How to align a portfolio to net-zero?

What is net-zero and which challenges do investors face?

by Federica Casarsa (Eurosif – European Sustainable Investment Forum)

Achieving net-zero is a complex challenge, and financial market participants usually face many hurdles along the way. When it comes to aligning a portfolio to net-zero, at least three challenges can be identified:

1. how to convert investment decisions into a concrete reduction of Greenhouse Gas (GHG) emissions in the real economy?
2. how to gather accurate information about the decarbonisation plans of the investee companies?
3. how to reconcile net-zero ambitions with fiduciary duty obligations on risk-return and diversification?

Let’s start by clarifying what net-zero means for investors. Decarbonising a portfolio should be intended as progressively eliminating the GHG emitted into the atmosphere by the investee companies – or offsetting them, when elimination is not feasible. In turn it should result in a reduction of the GHG emissions in the real economy.

That is key to assess some strategies that are commonly used to make investment portfolios climate-neutral and verify whether they are efficient or not. For example, most of the existing investment strategies and tools, such as climate benchmarks, focus on lowering the GHG score of a portfolio. This is obtained by overweighting investments in low-emitting sectors (e.g. media companies), or concentrating only on climate solutions (e.g. renewable energies). However, reaching net-zero requires first and foremost a massive transition in hard-to-abate sectors (e.g. steel, cement and chemicals). To that end, engagement is one of the most powerful tools for investors willing to encourage the investee companies to adopt ambitious emission reduction pathways.

As for the second challenge on data, having a clear picture of the amount of emissions currently financed through a portfolio (i.e. financed emissions), and a good understanding of the decarbonisation plans of the investee companies, will help investors to make robust net-zero investment decisions. However, the way in which companies currently describe their transition plans is largely heterogeneous, and often poor in terms of clarity, quality and comparability. In many cases, there is no disclosure at all.

Introducing mandatory reporting requirements into law would be of outmost importance to mainstream, harmonise and improve net-zero reporting. This would allow investors to obtain accurate, comparable, and investment-decision useful data. In that sense, the implementation of the Corporate Sustainability Reporting Directive (CSRD) and the standard-setting process led by the EFRAG represent a main cornerstone of the EU sustainable finance agenda.

That said, transparency – while necessary – is not sufficient to achieve net-zero. It should be complemented by adequate market incentives for companies and investors. Investment strategies and analytic tools must be improved and refocused to drive for change in the real economy. Financial institutions can do a lot to move closer to net-zero, even without perfect information made available by companies.

Finally, a main concern for investors is combining net-zero ambitions with fiduciary duty constraints. Asset owner and asset managers must ensure they are acting in the best interests of their clients, meaning maintaining an appropriate risk-return profile and diversification at a portfolio level.

This combination can work only if high-emitting activities become less attractive than the green ones, which is not often the case in the EU. For example, it has been estimated that within the next 30 years, the EU will need €28 trillion investments in several key sectors (e.g. power, transportation, buildings, industry, agriculture and infrastructure). However, at present nearly half of these investments would not have positive investment cases.

This demonstrates the crucial importance of public policy measures and regulations, such as carbon pricing, blended finance frameworks, or setting emissions targets per specific sectors. Therefore, investors should engage more with policymakers and regulators to advocate for the implementation of a "net-zero friendly" policy and regulatory framework. For instance, through an active membership in Eurosif and national SIFs such as FNG.

Challenges when aligning a portfolio to net-zero – a DACH-perspective

by Anika Leufen & Miriam Vallant (FNG – Forum Nachhaltige Geldanlagen e.V.)

During the COP26 on 9 November 2021, FNG and Eurosif organized a joint event on net-zero portfolio alignments to exchange ideas and concrete solutions to overcome challenges faced when implementing net-zero commitments. Together we identified best practices in the DACH-market and created a safe peer learning space among FNG-members.

The event gained great attention and interaction among participants. During the event we launched two polls with altogether three questions. The first question was: "Has your organization committed to net-zero?" which only 7% of respondents declined. Most participants answered that their organization has not yet committed to net-zero, but that the decision is under consideration (33%).  27% and 20% of the respondents answered with "yes, we set interim targets" or "yes, we joined an international coalition". Finally, 13% indicated that they pledged and are now defining the strategy.

Following up on these results we wanted to explore their motivations for pledging to net-zero. The vast majority answered that it is the right thing to do, concerning the Paris Agreement, the EU Climate Law, and the latest IPCC report. Some respondents indicated risk management as a reason for pledging, very few named marketing-related considerations. It’s worth mentioning that net-zero portfolio alignment also provides an opportunity to assess the risks caused by climate change and to identify net-zero investment opportunities.

In the second poll we asked for the main challenge faced by financial institutions when implementing net-zero commitments. The majority (58%) of the participants identified "assessing data disclosed by companies" as the main challenge. 25% of respondents highlighted internal capacities; only few indicated engaging effectively with companies or portfolio constraints (reconciling risk-return optimization with net-zero).

These results are by no means representative of the financial sector but they clearly indicate two main challenges faced by FNG-members in Germany, Austria and Switzerland.

