Many countries and companies have made “net zero” commitments to acknowledge their responsibility, and intent to impede further climate change by reducing their greenhouse gas (GHG) emissions.
Investors may be asking themselves whether they should, or can, be making similar commitments to align their portfolios with the Paris Accords goal of a net-zero carbon economy by 2050.
As an individual or family, if you want to support the transition to a net zero economy, the most direct approach remains to invest in companies providing climate solutions, as explained in October’s Market Perspectives.
However, these ventures will likely account for a fraction of any investors’ existing, or future, portfolio. Not all companies will drive the transition via their products or services. That said, all businesses contribute to, and are affected by, climate change; and the efforts to adapt or mitigate its effects.
So what can investors do? This article focuses on the likely majority of an investors’ portfolio, explaining what a net zero portfolio is, and why an investor might decide to align their portfolio in this way.
Understanding a net zero portfolio
Like many aspects of this evolving field, there is no single agreed view of what constitutes a net zero portfolio. Or how to arrive at one.
The Paris Aligned Investment Initiative starts to clarify what a “Paris Aligned” portfolio means, stating that “implementing an investment strategy that is consistent with achieving the goal of global net-zero emissions by 2050.” To understand that more clearly, and the implications for investors, the definition can be broken down into two parts.
Net zero as an assessment
Having recognised the risks and opportunities around climate change and transition efforts, many have already started to account for climate change in their investment decision-making.
A net zero commitment has more specific implications to be “consistent” with the global GHG emissions goal of being net zero by 2050. This adds a comparative element for your decision-making and performance measurement.
Understanding the pathways to achieve this goal at the level of countries, sectors, and companies should help to inform the decision on how to invest. Those on or ahead of these trajectories may be more attractive (from a climate perspective) than those that are not. As well, assessing the net zero commitments against plans, and against the progress made to achieve them, for these entities, can help investors to judge climate readiness, and ideally to achieve the net zero goal to limit global warming to 1.5C.
As a result of this framing, portfolio temperature alignment methodologies and tools are available to assist investors with assessing their portfolios against an implied temperature rise.
Again, while variations in calculation methodologies and underlying challenges around issues, such as data quality, exist, these provide a “performance” measurement for investors. The estimated temperature of portfolio holdings enables a simplified metric for investors to understand their capital’s contribution to climate change, or compare investment strategies based on a net zero framing.
Net zero as a process
Beyond assessment, the above definition implies that net zero is a process of investing; not on a prescribed set of portfolio holdings. By “implementing an investment strategy” investors have flexibility on the approach they take to achieve net zero.
Most frequently, this means tilting portfolios either away from high carbon intensity sectors or companies, or toward lower intensive ones. Already, investors can use the carbon footprints, or quantification of GHG emissions, on an absolute or relative basis, to inform these decisions. Implementing a net zero process requires more active monitoring and clear decision guidelines against the backdrop of the global transition, as well as increasing expectations to reduce these emissions.
Flexibility in approach also means that your investments may vary considerably. To maintain a diversified sector allocation for a portfolio, it’s possible carbon intensive sectors may remain as holdings. At the most extreme end, fossil fuel producers could be included if they have Paris-aligned net zero plans. While less likely, it does indicate for investors the importance of understanding, or defining, the parameters and process to be used.
Should investors be interested in a net zero portfolio?
From a purely investment standpoint, Paris-aligned portfolios may help investors to avoid risks or to generate alpha.
Additionally, investors may have personal, ethical views about climate change. Likely these will be around sectors or companies that generate the greatest proportion of GHG emissions. Investors may not want to own or fund any of these companies, given views about past or potential climate damage linked to these organisations. Then, divestment and/or excluding these holdings is an acceptable way to align the portfolio to their personal views. For the moment, we’re focused on the investment case, rather than ethical one.
Returning to the financial aims, the risk and reward opportunities will be generated by the relationship of portfolio holdings to the impact of climate change, and the efforts to address. This is most clearly seen through scenarios for how specific industries and countries will need to operate to align with a net zero economy.
As an illustration of this, the International Energy Agency has published various scenarios for the energy economy and transition roadmaps. Considering the scenario of Net Zero Emissions by 2050 (NZE) showcases how net zero scenarios can provide insight to investors (see chart).