Implementing net-zero portfolios in practice

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Tilting portfolios toward companies that are low emitters and allocating to those that reduce their carbon emissions over time are among alternatives investors can use in climate-aligned portfolios, according to a report by MSCI ESG Research.

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Investors who aim to align their investments with the global temperature targets can draw on several alternatives for putting portfolios on a pathway to net-zero emissions, a report by MSCI ESG Research shows.

Options include tilting portfolios toward companies that are low emitters of carbon and other planet-warming greenhouse gases, such as through a rebalancing process. Investors also can allocate to companies that improve their emissions over time, even if their emissions overall remain relatively high.

Or investors can combine the two approaches. That is, they can shift capital to companies that have set ambitious decarbonization targets (and that have a track record of cutting emissions). And they can rebalance toward lower emitters.

Whichever approach they choose, laying out a broad investment policy and then breaking it down by investment mandate has produced greater consistency in integrating environmental and other sustainability objectives than an approach that considers such goals mandate by mandate, the report notes.

“To fully align with a net-zero target, a top-down approach is crucial to ensure consistent coverage of the entire investment portfolio and consistent application of all relevant parts of the investment process, i.e., capital allocation, portfolio construction, risk management and reporting and active ownership,” write the report’s authors Guido Giese, Zoltan Nagy and Chris Cote.

Advantages (and disadvantages) of tilting toward low emitters

Rebalancing portfolios to move capital to companies regarded as low emitters from those that are high emitters holds the advantage of being relatively straightforward; investors need only review the latest greenhouse gas emissions for each company and shift capital at each rebalancing to achieve an annual emissions target.

But tilting toward low emitters, by itself, does not shift capital to companies that might be serious about improving their emissions over time. It might redirect capital away from a utility company, for example, because the company’s overall emissions remain above a threshold set by the investor notwithstanding the company’s investing significantly in renewable energy to decarbonize. Rebalancing only to low emitters as a stand-alone strategy also could cause portfolios to become increasingly concentrated over time if they move more money to an ever-smaller universe of companies. Shifting capital to companies in the financial or consumer industries (to cite two low-emissions sectors) also does little to reduce emissions in the economy.

Money for emissions improvers

Investors alternatively might shift capital to companies that are improving their emissions over time, even if their emissions remain relatively high. That helps target the market broadly but relies on company’s achieving significant reductions in greenhouse gas emissions – something they’ve not accomplished to date. Less than a quarter of the world’s listed companies cut their carbon intensity by at least 10% every year – the amount that companies need to cut each year on average to align with a 1.5°C warming scenario – in the five years that ended Dec. 31, 2020.

The approach also can be challenging to implement because it requires both a sufficiently large number of companies to decarbonize and the ability of investors to assess companies’ current and projected emissions.

Investors also might choose to combine approaches. For instance, they can shift capital to low emitters, to achieve greater decarbonization in the portfolio.  And they can tilt toward high emitters that have a track record of cutting their carbon intensity. The portfolio’s actual rate of decarbonization would depend on the number of low emitters versus the number of high emitters that are decarbonizing successfully over time.

Forward-looking measures such as implied temperature rise can help assess companies’ alignment with net-zero emissions. Implied temperature rise estimates a company’s projected emissions as a share of its remaining carbon budget and shows the result as a temperature this century.

Investors might, for instance, define a pathway for each industry sector to reach a portfoliowide implied temperature rise well below 2°C by 2050, the globally agreed goal. That may give investors better insight to enable them to shift capital toward sustainable technologies such as direct-air capture, sustainable aviation fuel or low-carbon hydrogen, if currently carbon-intensive companies are incorporating such technologies into their own research and development, spending plans and decarbonization strategies.

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Net-Zero Alignment: Objectives and Strategic Approaches for Investors. An examination by MSCI ESG Research of three common approaches to net-zero investing to see whether they can have a real impact on decarbonizing the economy.