Climate change presents a systemic risk to economies, financial markets, and investments. To spur the action required to mitigate its most severe impacts, the owners and managers of trillions of US dollars have committed to net-zero emissions by 2050 or sooner. Yet global emissions continue to rise.
While investors alone cannot bend the trajectory of emissions, the most common approach to net-zero investing – imposing targets to reduce portfolio emissions over time – is clearly not helping:
- Portfolio emissions reductions are often achieved by divesting from high-emission assets or regions. This reduces a portfolio’s carbon footprint on paper, but does nothing to actually lower emissions.
- Excluding high-emitting assets and regions often means cutting allocations to emerging markets. This limits the availability of capital where it is most needed to effect the energy transition.
- Shrinking the investment universe by excluding industries and regions on emissions grounds may result in suboptimal allocations and lower returns.
Our discussions with asset owners indicate a lack of confidence in the traditional approach to constructing net-zero portfolios. A survey we conducted in 2023 revealed that one-third of asset owners are unsure if their approach to transitioning their assets to net zero is actually helping to reduce emissions in the real world.
We believe there are ways to construct portfolios that do not compromise returns, fiduciary responsibilities, or progress towards a low-carbon future. But they require a shift away from approaches built around targets to reduce portfolio emissions over time.
From reducing financed emissions to financing reduced emissions
The starting point for getting net-zero investing on track is redefining what a net-zero investor is. We propose: one who acts to maximise their contribution to real-world emissions reduction and a socially responsible transition, without compromising investor returns or fiduciary responsibilities.
This means not seeking to reduce financed emissions (emissions linked to investment activities), but rather aiming to finance reduced emissions. This is particularly important in the current political climate – with potentially less supportive policy and fewer companies pushing hard for net zero and hence a slower pace of decarbonisation – which may make it harder to construct a portfolio of lower carbon assets without substantially restricting the investment universe. At the same time, supporting real-world carbon reduction to help mitigate climate risk has become even more important.
While one size cannot fit all, an effective net-zero investment approach should include the following five components. Each of them plays a different role in supporting net-zero alignment:
- Dedicated allocations to climate solutions equities and fixed income. These include investments in businesses that enable decarbonisation, such as those focused on renewable energy, battery storage, electric-vehicle and energy-efficiency technologies, and green hydrogen. We believe this group of companies can achieve above-market structural growth as the world decarbonises, potentially adding a differentiated source of returns to a portfolio.
- Dedicated allocations to transition equities and debt. These investments include financing for companies or issuers in high-emitting sectors with credible transition plans, and companies providing products that enable the transition, like critical minerals. Such companies may often not fit in a typical net-zero portfolio, given their high emissions. But we see significant return and impact potential if they successfully implement their transition strategies.
- Other equity and fixed income investments. For the bulk of a portfolio, we recommend prioritising engagement to accelerate the work portfolio companies are doing to decarbonise their operations and value chains, rather than exclusion. Where engagement is not possible or unlikely to be effective, then investors may adopt a ‘positive inclusion’ tilt, directing investment towards companies with credible transition plans or potential.
- Sovereign fixed income investments. For domestic government bonds and other assets with limited options for adjusting allocations (such as those held for regulatory reasons), the main net-zero tool is advocacy. For international sovereign bonds, there is significant opportunity to allocate towards countries making progress towards net zero – for example, by using the Ninety One Net Zero Sovereign Index to measure alignment. Investors can also allocate directly to climate solutions and transition via sovereign green and sustainability-linked bonds, where available.
- Private markets and real assets. Investors can have significant influence via private investments. Investing in real assets can also be a way to contribute directly to the construction of low-carbon infrastructure and buildings, or to influence the management of these assets to reduce their carbon impact.
For good measure
A revised net-zero approach requires different metrics to appraise investments and measure progress, beyond simply measuring financed emissions.
- Climate solutions: use ‘carbon avoided’ – emissions avoided by the use of a product with lower emissions than the status quo.
- Transition investments: use ‘carbon reduced’ – the amount by which emissions have been lowered by a company or country.
- All investments: use ‘asset-alignment’ – the proportion of companies with science-based net-zero targets and credible transition plans; and ‘net-zero engagement’ – the proportion of emissions covered by strategic engagements aimed at influencing carbon reduction, ideally measuring engagement outcomes.
A new approach
The global economy is significantly off course to hit net-zero emissions by 2050. Yet the typical approach to building a net-zero portfolio is unlikely to be helping, and may even be hindering.
By focusing allocations on financing real-world emissions reduction and using engagement to encourage net-zero alignment, we think investors can help to shift the economy toward a credible decarbonisation pathway, while optimising returns for clients and beneficiaries.
