Investors are increasingly recognising the urgency of addressing climate change and reducing the environmental impact of their investments. Many, particularly in the institutional investor space, have already set net zero goals and commitments. However, the focus must now shift away from setting targets to finding practical pathways to achieving them.
As a portfolio manager who leads the ESG and responsible investment research strategy within a Global Equities team, here I will share insights on overcoming these challenges and effectively navigating the path to net zero.
Understanding decarbonisation obstacles
There is no single answer to the carbon challenge and route to achieving net zero. The route to net zero will differ based on the needs of underlying beneficiaries and the level of risk appetite. Some investors will want to take an exclusion approach, while others will seek to participate in the transition, seeing it as a glide path to a low-carbon future.
Common to all, however, is the need to understand and address the obstacles to decarbonising portfolios. This includes considering the full risk and return spectrum as climate risks are becoming more prominent.
For decarbonisation, it is essential to consider the specific challenges that different sectors and markets face. Individual companies should have their decarbonisation strategies mapped out. However, regulatory pressures vary by region, with countries like China and Japan targeting net zero by 2060 rather than 2050. Additionally, geopolitical uncertainties, such as the upcoming US presidential election, can affect energy demand dynamics, complicating firms’ adaptation efforts.
Emerging technologies such as carbon capture and storage (CCS) and green hydrogen are developing quickly, but they remain relatively untested at scale. This uncertainty can lead to delayed capital investment and as portfolio managers, it’s our fiduciary duty to evaluate the impact of these challenges on performance and adopt a forward-looking approach.
The way forward
For environmental factors, historical performance is unlikely to be representative of future performance. It is therefore important to use forward-looking data, tools, and frameworks to assess companies. Combining these with qualitative analysis allows us to challenge modelled outcomes and better understand potential risks and returns.
Alternative benchmarks can also help measure risk impacts but can have style biases or be purely rules based and backward-looking – although one can question the validity of this latter approach.
Inevitably there are trade-offs involved with decarbonising one’s portfolio. Taking out names to remove carbon will have implications, whether positive or negative. While pursuing net zero may require the inclusion of sectors like nuclear power that are typically excluded.
Solely focusing on a company’s direct (owned) carbon emissions is insufficient. Assessing a company’s overall carbon impact requires the consideration of Scope 3 and even Scope 4 (avoided emissions). Related issues such as impact on nature and water use are also important to consider.
However, data and understanding around these areas remains immature, leaving the door open to greenwashing. Companies may fail to back up published targets with verifiable action. The Science Based Targets initiative is one framework commonly trusted by investors to understand their climate exposure and mitigation needs.
A sensible approach
Decarbonising portfolios sensibly involves using a variety of levers. Data and reporting are essential tools for understanding, and imminent regulatory requirements will make these tools even more significant in some jurisdictions. But being data led but not data constrained is essential. Qualitative research is therefore a vital adjunct to quantitative analysis, albeit one that requires significant resource to build experience and expertise.
Recognising that decarbonisation is a highly dynamic and complex theme is critical. From walking back ambitious targets to the competing environmental and social issues found when trying to decarbonise a supply chain – there’s no shortage of complexity. Unless these social challenges are addressed in tandem to net zero, an effective transition will be difficult to achieve and painful.
As the macro environment evolves, our approaches must be revisited and adapted. Industry collaborations and constructive engagement with companies will be key to staying aligned with net zero goals.
