent of FTSE 100 constituents had committed to net zero, some 34 per cent had committed to or set a science-based target (SBT), while 21 per cent had both a net zero target and had set or committed to setting an SBT. It's an encouraging level of engagement with the net zero transition, but it is far from universal. For argument's sake, if the FTSE 100 represents market capitalisation of around £2tr, then that is a significant level of equity assets at risk because of lack of commitment.
The task becomes more confusing still when you consider that there is not yet an agreed definition of what anet zero portfolio. As Bloomberg reported this week, former bank of England and COP26 advisor Mark Carney recently left experts "confounded" when he argued that Brookfield Asset Management, the investor at which he is vice chair, had a net zero portfolio despite holding substantial oil and gas assets. "The reason we're net zero is that we have this enormous renewables business," Carney explained at a recent event, adding that "all the avoided emissions that come with that" compensated for the firm's polluting interests.
The argument prompted an angry response from environmental campaigners and some investment experts who insist a much more robust definition of what constitutes a net zero emission portfolio is required under which avoided emissions would be strictly verboten. As Greenpeace's investigative website UnEarthed noted, Brookfield may have a sizeable renewables portfolio, but it also invests billions of dollars in fossil fuel projects, including highly carbon intensive assets such as a coal port and an oil sands pipeline.
There is a broad consensus that a company can only claim net zero status when it has eradicated all avoidable emissions and is only minimally reliant on credible carbon offsets to tackle any residual emissions. As Alexander Farsan, global lead on science-based targets at WWF, one of the partners for the Science Based Targets initiative (SBTi) told Bloomberg, "it's virtually impossible for a company to be a net zero company now". However, while SBTi is currently consulting on proposed criteria that would more clearly define what constitutes a net zero emission organisation, in the interim more lax definitions are allowing some firms to make highly contestable claims about their net zero status.
Our #NetZero Criteria has launched for public consultation. 📑— Science Based Targets (@sciencetargets) February 26, 2021
This is your opportunity to provide feedback, opinion and comments on the global standard for #ScienceBasedTargets aligned with net-zero by 2050 consistent with 1.5°C.
Learn more: https://t.co/B11wSkkzTe pic.twitter.com/MLpfxUa4MA
What then should investors do if they want to deliver a credible net zero portfolio that genuinely helps minimise climate-related risks and drive an economy-wide net zero transition.
According to a November 2020 KPMG report titled Towards Net Zero the key challenge in reallocating capital to manage climate-related risk centres on the ability to "improve the quantity, quality and comparability of climate disclosures".
The report introduction, penned by Carney, argued that: "First, every company needs to take action and establish (or further develop) climate reporting that aligns with all 11 of the TCFD's recommendations… Second, professional services firms have a key role to play in encouraging and supporting rapid and broad adoption of corporate climate disclosure worldwide… And third, climate-related financial disclosures must be made mandatory and be designed around a core framework - ideally the TCFD - to ensure comparability."
Thus, a key objective of any organisation pledging a Net Zero target is to show how it will quantify the changes it makes, facilitate disclosure of its data, and thereby enable investors and other stakeholders to compare how well it is managing the transition and its decarbonisation pathway when compared against other organisations. Markets can then draw on that data to better price financial instruments, as well as assets more broadly, in relation to the climate-related risk.
However, improving the data available to investors is not a simple task. The Investment Association (IA) outlined its thinking in a November 2020 report - The Path To Net Zero: Investing in a carbon neutral future - in which it outlined seven steps investors should take in early support of their net zero goals. Respectively, the recommendations are:
- Engagement with investee companies on climate-related disclosures
- Working with pension fund clients to help them meet their climate-related disclosure requirements
- Development of investment managers' TCFD disclosures
- Support improvement of sustainability-related disclosures at fund level (including best practice guidance; dealing with the EU Sustainable Finance Disclosure Regulation SFDR, particularly "helping our members to develop TCFD disclosures at a portfolio level, including supporting them to overcome current obstacles, in particular the current lack of data and data quality)
- Link with advanced initiatives to support disclosure of Paris-aligment of portfolios
- Supporting the FCA-PRA Climate Financial Risk Forum (CFRF) work
- Support creation of investable opportunities
A key point of note for the IA, which represents investment managers collectively managing some £8.5tr of assets, is that it then sees global investor initiatives and coalitions of investors as being increasingly important in then delivering results.
It points to the likes of Climate Action 100+ and the Institutional Investors Group on Climate Change (IIGCC) as playing a critical role in getting companies to align with Paris Agreement goals.
Having access to improved data allows investors to make a call about how to transition their portfolios towards net zero emissions: Should they divest of polluting assets? Should they engage with all the companies in their portfolio to encourage them to develop their own net zero strategies? What is the balance between the two approaches and what point should an investor exit a company that fails to take steps to curb its emissions?
