Commitment to the 2016 Paris Agreement and the momentum from COP26 makes it imperative for investors to plan their journey to net zero. We outline the key steps you can take to implement a Net Zero investment strategy.
Investment strategies should prioritize engagement and stewardship as a mechanism to drive alignment. Direct engagement may be diﬃcult for investors — there may be a lack of expertise or a significant learning curve required
— and for most asset owners such engagement is often implemented by their asset manager.
Our Climate Stewardship Approach
Divestment Can Be Useful
Engagement and stewardship actions are recommended as the main tool to achieve alignment. However, divestment and exclusion may be considered where there is climate-related financial risk, to escalate after unsuccessful engagement or where the company’s primary activity is no longer considered permissible in terms of credible net zero pathways.
Exclusions appear simple in terms of implementation but can rapidly become complicated as these are driven by strong visions where the route to engagement has been cut oﬀ. As climate change is a new and evolving topic it renders exclusion criteria diﬃcult and may need to be revisited and reviewed over time.
Other custom divestments can be made based the volume of CO2 emissions (in millions of tons) owned by a company, indirect ownership of companies involved with fossil fuels, or other particular metrics or indicators. However, determining appropriate thresholds for some of these metrics can prove complicated.
Oil extraction and power generation
Natural gas extraction and power generation
Thermal coal extraction and power generation
Oil sands extraction
Arctic oil and gas exploration
The debate around engagement and divestment is nuanced and it should be clear that it is not an either/or matter. There is room for both approaches, depending on an investor’s objectives. When evaluating the two approaches to address climate change, it is important to diﬀerentiate between immediate improvement in portfolio climate metrics and creating long-term environmental and societal investor impact. Divestment can be an immediate solution to reduce specific ESG and climate risks. However, it fails to address the systemic, long-term impacts of climate change.
Divestment also abrogates responsibility for tackling climate change to another party. Therefore, an investment approach purely founded on divestment is not desirable in our view. To sell companies within the fossil fuel value chain with immediate eﬀect would forego the opportunity to engage with these companies, to help them adapt and ultimately be a part of the climate solution. However, we expect divestment to remain an option for certain activities (like thermal coal) whose ESG thesis will remain unconvincing.
3. Asset Allocation
Strategic asset allocations for liquid portfolios encompasses asset classes ranging from sovereign bonds to equity markets. The weighted allocation will typically be derived risk return assumptions for a given horizon.
In addition the asset owner’s climate change policy will need to be implemented which requires the definition of measurable parameters at the underlying company level which can be aggregated, evaluated and monitored at the total portfolio level. Climate change parameters can be characterized as being linked to mitigation or adaptation, or alternatively said as being historical or forward looking.
Examples of historical parameters are a company’s current carbon intensity, green assets or brown assets. In order to aggregate, for example, the carbon exposure for an equity portfolio it makes sense to work with greenhouse gas (GHG) intensities, such as GHG per unit of revenue or per unit of EVIC (this is the enterprise value plus cash; cash is added so that the number remains positive). This allows normalization of the emissions of a small company versus those of a large company.
For a corporate fixed income portfolio or high yield portfolio these metrics still work as the bond issuance can always be linked to the parent company.
For sovereign bonds such definitions don’t apply. In addition there is the issue of double-counting, assuming that a country’s carbon emissions is the sum of the carbon emissions produced by the country’s companies. Still intensities can be calculated such as GHG per unit of GDP or capita. Here another double counting issue arises, as GDP is the sum of Domestic, Imports and Exports.
In terms of a forward-looking metric this is typically associated with the transition path of greenhouse gas emissions between now and a net zero value targeted in the second half of this century. The choice of transition paths is endless, generated by many models. Initiatives, like the sectorial TPI or the SBTi, provide the investor with transparency and support for the evaluation of the company’s proposed transition pathway. In addition there are models that allow for a forward looking assessment at the aggregate level such as Implied Temperature Rise model or the Climate VAR model.
For sovereign bonds a country’s current planned policies and its NDC would all be part of a forward looking evaluation. In its implementation guide the Paris Aligned Investment Initiative  suggests a country scoring methodology as developed by the CCPI index .
