Five challenges for net zero investing

Approaches include:

• The Net Zero Investment Framework, part of the Paris Aligned Investment Initiative
• The Asset Owner Alliance Target-Setting Protocol, developed by the UN-convened Asset Owner Alliance
• The Science-based Targets Initiative, which has a methodology for financial institutions
• The EU Paris-Aligned and Transition Benchmarks
• A variety of commercial methodologies from ESG data providers
• Portfolio alignment work from the Task Force on Climate-related Financial Disclosures

Our own approach is based on the Net Zero Investment Framework, which we helped to develop. It is worth noting, though, that there are many common elements between the approaches mentioned above.

A key guiding principle for us is transparency. We have therefore been cautious, so far, of temperature alignment portfolio measures. Whilst robust in theory, temperature alignment metrics can in practice can be a ‘black box’, with multiple assumptions driving the outcome, which are not easy to unpick and understand. Our preference is for a dashboard approach, providing multiple metrics, which can better capture the inherent complexity of the net zero transition.

Through our engagement we have spoken to several companies who, conscious of the intense investor focus on climate change, are wrestling with the choice of whether to invest in carbon reduction technologies for their high-emissions activities – or whether to divest them, which would immediately improve their emissions profile, but result in those emissions transferring to another owner, who might not be as ethically minded or not as transparent (for instance, by going private).

A similar dilemma could present itself to a fund manager with a portfolio-level emissions target to meet. A simple sector reallocation from, say, electric utilities to service industries could achieve the target at the push of a button. But engaging those electric utilities to cut their emissions, and achieving the portfolio target as these cuts are implemented, would have a greater positive impact on the climate.

The answer to this dilemma lies, in part, in what metrics we bring into the analysis. In line with the recommendations of the Net Zero Investment Framework, as well as looking at portfolio-level financed emissions, we are also looking to analyse ‘forward[1]looking metrics’ – in other words, assessing the performance of individual portfolio companies over time in aligning with a net zero emissions trajectory. This will enable us to understand the extent to which of our portfolio companies are net zero-aligned, and give us the confidence to continue to hold companies in higher-emissions sectors, if that makes sense from a financial point of view – as long as they are on the right pathway to reduce their impact. It will also allow us to target misaligned companies and use stewardship to encourage them to improve – with a clear message that companies which continue to be misaligned ultimately do not belong in net zero portfolios.

By combining analysis at the company level, together with the objective of cutting emissions at the portfolio level, we believe we can create a richer set of data. This will enable our fund managers to decarbonise their investments in the way that makes sense from both a financial and a climate point of view.

The good news is that nearly 160 of the world’s largest corporate emitters – covering around 80% of industrial greenhouse gas emissions – have been systematically scored on their climate performance using the Climate Action 100+ benchmark.

But for other companies, data provision is patchier. We have drawn information from sources including the Transition Pathway Initiative, Carbon Disclosure Project (CDP) and Science-based Targets Initiative, as well as our ESG data provider MSCI. However, corporate disclosure even of simple metrics such as Scope 1 and 2 emissions is not universal, and disclosure of more sophisticated data such as Scope 3 value chain emissions is very partial and often involves estimation. We are working with peers to improve this, such as through collaborative engagement organised by the CDP targeting non-disclosers. We do expect data provision to improve, but this will take time.

The challenge is greater for some sectors than others. Many of our strategies have a heavy exposure to financial institutions, such as banks and insurers, where climate risks come not from direct emissions, but from their loan books or their exposure to insured assets. Reliable, comparable data on financed emissions is not yet available. Instead we are looking at more qualitative indicators, such as the integration of climate factors into lending decisions.

Again, we wish to avoid disincentivising investment in these firms, as we know there is an urgent need to shift capital toward climate solutions.

We see it as vital to highlight investment in solutions as an integral part of a net zero approach. This is something we have already been doing in our Impact Reports for our Responsible and Sustainable funds, where we link company revenues to the Sustainable Development Goals, including SDG7 – Affordable and Clean Energy. The Net Zero Investment Framework recommends measuring and monitoring investment in solutions, using metrics such as alignment with the EU Taxonomy, which provides definitions of ‘green’ activities.

Some companies have started to report data on ‘avoided emissions’ – in other words, emissions that are avoided by using a company’s products, as compared with other products in the market. This type of data would allow us to quantify some of the benefits these companies bring.

The Net Zero Investment Framework sets out a broad structure for sovereign debt net zero alignment, but data sources on the alignment of government policies with net zero are not yet comprehensive, and there is not yet a systematic structure for organising investor engagement with governments. The ASCOR project (Assessing Sovereign Climate-related Opportunities and Risks) is an important initiative that is working to address these issues. This is an urgent area to make further progress, given the significance of sovereign debt in many asset owner portfolios.