It’s not often that the investment business is at the centre of a social, cultural and political movement (I don’t remember seeing activists on the streets smashing windows over the active vs passive debate or the death of value factor, maybe I missed it). So perhaps it shouldn’t have come as such a surprise to me that in 20 years in this business advising institutional investors in the U.K., I’ve never seen things move so fast.
I don’t think its hyperbole to say that we’re on the brink of the biggest econmic transformation and flows of capital that we’ll see in a generation – what a time to be an investment adviser!
The raft of Net Zero commitments from some of the largest U.K. asset owners has come think and fast: the £50bn BT Pension Scheme, £20bn National Grid Scheme, Brunel Local Government Scheme as well as South Yorkshire and many more.
In just the week of earth day in April 2021, we have the launch of a new Net Zero Banking alliance, and the UK’s latest carbon budget commitments to include new crucial sectors of aviation and shipping in a commitment to reduce emissions 78% by 2035 (vs 1990 levels). Two other reports in the last month from ECIU and the Transition Pathway Initiative signal that we are in the very very early days of what we should be thinking of this as The Transition Decade, with a vast amount of analysis and planning on the way to get the majority of companies into Net Zero commitments and staying on top of what’s feasible and what’s not in a fast evolving landscape.
Looking to the future, it seems pretty clear to me that a big part – perhaps up to 50% – of our job as investment advisers will be advising on the climate considerations of investment. That’s a vast (and exciting) change from where we’ve been and requires a lot of learning, upskilling and change of mindset.
To my US-based readers: this trend is coming for you too. Some large US institutions like Calpers are already signed to the Net-Zero Asset Owners Alliance, and the signatories the the Net Zero Asset Managers commitments is soaring – meaning that more and more mainstream funds will become aligned with this over time.
Why do I say this? There is simply so much important work to do to help asset owners here: cutting through the noise that only advisers can do: bringing conflicting frameworks together, aggregating key data insights for decision makers, thinking long-term in an uncertain world, weighing strategic tradeoffs, separating spin from substance, drawing lines in the sand etc etc.
A lot of the common criticisms of the responsible investing movement are actually opportunities for advisers: “there’s too much noise”, “there’s a lot of spin”, “it’s hard to see the wood for the trees”, “no-one knows what any of this really means” , ” a lot of these commitments are hollow and will fall over” – I think most of these are probably true, and they all present a huge opportunity for skilled advisers to help their clients.
There’s a lot of global variation on this trend with continental Europe slightly ahead of the U.K. which seems ahead of the US. So while my US-based readers might not see a lot of evidence of this trend right now, have no doubt that it is coming for you too.
First published in LCP Viewpoints.
Climate-related announcements are coming thick and fast at the moment but one of the bigger ones came on 10 March 2021 with the IIGCC Paris-Aligned Investment Initiative Net Zero Investment Framework (“NZIF”) being launched.
I’ve been doing some future-gazing recently, and one prediction I feel pretty confident on is that a significant proportion of my job (up to 50%?) as an investment adviser over the next decade will be advising on questions such as the carbon footprint of one investment strategy vs another, comparing the carbon intensity or stewardship credentials of investment managers, or the views on the latest shareholder resolutions for portfolio companies struggling to make a transition. Sound far-fetched? Read on for more detail on what this might look like.
The trillion-dollar question
The Net Zero Investment Framework looks like it’ll be a really helpful framework for asset owners getting to grips with the practicalities of a Net Zero target, which is increasingly a question that large asset owners are asking us. But the big question is …
What does Net Zero really mean?
This is a simple question with a long answer. The key point is that really, it’s not actually reducing emissions to zero that’s the real goal here but aligning the portfolio with the Paris Agreement on climate change, for which “Net Zero” has become a neat shorthand referring to reducing greenhouse gas (GHG) emissions to zero by 2050 or offsetting the residual emissions that can’t be eliminated. Alignment with Paris is more nuanced (and not as catchy).
Companies are one large group of emitters. Some companies’ business practices are already aligned with the trajectory of emissions reduction that needs to take place (shown below) – for example, they may have moved to using renewable-only energy, reduced travel etc; some have plans to make the changes necessary to align themselves; and others are not yet on board. An asset owner, sitting above a portfolio of companies and assets, can also think about the alignment of the overall portfolio – potentially sending important signals to the companies they are investing in.
Reducing emissions down to zero is a key part of the Paris Agreement but it is important not to focus too myopically on that measure. For example, for an asset owner, reducing emissions by allocating solely to low-emissions sectors like say, technology, (and stopping there) isn’t necessarily consistent with the Paris Agreement as today’s low emissions sectors will be allocated only a very small part of the future emissions “budget” under the future pathways, and might actually be expected to get their emissions to zero much sooner or even go negative. The whole economy needs to transition.
Source: Climate Action Tracker
With a large and diverse investment portfolio comprising things like listed equities, sovereign bonds in developed and emerging markets, private market real assets like property and infrastructure, it’s a very complex job to try and understand the current emissions footprint of the portfolio, let alone where to start in how to align all of those underlying assets with the Paris Agreement and what that even means. That’s where a variety of initiatives and affiliate bodies can come in.
It’s important for asset owners to understand the various pathway frameworks and commitments that have already been developed such as the Net Zero Asset Owners Initiative, the Net Zero Asset Managers Initiative and the IIGCC’s NZIF. These initiatives can support a lot of the heavy lifting of a Net Zero program by setting out a pathway, which is a series of steps and actions that can be taken within each asset class to make a portfolio align with the Paris Agreement. After all, asset owners, being one level above the underlying investee companies, have a number of different levers at their disposal including disinvestment (selling holdings), portfolio tilting (allocating more to better-aligned companies), and engagement (using voting power to push for better alignment).
