Net zero and its impact on institutional investors

September 27, 2022
5 min read
Climate is changing business

The adverse effects of over 200 years of human-generated carbon emissions are all around us. From global forest fires and changing weather patterns to melting glaciers and disappearing animal life, the outcome of excess greenhouse gas accumulation is no longer just theoretical predictions. They are upon us.

While scientists and researchers have raised alarms for decades, their calls for change routinely met strong pushback from the fossil fuel industry and lobbyists pushing their various agendas in the political realm. As a clear correlation has emerged between climate change and its impact on the economy, resistance from leaders in business and finance has finally begun to erode.

Over the past two decades, impact investing has emerged as a growing niche appealing to investors who seek to place funds in assets that meet their values. Using a set of criteria called Environmental, Social, Governance or ESG, investors are able to qualify an asset for funding based on how responsibly it operates.

ESG investing is referred to by several names:

  • Responsible investing
  • Sustainable investing
  • Impact investing
  • Socially responsible investing (SRI)

Global Sustainable Investment Alliance issued a report showing that ESG Investment strategies grew by over $30 trillion in 2018 and is forecast to easily top $50 trillion within the next two decades.

Tried and true investment strategies continue to be used such as impact investing, but the demand for ESG investing is snowballing. The pressure is pushing companies to take notice of their ESG rating and if they are lacking then they are scrambling to become more ESG friendly.

Twenty years ago, the concept of investing in ESG started to emerge. However, since those early days, the demand has truly taken hold. At this time, over 2,250 money managers now manage $80 trillion in assets with the United Nations backed Principles for Responsible Investment

As financial market influencers, institutional investors are under ethical and economic pressure to ensure their portfolios are environmentally friendly and in line with the global initiative to reach net zero carbon emissions by 2050. In this article, we explore how they are striving to align their business practices with this mandate.

The push for net zero emissions

The planet's global temperature is 1℃ higher than it was before the industrial revolution. Science-backed calculations have determined that we need to limit global warming to 1.5℃ to avoid the ecological collapse of the planet by reducing carbon output. All major carbon-emitting nations need to work cooperatively to reach net zero carbon emissions by 2050.

The concept of net zero was introduced by the Intergovernmental Panel on Climate Change (IPCC) a decade ago. Net zero is relatively simple and focuses on achieving a semblance of balance by consuming the energy produced and releasing the same quotient in an effort to achieve equilibrium between availability and demand. The ultimate goal is to only release the percentage of greenhouse gasses into the substratosphere that are taken out. By adding no more than what is used net zero is reached (also sometimes referred to as carbon neutral).

The impact of carbon emissions on the environment has become indisputable from a scientific perspective. Many wonder why the world isn’t striving for zero/gross zero emissions instead of being satisfied with net zero. To achieve gross zero, all emissions must stop, which is an unattainable goal at this stage even if there was worldwide cooperation, emissions would still remain a reality.

The race to accomplish carbon neutrality has gone from scientific proposal to actual policy in many states and abroad. As this movement continues, institutional investors, like professionals in nearly every other field, are finding that adherence to net zero mandates is required to remain relevant and profitable.

In response, institutional investors and asset managers have begun launching their own net zero frameworks and partner groups. These programs are intended to help ease the transition to net zero for the investment industry.

Net zero investment framework

Managed by the Institutional Investors Group on Climate Change (IIGCC), the Net Zero Investment Framework is a series of recommended actions designed to enable investors to align their portfolios to meet net zero criteria. By doing so, investors are empowered to deliver on the goal set by the Paris Climate Agreement to keep global warming to 1.5℃ or below.

The Framework has been designed cooperatively with input from fund managers and asset owners to ensure that the targets and guidelines are practical and credible. Using the Framework, investors are able to "decarbonize" their collection of asset holdings by developing an investment strategy that focuses on five core components:

  • Objectives and targets
  • Strategic asset allocation and asset class alignment
  • Policy advocacy
  • Investor engagement activity
  • Governance

The effectiveness of an investor's strategy is assessed based on how well their portfolio meets specific time-bound thresholds for decarbonization and investment in climate change solutions.

Pathways are laid out to explain emissions, technologies, and investment curves to achieve net zero. The information rendered by pathways is utilized by investors to build their portfolio level targets when focusing on emissions reductions and investments. It provides the guidance needed to travel the net zero pathway and achieve a stable investment strategy to effectively reach net zero.

At minimum, all investment pathways must include the following:

  • Limit warming to 1.5 Celsius over pre-industrial levels that display at least 50% probability.
  • By 2050 achieve global net zero emissions.
  • Draft a pathway plan that addresses sectors or regions which have the ability to reach net zero sooner, or in some cases, later.
  • Refer to the peak season year of the current year or a previous one.
  • Link to a multi sector novel that considers emissions sources
  • Ensure that you rely on a very low volume of Negative Emissions Technologies (NETs) by 2050.
Net zero asset managers initiative

Launched at the end of 2020, the Net Zero Asset Managers Initiative is an international association of asset managers committed to aligning their investment portfolios to achieve net zero by 2050 (or sooner). The initiative aims to galvanize the industry into action by creating a critical mass of impact investors. In less than one year, it's attracted 220 investors managing over $57 trillion in assets.

Similar to the IIGCC's program, the Net Zero Asset Managers Initiative is focused on providing guidance and support for signatories to its pledge. The initiative's steering committee is responsible for propagating best practices that help asset managers meet carbon-neutral status.