Challenge 1: Assessing data disclosed by companies

As mentioned before – decarbonising a portfolio means progressively eliminating the GHG emitted into the atmosphere by the investee companies or offsetting them. In order to eliminate or offset GHG, investors need data on a company’s emissions which can be classified in three scopes. Scope 1 are direct emissions, scope 2 are indirect emissions – such as those associated with the purchase of electricity – and scope 3 are emissions produced up and down the value chain. Company reporting is usually focused on scope 1 and 2 emissions. Scope 3 is often more challenging to measure, but it accounts for the majority of the carbon footprint in certain sectors – meaning: addressing scope 3 emissions is often more challenging, but necessary to reach net-zero. In addition to the heterogenous nature of company reporting on net-zero, incomplete data on scope 3 emissions represents another challenge when aiming to decarbonize a portfolio genuinely and substantively. And again – introducing mandatory reporting requirements into law and improving methodologies can help to overcome this challenge.

In a joint project with the Heinrich-Heine-Universität Düsseldorf, Universität Hamburg, Universität Kassel, WWF Deutschland and Radboud University we assess climate reporting as instrument for CO2-Reduction. Up to now we have published two policy briefs on climate reporting and challenges when integrating ESG data in investment processes. We’ll soon publish another policy brief and three management summaries with recommendations for investors and companies. You can find more information here (in German only).

Challenge 2: Building internal capacities

Climate change puts increasing pressure on companies and financial market participants to commit to net-zero. Which internal organisational and strategic changes are necessary in order to commit to net zero? To ensure that commitments are genuine and substantive and to avoid green washing, a net-zero strategy needs to be implemented at different levels of the organisation. One of the challenges is therefore to align everyone in the organisation (from the board to top management and staff) with net-zero commitments, which requires good communication within the organisation. Net-zero initiatives can among others offer tools for that.

COP26 – Unleashing the trillions in private finance?

The COP26 brought parties in Glasgow together to accelerate climate action and to get closer to achieving the goal of the Paris Agreement of "limiting global warming to well below 2, preferably to 1.5 degrees Celsius, compared to pre-industrial levels". One of the four COP26 goals, which were set before the conference, was to mobilise finance.

"To achieve our climate goals, every company, every financial firm, every bank, insurer and investor will need to change. Countries need to manage the increasing impacts of climate change on their citizens' lives and they need the funding to do it.

The scale and speed of the changes we need to make will require all forms of finance:

1. Public finance for the development of infrastructure we need to transition to a greener and more climate-resilient economy.

2. Private finance to fund technology and innovation, and to help turn the billions of public money into trillions of total climate investment." (COP26 Goals – Finance)

As an initial assessment by FNG-member Germanwatch clarifies – COP26 was a turning point for coal but limiting global warming to 1.5 degrees Celsius remains a long way to go – leaving the international community with an outcome of ambivalence. The pressure for developed countries to step out of coal and to phase out subsidies and international financing for fossil fuels, has consequently further increased after the conference.

Referring to public finance or more specifically climate finance, the "industrialized countries" have unfortunately not kept their promise to mobilize $100 billion a year for climate mitigation and adaptation in the so-called "developing countries". They have now announced that they want to reach the target by 2023 at the latest and then further exceed it.

On private finance, further outcomes from the COP26 Finance Day are the following ones:

On mobilizing private finance for clean energy:

• the US, the European Commission and the UK committed to work in partnership with countries to support a green and resilient recovery from the pandemic and boost investment for clean, green infrastructure in developing countries
• A new financing mechanism – the Climate Investment Funds' Capital Markets Mechanism (CCMM) – was launched. The aim is to boost investment into clean energy like solar and wind power in developing countries

On aligning private finance to net-zero:

• 35 countries agreed to mandatory actions to ensure that investors have access to reliable information about climate risk to guide their investments into greener areas; 36 countries welcomed the International Sustainability Standards Board (ISSB), an international sustainability disclosure standard-setter for the financial markets
• Over $130 trillion of private finance is now committed to science-based net-zero targets and near term milestones, through the Glasgow Financial Alliance for Net Zero

Initiatives

International initiatives can help investors to align their portfolio to net-zero by setting science-based targets, reporting progress against targets and engaging effectively with investee companies. Forum Nachhaltige Geldanlagen e.V. therefore encourages it’s members to commit to achieve net-zero emissions by 2050 (or earlier) by signing an initiative (of which we have collected a few).

International initiatives – coordinated action:

• Net-zero Asset Owner Alliance: global asset owners setting and reporting on interim targets for net-zero emissions by 2050
• Net-zero Asset Managers Initiative: international group of asset managers committed to supporting the goal of net zero greenhouse gas emissions by 2050 or sooner
• Net-zero Insurance Alliance: fifteen of the world’s leading insurers and reinsurers to play their part in accelerating the transition to net-zero emissions economies
• Net-zero Banking Alliance: industry-led, UN-convened Net-Zero Banking Alliance brings together banks worldwide representing over 40% of global banking assets, which are committed to aligning their lending and investment portfolios with net-zero emissions by 2050
• Paris-Aligned Investment Initiative: collaborative investor-led global forum enabling investors to align their portfolios and activities to the goals of the Paris Agreement
• The Investor Agenda: focused on investment, engagement, disclosure and policy advocacy
• Climate Action 100+: investor-led initiative to ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change; collaborative engagement