These are the crucial questions that will shape an investors net zero strategy. But as the IA also outlines in its report ultimately ambitious economy-wide efforts are also required if net zero portfolios are to become commonplace. The group delivers a sort of 'wish list' of broader economy-wide priorities required for the UK to hit its 2050 Net Zero target, including action on heating and cooling buildings; carbon capture and storage; electric vehicles; low-carbon power generation and supply; increasing forest cover; changing fuel taxation regarding heavy goods vehicles; and removal of fossil fuel subsidies.
How are investors responding?
There is no question levels of engagement with the net zero agenda are hugely varied, leaving investors to ponder how best to effect the changes needed to avoid climate catastrophe.
Consider, for example, the sheer number of companies represented across the ubiquitous Global Industry Classification Standard, GICS, sectors used by portfolio managers to define their investment universes and construct their investment portfolios. Each of those sectors could be hit in different ways by measures and actions required to deliver net zero emissions.
And since Net Zero is about the future, consider the challenge facing portfolio managers relying on the equally ubiquitous MSCI Emerging Market index; where the index maker has already charted a path towards greater exposure to China in future. Funds using this benchmark, or tracking it, will need to adjust accordingly, and ensure the companies in scope of this changing universe are sufficiently adept at providing the climate-related risk data that they need to make investment decisions.
Still, advances are occurring.
For example, in the insurance sector members of the influential ClimateWise initiative are increasingly communicating their beliefs and strategies on climate-related issues to customers and clients. Members are developing and revising policy statements with associated communication campaigns to support portfolio alignment targets with a view to transitioning investment portfolios to net zero emissions by 2050 or sooner.
A key objective is to make insurance customers more resilient to the related downsides of climate change; flooding, wildfires and hurricanes among them. Teaching customers how to manage this type of risk better themselves is better for insurers too.
Meanwhile, the Net Zero Asset Owner Alliance convened by the UN includes institutional investors representing more than $5tr of assets, who are committing portfolios with net zero greenhouse gas emissions by 2050. This means aligning portfolios with a 1.5C warming scenario in keeping with the Paris Agreement.
The Alliance has initiated an Inaugural Target Setting Protocol, which requires companies to set out interim emissions targets for their portfolios for 2025. The aim is for some of the world's biggest investors to publicly release "transparent, rigorous and realistic targets and then commit to report against them in the next four years".
The hope is that such short term targets will force investors to ramp up both their engagement efforts and their divestment strategies. More broadly, there are signs that both long term and short term targets are shaping investment strategies. As ClimateWise noted in 2020 "at least 65 insurers had adopted some form of coal divestment policies". Meanwhile, scores of banks have adopted similar policies in recent years, pledging to end financing for coal, tar sands, and Arctic oil projects.
However, Robert Howard, senior compliance manager at Charles Stanley, sees distinct challenges facing institutional versus retail investors in respect of Net Zero targets. He says by way of example, that if a bigger financial group is investing in its own portfolios to support its own products, then it will have its own internal teams making decisions on their own investments. That gives more control over being able to state that they intend to be Net Zero by 'date X'.
The retail investment space is a more complex story. A provider may have a 'responsible investing' tab on its public website, including a commitment to reduce emissions by 'x per cent' by 'date x', but how are they reporting this, and how are they being held to a public commitment such as that?
"It is conceivable for a boutique investment firm to make a 2050 pledge now, knowing full well nobody is going to be around in 2050 to check it," Howard counsels. "It is a great sales opportunity. But greenwashing is a possibility unless firms have actually through it through and actually have a roadmap." However, Howard acknowledges that the FCA is cognisant of such concerns.
A good approach to take in respect of greenwashing fears is to check what interim targets may have been set for 2030, rather than focusing solely on longer term targets, Howard suggests, given targets set for 2030 may "hold feet to fire". Portfolio managers may still be in charge at that point, and shareholders are more likely to still be around in nine years' time, and they might not be happy if called out on having failed to sufficiently press companies on their net zero progress.
Mark Lewis, chief sustainability strategist at BNP Paribas Asset Management and task force member in the Data User Group of the TCFD organisation, recalls how the discussion about net zero really took off after the autumn of 2018, and thus is one of the more recent climate-related issues to hit companies and investors.
The data that warned the world would shoot past the 1.5C target unless net zero emissions are achieved by 2050 has caused a significant shift in terms of how to converse about carbon and climate change. It means, for example, that oil companies are under much more pressure to address responsibilities under Scope 3 than they were previously, Lewis suggests. With 2050 now just 30 years away, they need to start saying how they will get there.
"Like any long-term goal, you need interim milestones, to say how you are going to measure yourself, and allow third parties, investors, governments, society, to hold you to account," Lewis reflects.
As investors start to disclose what proportion of their assets are aligned to net zero, and how much is expected to be aligned by 2030, it will put increasing pressure on companies in which they invest to publish their own interim targets. Defining pathways and ensuring accountability will be key, Lewis suggests.
Iselin Aslakstrom, Responsible Investment Officer, Fulcrum Asset Management, notes Net Zero pledges are important in setting the tone for where companies want to go. But, like others, she stresses that any pledge need underpinning with a strategy setting out how it will be achieved.