For green bonds we assume zero carbon emissions, even if issued by a high emitter. This is to encourage green bond issuance, however a very rigorous framework should be applied for a strategy to be categorised as a green bond. In this context we can mention the Climate Bond Initiative, of which State Street Global Advisors is a partner.
Ultimately the investor may wish to align the portfolio to a transition path according to its Climate change policy. This can be done for example by favouring companies that have a transition plan. If the allocation is well chosen then the portfolio will have minimal exposure to potential stranded assets while at the same time decarbonizatio occurs automatically.
Simply allocating the portfolio to low carbon emitters defeats the purpose of a smooth transition from a fossil fuel energy derived economy towards a clean energy economy.
The asset owner may decide to allocate some investment to illiquid alternative vehicles. This can be for example private debt, private equity, direct real estate or infrastructure. Evaluation of climate change alignment for illiquid investments is still much a work in progress. Reporting is typically not standard and not necessarily transparent, engagement has a central role.
An Essential Element
Reporting is a vital component in a successful Net Zero strategy. State Street Global Advisors can provide reports and assessments of clients’ investment portfolios that include several ESG components, including TCFD metrics and climate profiles such as:
Weighted average carbon intensity
Scope 1 and 2 carbon emissions
Total reserves of carbon emissions
In the event that additional climate metrics such as green revenue and brown revenue share and/or climate adaptation scores are integrated, we can report on these as well. Lastly, we are also able to provide climate scenario analysis results via specialized third-party analytics tools. In summary, we are able to provide covering the following areas:
Carbon emissions-related data (including TCFD aligned metrics)
Climate data (including fossil fuels, brown/green revenues, adaptation score)
General ESG scoring using our proprietary R-Factor framework
Climate scenario analysis via third-party reporting tools
‘Net zero’ means that the total greenhouse gas (GHG) emissions being emitted should be lower than or equal to the total GHG emissions being removed or absorbed. On a net basis, no additional emissions should be released into the Earth’s atmosphere.
Scientific models that target a temperature rise of less than 1.5°C over and above pre-industrial levels show that we need to achieve net-zero emissions by the year 2050.
In October 2016, the European Union formally ratified the Paris Agreement, which aims to strengthen the response to climate change, among other means by making investment flows consistent with a pathway towards low GHG emissions and climate-resilient development. To comply with the Paris Agreement goals, countries need to achieve net zero emissions by 2050.
There have been a number of Net Zero Initiatives and Net Zero Frameworks released in recent years, including a variety of EU regulations, the Paris Aligned Investment Initiative (PAII) by the IIGCC, the Net Zero Asset Manager Initiative (NZAMI) and the Net Zero Asset Owner Alliance (NZAOA).
The focus of these initiatives are broadly the same. They tend to focus on decarbonization, increasing investment in climate solutions and green technologies, and achieving better reporting.
The IIGGCC along with four regional investor networks has proposed a framework for asset owners. The Paris Aligned Investment Initiative (PAII) from the Institutional Investors Group on Climate Change (IIGCC) is an initiative involving over 110 investors and $33 trillion in assets. The IIGCC released their Net Zero Investment Framework in March 2021.
The Framework is intended to be adopted by asset owners or asset managers following a formal commitment. Initially, the framework covers four major asset classes — sovereign bonds, listed equities, corporate fixed income and real estate, with others to follow.
All net-zero frameworks pull on the same levers to varying extents to drive change in portfolio companies, but the IIGCC Framework is highly regarded and vetted by industry participants. It provides somewhat flexible guidelines to investors, along with recommended actions, metrics and methodologies to achieve the goal of net zero global emissions by 2050 or sooner.
The returns on a portfolio of securities which exclude companies that do not meet the portfolio's specified ESG criteria may trail the returns on a portfolio of securities which include such companies. A portfolio's ESG criteria may result in the portfolio investing in industry sectors or securities which underperform the market as a whole.
Responsible-Factor (R Factor) scoring is designed by State Street to reflect certain ESG characteristics and does not represent investment performance. Results generated out of the scoring model is based on sustainability and corporate governance dimensions of a scored entity.
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