Overview
A client we work with recently decided to target net zero across all its operations and services. But there was a problem. The managers of its pension fund weren’t sure of the best way to achieve this goal across their entire investment portfolio.
As investors move beyond setting long-term targets and start implementing concrete actions to achieve them, they face common problems: how to measure companies on their progress and credentials? What path towards net zero should they assume? How do you benchmark results? Or how to deal with the crowding out - and volatility - of some sectors most obviously contributing to the transition?
For our pension fund client, early discussions focused on a traditional credit mandate. But after we shared results of our climate analysis - including temperature alignment estimates which showed how a traditional portfolio compared against their target - the conversation quickly moved to practical steps to adjust the client’s portfolio to a 1.5-degree pathway.
The first of those steps is identifying the most effective tools an investor can use to achieve alignment with a decarbonisation goal. That can be simple portfolio decarbonisation - aiming to reduce portfolio emissions on a specific ‘glide path’ either to net zero or relative to a benchmark. Or the investor might aim to increase over time the proportion of stocks from issuers that have targets approved by the Science Based Targets initiative (SBTi). Another option is to aim for a specific level or rate of improvement in the portfolio’s Implied Temperature Rise, a metric designed to show how companies align with global temperature goals.
The next step is deciding how aggressively to apply those tools. In other words, what’s the pathway to achieving the investor’s climate ambition? Answering that determines what actions to take now, and depends in turn on questions like:
- How quickly will different economies reduce their carbon emissions, and how will the outcomes differ between, say, the EU, Asia, or the US?
- Will adoption rates for 1.5 degree-aligned targets, such as under the SBTi, continue to increase rapidly?
- How much active risk should you take on climate?
These questions help to define your decarbonisation path.
That might be positioning for rapid change now, with the aim of getting ahead of the energy transition and looking to profit from the change. The approach has the advantage of reducing an investment portfolio’s impact quickly, but at the cost of greater tracking error and more turnover.
Or you might choose a Paris-aligned path, aiming to follow the decarbonisation of the economy in line with the Paris Agreement of 2015. This provides a more predictable course aligned with climate science but there is an increasing gap between national policy and the actions needed to achieve the objectives of the Paris Agreement. That could introduce risk in the absence of a ‘catch-up’ policy response, as well as from sector or geographical concentration if decarbonisation is uneven.
There’s also the option to define a custom path by using your own targets and macro-economic expectations to determine your investment strategy. This can be a pragmatic approach for managing near-term risk, but it may be misaligned with the transition required to limit the worst impacts of climate change. It could also be subject to policy risk if there is a rapid unanticipated adjustment to global climate ambition.
Balancing acts
Climate change presents some obvious (and some not so obvious) risks to portfolios, but also a universe of sustainable investment solutions that can generate returns. The risk side breaks down into transition and physical risks. Managing transition risks includes assessing companies’ commitments to achieving net zero and, where material, selecting issuers with lower carbon intensity and better climate risk management than their peers (how we achieved the 1.5-degree portfolio for the pension fund).
Mitigating physical risks involves trying to minimise the adverse effects on a portfolio resulting from climate change, or otherwise ensuring investors are compensated for taking that risk. In practice this means considering the location of assets and their exposure to climate threats, what adaptation measures are in place, how resilient supply chains are, and how well diversified the portfolio is when these risks are taken into account. The longer the investment time horizon, the bigger this risk.
When it comes to the opportunities, investors can focus on companies that are making a quantifiable contribution to positive climate outcomes. This may sound straightforward, but investment strategies that are aligned with sustainable themes tend to be concentrated in a smaller subset of sectors compared to the typical investment universe. This concentration can lead to volatility. Clean energy, for example, has underperformed since the third quarter of 2023, while traditional energy companies have rallied.
Sustainable thematic funds meanwhile tend to be overweight stocks whose multiples became stretched in the early part of this decade, only to experience compression more recently. These are stocks with a relatively narrow set of revenue drivers, in sectors that can fall out of favour quite quickly if there’s a shock. And of course, geopolitical tensions have risen and central banks have hiked interest rates in the years since sustainable thematic stocks were at their most favoured.
By contrast, the premium on sustainable blue chips that are more widely owned has been much more robust. These companies, taken together, have more diverse exposure than those typically held in thematic portfolios, which means they are naturally hedged against volatility in any one sector. They are more likely to move in line with market sentiment as opposed to sector or theme sentiment, making them less of a ‘pure play’ option.
Pragmatic approaches
Rather than relying on a menu of pre-existing funds, investors are increasingly turning to asset managers for advice and intelligence, as well as co-designing sustainability and outcome- based strategies for customised solutions.A fixed-income investor looking to achieve a Paris-aligned path can aim gradually to reduce the level of carbon emissions in their portfolio, thereby reducing exposure to potential carbon and stranded asset risks. Or, if they were pursuing a temperature targeting strategy, they can tilt towards bonds issued by companies that operate with more carbon efficiency than others in their sector, and so are less sensitive to potential carbon costs. A direct lender can make sustainability-linked loans, using coupon step-ups and climate-related covenants to hedge climate risks.
As well as addressing climate risks, an investor might also aim to hold a portfolio of companies whose revenue sources align with the energy transition.
Equity investors can seek exposure to the structural climate change theme and invest in companies providing solutions (those producing the materials necessary for the energy transition, for example).
A real estate investor can lock a green premium into an asset by improving a building’s climate performance. This can be especially effective if they are buying ‘brown’ (less green) real estate at a discount. Returns can materialise through direct cost savings from lower energy consumption or through selling buildings at a higher multiple once they achieve certain credentials.
For some sectors, aligning revenues with climate solutions is easier said than done, since future emissions reductions rely on technologies that are not yet commercially available, like low-carbon steel, reduced-emissions cement, or hydrogen fuel. Over the medium to long term, however, the range of solutions to invest in should grow. A common approach is a core-satellite portfolio, with the core focused on decarbonisation and a minority of satellite investments in companies expected to enable the energy transition.
A problem solved
As with so much in life, finding the right solutions begins with asking the right questions. In the case of our pension fund client, we were able to create an investment grade active credit strategy that fits with their 1.5-degree target. The liquidity and size of the relevant asset class certainly helped. But we were able to take advantage of this by considering salient sustainability questions, identifying the right decarbonisation path to target, and then using climate reporting to inform the investment strategy.
A similar approach will work for some investors and not for others. It can be tempting to see a solution and figure out how it could work for you. But before you do that, take the time to make sure it’s actually a solution to your problem. There is no one size fits all.