In less than one year, it's attracted 220 investors managing over $57 trillion in assets.
Companies committed to meeting net zero

At this time only one-fifth of the 2,000 largest companies around the globe have made net-zero pledges, only about 20% of those actually have definable pledges that are science based targets, according to research carried out by Capital Monitor.  

Organizations with genuine commitment have developed real science-based targets that have been approved by the Science-Based Targets initiative (SBTi),

  • 2,007 companies claim commitment to establishing net-zero science-based targets
  • 983 have targets that are approved by SBT

Without having actual scientific based goals that take into consideration the recommendations laid out by the International Energy Agency and Intergovernmental Panel on Climate Change, most corporations who claim dedication are probably only providing shallow lip service

The lack of policies, regulation, and mandatory disclosures mean that pledges really mean nothing and only denote a rather obscure ambition that might be nothing more than a smoke and mirrors game being offered by executives to seem more environmentally conscious when in reality they continue along the same unaltered pathway that shows no real net zero commitment.

The challenges of net zero investing

The dire realities of climate change have pushed the Race to Reach Net Zero movement. Businesses and the world’s major governments are all struggling to do their parts. The investor community is also now an integral part of the push with initiatives like the Net Zero Asset Managers Initiative and the Net Zero Asset Owner Alliance.

The importance of reaching net zero is indisputable to those who accept the science. However, the process is not eBay and investors are facing certain challenges.

Lack of net zero investing methodology

At this time, there is no set net zero investment methodology in place. Different approaches are taken by various groups which often leads to confusion.

Current approaches include:

  • The Science-based Targets Initiative, which has a methodology for financial institutions
  • The Net Zero Investment Framework, part of the Paris Aligned Investment Initiative
  • The EU Paris-Aligned and Transition Benchmarks
  • The Asset Owner Alliance Target-Setting Protocol, developed by the UN convened Asset Owner Alliance
  • Commercial methodologies created by ESG data providers
  • The Task Force on Climate-related Financial Disclosures’ consultation paper outlighting portfolio alignment.

Many of the approaches above do share common elements.

Concerns do exist over temperature alignment portfolio measures due to the many temperature alignment metrics which can drive the outcome and make things cloudy.

Meeting the target and not reducing emissions

There is a strong focus on meeting emissions targets, but do not actually provide real-world reductions in emissions. This is a risk for both companies and investors.

Investors are focused on climate change and trying to decide whether to invest in technologies that are based on carbon reduction due to their high emissions activities or divest them which actually improves their emissions profile. However, when transferring the emissions to another owner, the new owner might not be ethically minded or transparent. One would meet the target but fail to actually reduce emissions.

Investors will need to analyze so-called ‘’forward looking metrics” to assess the performance of each portfolio company and see how they align with a real and tangible net zero emission trajectory. This will enable investors to focus on portfolio companies that are net zero aligned and also enable investors to continue holding companies in higher emissions sectors as long as they have shown they are on a proper pathway towards reduction.

Analysis is the key towards creating a truly objective portfolio that focuses on decarbonization while still making sense from a financial perspective.

Emissions and solution providers

Companies involved in manufacturing cutting edge emissions savings technologies are not always emission free. In fact, many have a significant carbon footprint. However, investors have to weigh the emissions savings the companies can create with their products and make sure it offsets to create the so-called balance of net zero.

At this time, there is an urgent move to shift capital and focus towards climate solutions. The Net Zero Investment Framework suggests taking the time to measure and monitor investments in solutions through the use of solutions that show they align with the EU Taxonomy, which is used for their definition of verifiable ‘green’ activities.

Many solution providers are now reporting data on their avoided emissions, which are emissions avoided by the use of their products. Clearly, the information helps to quantify investment in the companies due to the benefits they bring and their ability to meet the definition of net zero.

Expansion of asset classes

Investors who are committed to transitioning their assets to net zero emissions by 2050 have the benefit of many methodologies becoming available in asset classes such as equities,  credit and direct real estate . However, some are less mature.

  • Sovereign Debt: At this time there is no real systemic structure in place to organize any type of investor engagement with governments. The ASCOR project (Assessing Sovereign Climate-related Opportunities and Risks) is striving to overcome the issue. However, sovereign debt is significant for many asset owner portfolios so the problem must be addressed.
  • Private equity: In the perfect world, the same approach that outlines net zero alignment should be in place for private companies and those that are publicly listed but there is no reported data which creates huge hurdles. At this time, the Institutional Investors Group on Climate Change is working to ensure this asset class has the same standards.
  • Multi-Manager Funds: In order to convert a multi manager strategy to the pathway of net zero, information and data must be collected from fund managers, but the range of methodologies used is making the process almost impossible to aggregate. Many are working to overcome the methodology gaps. Some asset classes might have to adopt the net zero approach at a later date than others.
Institutional investors calling for change

Far from simply taking a reactionary approach to climate change, a large Collective of Institutional Investors around the world have banned together to demand that governments do more to help them meet net zero mandates. The coalition represents more than $52 trillion in managed assets and 733 international members. They argue that trillions of dollars needed to effectively address the climate crisis would be available with the right policies in place.

Some of the demands made by this group include a significantly more ambitious goal of reaching net zero by 2030 instead of 2050 and the requirement that governments avoid investing in carbon-intensive infrastructure. Their belief is that the work of impact investors and other climate-change advocates is being hindered by a lack of political will.

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