Olivia Lewis and Joseph Pigott: Low-carbon investing

01 Mar 2023 Expert insight

Olivia Lewis and Joseph Pigott measure a portfolio’s temperature.

By malp / Adobe

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As the climate crisis deepens, we are seeing many UK charities looking to align their investment portfolios with the Paris Agreement’s goals to limit global warming to well below 2 degrees, ideally to 1.5 degrees. In doing so, they are often working towards achieving net-zero emissions by 2050.

It’s part of a wider shift we have observed within the sector to bring investments in line with charitable aims, spurred in part by the Butler-Sloss case, in which the High Court ruled that Paris-aligned investment policies are permissible under charity law. The Charity Commission has also been focusing on responsible investing more broadly, issuing updated draft guidance to provide clarity for trustees on how to balance their financial and ethical goals.

The relevance of climate risk

From an investment perspective, trustees seem to be recognising the potential impact of climate risk on their portfolio returns, as well as related opportunities. The importance of measuring and tracking progress towards net-zero is also moving up the global regulatory agenda.

The Task Force on Climate-related Financial Disclosures (TCFD) has set out recommendations for company disclosures on climate risk, which have been backed by more than 120 governments and regulators, and over 3,900 organisations to date. The TCFD has also issued specific guidance to financial institutions, including asset owners, to disclose their degree of alignment to the Paris goals.

But what does a Paris-aligned portfolio mean in practice, and how can charity investors assess their progress? Here, we discuss the reality of measuring a portfolio’s temperature, and how it could potentially be used to inform a portfolio strategy.

Building a Paris-aligned portfolio

There is no standard definition of a Paris-aligned (or net-zero) portfolio or how to achieve one, but various investor-led initiatives offer guidance and support in this space.

For example, the Paris Aligned Investment Initiative (PAII) has devised the Net Zero Investment Framework 1.0, which suggests investors should take a two-pronged approach:

  1. To decarbonise portfolios in way that is consistent with achieving global net-zero emissions by 2050, and
  2. To increase investment in climate solutions.

The Net Zero Asset Managers Initiative endorses the PAII’s methodology, as well as the Science-Based Targets Initiative for Financial Institutions and the Net Zero Asset Owner Alliance Target Setting Protocol, which have similar aims.

An essential part of setting a net-zero strategy is assessing where a portfolio currently stands in relation to a net-zero pathway, including both current and projected emissions, to gauge what action you might need to take. Again, there is no standard way to do this. There are various metrics available, with a sliding scale of sophistication: some are relatively simple, such as looking at the percentage of portfolio companies that have set science-based net-zero targets. Others consider the gap between a portfolio’s current emissions intensity and a net-zero pathway, or compare them to a financial benchmark, such as the MSCI AC World index. These add more complexity, as there are different benchmarks and methodologies used to calculate carbon intensity.

Implied portfolio temperature rise

One approach that appears to be gaining traction is to calculate a portfolio’s implied future temperature rise. Unlike carbon intensity metrics, which are based on backward-looking reported emissions data for each investment held, an implied temperature rise metric is based on a forward-looking projection of each holding’s carbon emissions, and importantly, also considers any emissions reduction targets.

 This data is then aggregated into an overall increase in temperature, which gives an indication of the portfolio’s current trajectory in relation to meeting the Paris goals. Essentially, this metric aims to show what the level of global warming would be if the world had the same emissions profile as your portfolio. It can therefore be a useful indicator of whether action is needed to improve it.

Forward-looking temperature metrics offer a simple and intuitive way to assess, and track, a portfolio’s alignment with climate goals. They have the added benefit of being easy to communicate to stakeholders. By incorporating companies’ net-zero targets, they allow a focus on expected future outcomes rather than current outputs. For this reason, we have seen examples of Paris-aligned portfolios still investing in carbon-intensive companies, on that basis that there are clear emissions-reduction plans in place.

Caution needed

That said, some caution is needed. Temperature metrics are based on projections, which could be sensitive to change, so any figure should be treated with a degree of tolerance. There are also challenges around the availability and comparability of data. Not all companies disclose emissions in the same way, if at all, which means estimates are used instead – scope 3 emissions, or supply-chain emissions, can be particularly challenging to calculate with accuracy. Similarly, not all companies have set net-zero targets, or indeed realistic ones.

Climate-related data is a highly evolving space, and frameworks like that of the TCFD are helping move disclosures in the right direction. As asset owners and managers increasingly request company disclosures and targets, and engage and challenge companies on them, their quality and accuracy are expected to improve.

Could charity investors leverage this approach?

A temperature metric can give visibility on a portfolio’s direction of travel in relation to climate goals, and help inform decisions around how to achieve them. With less than 10% of companies in the MSCI AC World Investable Market index having an implied temperature rise of 1.5 degrees or less, and less than half aligned to a 2-degree rise as of September 2021, it is likely that some action will be required.

Looking at each holding’s contribution to the overall temperature rise can help you identify any problem areas that you may need to address. There may be outliers that are skewing the results, where net-zero plans are not robust enough. Given the margin of uncertainty, however, it’s important to complement this with other metrics, as well as fundamental analysis, to gain a more comprehensive view. This might include assessing a company’s financials, management quality, strategy and commitment to carbon reduction. It can also be helpful to stress test a company under different climate scenarios to build a deeper understanding of its potential pathway.

Armed with this information, charity investors can then decide if they need to adjust their portfolio allocation to better support decarbonisation – either by increasing exposure to companies on a credible path to net-zero, or reducing those that are not. Temperature metrics can also highlight areas where voting and engagement could be used to influence change. Investors can use their voice to communicate expectations around necessary action, set targets and timeframes, and hold companies accountable for their progress.

Can Paris-aligned portfolios have real-world impact?

Many charities are looking to use their investments to support their wider mission and the real-world impact they are making through their core activities. However, while decarbonising a portfolio may reduce exposure to climate risk from an investment perspective, that alone won’t change global emissions. Simply divesting from high carbon emitters does not necessarily spur them to change (although if enough investors starve them of capital, they may be forced to adapt to avoid becoming stranded). And even a net-zero portfolio won’t be immune to the effects of climate change, which will likely impact all companies and sectors to some extent regardless of their own level of emissions.

One of the more direct ways to help reduce global emissions is to invest in companies providing solutions to climate change – from renewable energy to sustainable food production and farming, from protecting biodiversity and forests to sustainable transport and buildings. Funding climate solutions that can help facilitate the net-zero transition is an essential component of a Paris-aligned strategy.

Using your voice and influence as an investor, by engaging regularly and strategically with company management, may also drive real-world change over time. This doesn’t only apply to the heavy emitters – in reality, most companies need to take some action to reduce emissions. And by prioritising Paris alignment and pushing the need for climate reporting up the global agenda, investors can incentivise companies to disclose and ultimately reduce their own climate risks.

Olivia Lewis is a private banker, charities & not-for-profits, and Joseph Pigott is a climate change specialist, at Barclays Private Bank

Charity Finance wishes to thank Barclays Private Bank for its support with this article 

The Charity Finance Yearbook is the ultimate reference source for charity finance professionals. Produced by the Charity Finance editorial and research team it includes updates, advice and trends on accounting and audit, VAT and taxation, investment strategy, responsible investment and finance, risk, funding, performance and governance, law and regulation, HR and pensions, IT and property. Purchase online here.


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