Many asset owners are pursuing net zero targets to administer their investments against the chance of climate change. A net zero investment objective goals to attain net zero greenhouse gas (GHG) emissions within the portfolio by 2050, in keeping with the worldwide goal of zero growth in real greenhouse gas emissions set out within the Paris Agreement.
Strategies to attain a net-zero investment goal typically include reducing portfolio emissions to scale back transition risk, investing in climate change solutions to capitalize on macroeconomic trend opportunities, and using engagement and advocacy to scale back systemic risks.
Adding a net zero goal to a conventional investment program presents challenges for asset owners as they have to grapple with balancing a net zero goal with fiduciary responsibilities, setting climate risk policies and evaluating net zero investment strategies, incentives for managers and set performance horizons. In “Net Zero Investment: Solutions for Benchmarks, Incentives and Time Horizons“We investigate these problems and propose solutions.
Net zero targets
A net zero goal must not jeopardize an asset owner’s risk, return and actuarial objectives. On the contrary, a well-executed net zero investment program can support the achievement of those goals in keeping with fiduciary duty. Decarbonizing portfolios and decarbonizing in practice should not an end in themselves, but fairly a method to an end – to guard and enhance a plan’s assets.
The concept of fiduciary duty varies by region, however the duty to act with care and prudence is universal. This remit includes net zero investment programs that rigorously consider climate risk while aiming to attain an asset owner’s financial risk and return objectives.
Climate risk policy
In a conventional investment program, asset owners can measure investment risk as tracking error, volatility, value-at-risk, or one other mean variance risk metric. A net zero investment program also requires risk measurement. However, mean-variance evaluation doesn’t capture climate change risk because historical data is insufficient to predict how climate change risk might affect stock price behavior.
A portfolio’s climate change risk is complex and involves multiple aspects, including transition risks, physical risks and systemic risks – risks that can not be mapped to the aspects in a mean-variance risk tool. Although greenhouse gas emissions are sometimes used as an indicator of climate risk, simply measuring and managing portfolio emissions will not be sufficient to totally account for climate change risk.
Other transition risk aspects which may be monitored include the corporate’s existence of science-based emissions reduction targets, transition plans, or capital expenditures to scale back emissions. Measuring firms’ physical risk aspects is time-consuming and data-intensive; Third-party databases can often provide good solutions.
In the meantime, as climate risk measurement evolves, asset owners can focus their efforts on investments that pose the very best risk related to climate change, typically their public equity portfolios. Risk management also includes managing upside risk; Investing in climate change trends and solutions offers opportunities to extend portfolio returns.
Benchmarks
As with all investment strategies, net zero investing requires appropriate metrics and benchmarks. Some asset owners default to their existing market index benchmarks and argue that climate risk management efforts must be reflected in portfolio returns. Others are passively pursuing a decarbonization benchmark. Some create a custom reference benchmark portfolio that reduces the investment universe to a subset of firms that higher fit the investment strategy.
Finally, some asset owners use a “scorecard” approach that mixes a market index to measure financial performance with key performance indicators for every component of the online zero strategy. We compare the advantages of decarbonization benchmarks and scorecards.
The Paris-Aligned Benchmarks (PAB) and Carbon Transition Benchmarks (CTB) are probably the most commonly used decarbonization benchmarks. PAB and CTB indices are designed as derivative indices of parent market indices based on criteria established by the European Union. They aim for a 50% or 30% reduction in emissions in comparison with the parent indices and an annual reduction of seven% thereafter.
Decarbonization benchmarks provide a useful method to launch a net-zero investment program, but they’ve several drawbacks, including potentially high tracking error relative to the parent index, a limited impact on real-world carbon emissions, and for a lot of decarbonization benchmarks, the Lack of transparency in construction methodology.
The scorecard approach might be used to handle a key problem with net zero benchmarking – namely that no single index or benchmark can meet the entire measurement requirements for an investment program that has each financial risk and return objectives and net zero objectives .
A scorecard benchmark can include a set of metrics or performance indicators that measure each financial and net-zero goals. For example, the UK pension scheme NEST has set three key expectations for its external asset managers as a part of its net zero investment program: (1) reporting on climate risks and opportunities using the TCFD framework, (2) reducing emissions and (3) voting and participation in business transition plans and efforts.
NEST makes its managers chargeable for climate protection goals along with financial goals. Scorecard benchmarks are commonly utilized in other industries to measure performance. The investment industry’s reliance on market indices as its sole measure of performance makes it an outlier.
Incentives
Asset managers who’re compensated solely for beating a market index may in a roundabout way pursue investment actions that contribute to the asset owner’s net zero goal. To motivate managers to attain net zero targets, asset owners must provide appropriate incentives.
Although asset owners have little influence on asset management remuneration systems, they will set conditions for net zero mandates that include sufficiently motivating remuneration structures. In a 2011 report titled “Impact-based incentive structures“The Global Impact Investment Network (GIIN) suggests that asset owners consider several aspects when deciding methods to structure impact-based compensation, resembling whether to reward short-term performance, long-term performance, or each.
The industry is just starting to see the emergence of net-zero incentive compensation structures. For example, one asset manager linked deferred compensation to net zero targets. We expect this to proceed to evolve as net zero investments gain momentum.
Time horizons
The long-term goal of achieving net zero by 2050 should be achieved by meeting interim targets over short and medium-term time horizons. Climate change may impact portfolio values in material and unexpected ways, each within the near term and within the years ahead because the world seeks to mitigate this systemic risk. Evaluating the success of a net zero investment program must reflect this reality, which is in stark contrast to the three to 5 12 months cycle of most performance targets.
To achieve net zero targets, asset managers must invest time and resources to evaluate firms’ transformation strategies and risks, measure emissions trajectories, discover transition opportunities, and advocate for corporate and policy changes. Asset owners should provide managers with sufficient opportunities for achievement.
For example, five-year time horizons offer higher probabilities for commitment success and a gradual reduction in emissions. In practice, asset owners have set various goal dates starting from starting in 2025 to early 2040, typically with several intermediate dates in between.
Net zero investing in the longer term
What can we are saying concerning the way forward for net zero investing? The planet is undergoing a climate change that’s driving one of the crucial significant economic shifts in history. We expect net zero investments to proceed to grow as emissions reduction plans and programs develop into mainstream, opportunities to handle climate change increase, and the industry develops higher tools and capabilities to measure and manage climate change risk .