A science-based approach is arguably the best-in-class way to provide that clarity. It forces companies to outline how they will decarbonise and within which particular sectors. It also gives credibility to any target. Without setting a science-based target, any pledge will instead speak to ambitions rather than how to actually get there, Aslakstrom says.
In the investment industry, it is only relatively recently that institutions have been setting such science-based targets, she adds.
Net Zero by 2050 and a 1.5C temperature rise by the end of the century are targets based on science. It may not be perfect science, but if an asset owner sets these targets, at some point they will really need to set out how they will achieve it.
Meanwhile, investors also need to beware that decarbonising portfolios does not necessarily decarbonise the economy. The asset management industry can encourage decarbonisation, can direct capital to incentivise and modify behaviour, but investors can only do this if they know the facts themselves. Metrics such as the Implied Temperature Rise (ITR) can give a clearer idea if companies are decarbonising quickly enough, or whether they require lots of engagement. Just having a low carbon portfolio is not enough; investors need to know the role they are playing in driving economy-wide change.
Pooja Kholsa, vice president, client development at Entelligent, a Boulder, Colorado-based provider of climate-related risk analysis and solutions, notes that as such improvements may need to be made to the frequency at which companies report their Scope 1, 2, and 3 data.
Third party data providers need to put some pressure on this area, or else there is a risk that companies simply are given more time to make pledges without sufficient accountability. Standardisation in carbon accounting will help with this, she argues, although there also needs to be a mechanism allowing for discounting for differences between the most and least developed parts of the world - in mind of the need for emerging markets to maintain GDP growth.
A diversity of approach matters. Kholsa puts forward the example of a 95-year-old person decarbonising per their risk objectives being very different from a 40-year-old looking to save for her children's tertiary education costs. Achieving Net Zero in aggregate is still possible.
But to achieve the 1.5C goal of the Paris Agreement may need a carbon tax and energy transformation sooner rather than later. The question then becomes whether companies are ready to take on the subsequent shocks to their balance sheets, and whether investments are derisked to these shocks.
It is against this backdrop that Carlo Funk, EMEA head for ESG investment strategy at State Street Global Advisors, believes the debate over engagement versus divestment is going to intensify.
When looking at the MSCI World index and considering the number of companies associated with fossil fuels the current state of play means that if an investor wished to reduce exposure to zero, they would need awareness that they are pretty much excluding the entire energy sector. There follows two theoretical questions, Funk argues: What happens if investors take a hard stance from one day to the next and cut off energy from capital markets - meaning, for example, the Amazon order will not arrive tomorrow, and there would be implications at the societal level - and secondly, will energy companies be helpful in the long run if investors jumped to 2050 and looked back, and asked whether they could transition to renewable energy companies - the answer is probably 'yes, but not all of them'.
"This is where the nuance is important and understanding this is so important from an asset allocation perspective," Funk explains. "For example, in terms of how deep a person wishes to 'move the dial', such as down to zero on fossil fuels, then they need to understand it will explode an entire sector. Or, does a person wish to identify which companies are best at making the change, and keep a foot in the door for focused engagement."
Investors may have their own views on this, but they will ask SSGA for options, Funk notes. Having these conversations will generally lead to some decisions and reallocations. Investors and asset managers absolutely have a role to play in the change, he stresses.
Rick Stathers, senior global responsible investment analyst and climate specialist at Aviva Investors, similarly argues those developing pathways to net zero need to look at a range of issues rather than boil it down to a single figure. While long-term net zero targets exist, it is in interim targets that are criticial to consider, especially for high emitting sectors.
Stathers also believes that there will be increased focus on negative emissions technologies as part of net zero transition plans. For example, Shell is seeking to use so called 'Nature Based Solutions' as part of its Net Zero policy. But critics warn there is a limit to the amount of suitable landmass available for such solutions. As such as more investors align with net zero targets, asset owners will increasingly ask for information on intermediate targets and the level of reliance on negative emissions, which should result in more pressure for firms to come forward with credible and ambitious plans.
Other factors will also help drive momentum in support of the net zero transition. The US is starting to engage with the climate agenda again after four years of lost time. The EU is talking about a carbon tax border mechanism. China has finally launched its national emission trading scheme. The long term investment signals are clear. There could be a general underestimation of the snowball effect that is building, Stathers suggests.
"It is not just about investors saying they want a portfolio to be Net Zero aligned, but it is also about, for example, stress testing - the cost of capital may increasingly reflect the cost of climate change - and there might be future technology that can capture carbon like trees," he predicts. "Now when we talk, everybody wants to be involved in the discussion, not just corporate social responsibility people any more. It is embedding as a topic across organisational structures in a way not seen before."
There are multiple pathways available for the global investors now committed to building net zero portfolios, but the good news is they seem intent on exploring them.
Additional reporting by James Murray.
Want to find out more about Net Zero Finance, TCFD reporting, and the investment trends impacting businesses and investors of all types? Then join us at the Net Zero Finance pathway event, as part of the Net Zero Festival 2021, which will take place online on March 16th. You can request an invitation to the event here.