Tilting equity portfolios toward lower-carbon emitting companies has become pretty standard, and corporate bond portfolios are starting to go that way too (get in touch for further information on this). Both debt and equity investors can be a powerful force for change in companies.
A £100m portfolio of low-carbon tilted equities would be responsible for roughly 15,000 fewer tonnes of C02 emissions a year (equivalent to taking 17,000 cars off the road) compared to a standard global equity portfolio. Of course, the overall impact at the moment of switching assets is not the same as actually taking cars off the road, but decisions taken in allocating capital in the financial world do have important real-world knock-on effects down the line. 0%20%40%60%80%100%Current portfolioReductiontrendDivestmentTilting allocationImpact allocationEngagementFuture positionFigure 1: Illustrative bridge to lower emissions
If you’re confident that all of your underlying assets are aligned with Paris targets, your portfolio is aligned without needing to make changes. Few if any portfolios can say this today, so the work for asset owners is to figure out what combination of levers they need to use over time to make a pathway consistent with Paris in the most financially beneficial way for their stakeholders.
Step Zero to Net Zero
Net Zero announcements have quickly become all the rage at the corporate level, with a slew of financial corporates announcing this year like Goldman Sachsand Citigroup in addition to other big names like Tesco, BT and National Gridcorporations last year. And they are taking off among asset owners and pension schemes too. Microsoft even announced it will become net negative by 2030. These look and sound great, but huge challenges and uncertainties remain; how many of these hundreds of commitments will really be intact in ten or twenty years? Time will tell.
Net Zero is easy to say but potentially involves a huge amount of changes in an investment portfolio over a long period of time. The first thing for any asset owner considering a Net Zero target for their portfolio is to establish consistency with their mission statement – for example, an endowment may want to amend its mission statement (as Trinity College did) or a pension fund trustee will want to check that adopting a Net Zero policy is consistent with the scheme rules and their trustee duties as they see them, as you would for any significant strategic step. It is well established that the fiduciary duty of pension trustees includes taking into account the financial risks of climate change on their portfolio, but setting a Net Zero target goes a step further than that.
The number of UK Defined Benefit pension schemes that have announced Net Zero commitments now runs well into double figures. Around 10 did so last week under the auspices of the IIGCC Net Zero Investment Framework, including Brunel, Northern LGPS and Lloyds among others, while others such as the BT Pension Scheme have made independent commitments.
Interim targets are one thing that is increasingly recognised as important. Last week’s IIGCC NZIF announcement emphasises 10-year targets for emissions that align with a “fair share” of the overall 50% global decrease in carbon emissions deemed to be required by 2030. There are also 5-year targets for the asset classes brought within the scope of Paris-alignment and the percentage of the portfolio invested in transition enablers.
The NZIF reinforces the idea that listed equity, public markets debt and real estate are all asset classes that can all be brought within the scope of a Net Zero commitment today with credible pathways for these sectors now in existence that bring them to Net Zero by 2050.
Importantly, the NZIF emphasises the role of engagement and suggests interim targets are set for the percentage of emissions subject to engagement.
Overall the interim target framework described in the NZIF is less prescriptive than that put forward by the Net Zero Asset Owners Initiative (which targets a 16-25% emissions reduction by 2025).
Figure 2: Asset class targets and measuresAsset ClassSovereign BondsListed Equity/Corporate Fixed
objectives– Increase average climate performance / AUM (maximum extent possible), exceeding the average benchmark score
– Increase allocation to green
or SDG climate bonds,
if possible- Set portfolio coverage target for % of AUM in Net Zero, aligned, or aligning assets
– Set target for increase % climate solutions revenues/AUM
– Set engagement goal for coverage of assets aligned or under active engagement at >70% of financed emissions from material sectors- Set portfolio coverage target for % of AUM in Net Zero, aligned, or aligning assets
– Set target for increase % climate solutions revenues/AUM
– Set engagement goal for coverage of assets aligned or under active engagement at >70% of financed emissions from material sectorsAsset alignment and climate solutions assessment criteria– Past and future expected territorial production emissions performance /capita or /GDP against Net Zero pathway
– Past and future performance on key sectors (energy use, and exposure of the economy to fossil fuels)
– Other national and international policy positions + allocation to verified green or SDG climate bonds- A long term 2050 goal consistent with global Net Zero
– Short & medium term emissions
– Current emissions intensity performance (scope 1, 2, and material scope 3)
– Disclosure of scope 1, 2 and material scope 3 emissions
– A quantified plan to deliver targets
– Capital allocation alignment + Revenues from EU mitigation taxonomy activities- Current alignment of building carbon emissions and energy use in line with regional/building type Net Zero pathway
– Future expected alignment based on plan for retrofit, demand management and renewable energy useRecommended
methodologiesGermanwatch Climate Change Performance IndexClimate Action 100 benchmark;
Transition Pathways Initiative;
Science Based Targets InitiativeCarbon Risk Real Estate
“Net Zero” as part of investment thinking looks like it’s here to stay and signals a huge amount of work for asset owners and their managers, if they choose to adopt such a target.
But the key is to see beyond that one slogan and think in terms of aligning with the Paris Agreement, and ask deeper questions about interim targets and how it applies to different parts of the portfolio. An important first step is understanding the various frameworks out there that exist, what these might mean applied to your portfolio and what specific constraints such as pooled funds or regulation you face. Get in touch with our experts for a friendly chat to find out more.