How can I decarbonise my portfolio? Institutional investors are increasingly asking Willem Schramade this question. In the week after the Intergovernmental Panel on Climate Change has released its “final warning” over climate change, he shares some of the challenges, opportunities and basic principles.
Many institutional clients are setting net zero targets, or other decarbonisation targets, but they tend to struggle with the question of how to do it in practice. After all, what does net zero really mean? How do they track progress? And how should they take action in terms of concrete investment decisions?
Decarbonisation is challenging in many ways. First, there is the issue of now versus later. Over what horizon do institutional investors want to achieve the decarbonisation? Against what basis? Current carbon intensities are the obvious starting point (and easiest to measure), but the objective is to achieve much lower future emissions, which need to be assessed and tracked.
This requires a view on investee companies’ emissions targets and pathways – and how credible are they? Do they make sufficient investments? This in turn requires assumptions, and aggregation tothe portfolio level by means of tools like implied temperature rise, carbon value-at-risk scenario analyses, for example. Perhaps foremost in the minds of many of our clients is the question of how decarbonisation goals are best delivered while also maintaining – and preferably enhancing – return goals.
Second, there is portfolio versus the global economy. Decarbonising a portfolio does not mean that the global economy decarbonises. So far, global emissions are still quite high.
And the cynic might say that decarbonisation is mere virtue-signalling, especially if done simplistically. One could argue that universal owners like pension funds and insurers are so connected to capital markets that they cannot even divest. They have no choice but to take responsibility for guiding their holding companies so as to successfully navigate transitions, including the transition to net zero. Making the biggest emitters decarbonise is the main challenge but also the biggest opportunity to push global emissions down. Hence no simple exits, but deep and committed engagement.
Third, what does decarbonisation mean for financial risk-return profiles? Moving too fast or too slowly might bring significant financial risks. Moving too slowly can result in heavy losses on stranded assets or on companies that are unwilling to change. And moving too fast might involve the costly loss of business or missed opportunity. And there are more difficult questions to address, such as outlined in this article.
So then, how to navigate and how to track progress? All three challenges imply that we need a strong data dashboard, with a diverse toolbox that makes assumptions, not just on the portfolio’s decarbonisation pathway, but also on its financial implications (Challenge nr. 3) and on the effects of your portfolio decarbonisation in the context of the global economy (challenge number two). That dashboard should track both the progress of investee companies over time and across time horizons; and investor progress, in terms of your investment decisions and engagement results.
The path to action starts with putting the right governance in place: setting targets; taking sustained action, building the dashboard; and then start steering on it. The action itself can take roughly two forms: shifting assets towards assets that decarbonise; and engaging with the most challenging assets. The below figure illustrates that by ranking assets on carbon intensity (again, this is just the starting point) ideally investments are shifted to the right, with heavy engagement on the left. Over time, the entire curve should fall, with the most dramatic shift on the left.
In practice, there are several ways to do this. For example, a Swiss pension fund told me that they divest the worst emitters from their portfolio; engage with the remaining high emitters; and shift assets from public to private, since the latter tend to have much lower carbon intensities due to different exposures (e.g., more healthcare, technology, and services).
A very public example is the giant Dutch pension fund PFZW, which demands a credible transition plan from its oil and gas holdings. PFZW discloses how it does so. So far, it has divested from 192 companies, while it is in dialogue with 12 companies, and the rest still need to be considered.
In the end, PFZW expects to end up with just a few dozen oil and gas holdings instead of 400. So, unless it wants to dramatically reduce its exposure to the sector, PFZW will have to increase stake sizes and go active instead of passive.
I’d be very interested to get the perspective of more insurers on this. After all, they often have similar goals, but with heavy allocations to fixed income (which tends to be more carbon heavy and transition challenged) in their general accounts. Their challenges can be tougher in our experience.
The next frontier is to integrate decarbonisation goals in strategic asset allocation, and we are exploring several routes there.
Willem Schramade, Head of Sustainability Client Advisory Schroders