While a lot has changed since Cop26, the role that investors can play in reaching those targets has again been highlighted.
There are many investor-orientated net-zero initiatives, all of which have the same objective: to provide broad guidelines to investors around the theme of decarbonisation.
Investors, especially those who follow these guidelines, increasingly include climate change considerations in their investment practices.
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The ultimate goal of these initiatives is to guide investors who want to support a transition to a low-carbon economy or, in other words, achieve real-world decarbonisation.
This naturally tends towards decarbonising portfolios over time. However, the interaction between portfolio and real-world decarbonisation is an area of ambiguity.
Here, I explore these two concepts and try to shed light on how each one affects the other.
What is real-world decarbonisation?
As the name suggests, real world decarbonisation is the reduction of emissions in the real economy. Generally, investors influence this by engaging with companies directly, making primary market investments in climate solutions and green technologies, and by contributing to discussions with governments and regulators.
What is portfolio decarbonisation?
Portfolio decarbonisation refers more precisely to an improvement in the emissions profile of a specific investment portfolio.
Generally speaking, this can happen in two ways: the first is more passive, namely a “natural” reduction in emissions associated with the investment portfolio driven by a reduction of emissions by investee companies within it — effectively through real-world decarbonisation.
The second is a more proactive approach, where investors can adjust the allocation of investments held in a portfolio.
This might involve tilts towards companies with lower carbon emission profiles relative to peers, for example, by setting carbon intensity reduction criteria or excluding the most emissions-heavy companies altogether.
How do they influence each other?
The impact of real-economy emissions reduction on portfolio level metrics is fairly clear — if companies you’ve invested in are decarbonising their own operations, the portfolios that hold stakes in those companies are also decarbonising.
This is the main channel of impact that net-zero frameworks push for.
However, understanding the interaction in the reverse direction is trickier — a recent paper reviewed empirical evidence on the mechanisms of investor impact and concluded:
“ … We conclude that shareholder engagement is a relatively reliable mechanism. Capital allocation can either accelerate the growth of companies, or incentivise companies to implement ESG practices, but there remain gaps in the evidence …”
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In other words, both engagement and capital allocation approaches have supporting literature, but more evidence is needed to support the second approach.
In general, portfolio decarbonisation approaches affect capital allocation — less money is allocated to high-carbon intensity businesses and more is allocated to low-carbon intensity businesses.
However, given that most equity and fixed-income investments are made in secondary markets, changing portfolio allocations only really transfers the ownership of those emissions from one investor to another, without having a clear impact on real economy emissions reductions.
Advocates believe that if portfolio allocation changes are made by a critical mass of investors, the stock and bond prices of highly carbon-intensive companies may then fall, while prices for less carbon-intensive companies rise.
This potentially leads to changes in the cost of capital for those companies affected and sends a negative signal to carbon-intensive companies and a positive one to those that are less so.
What are the implications for asset allocation?
So, what should investors do with their portfolio allocations to achieve their respective goals?
There’s unlikely to be a universal approach.
For example, if the investor prefers to pursue climate-risk management as a dominant element in their portfolio (potentially driven by a belief that climate risks are not fully priced in), then the most straightforward approach might be to favour investments in companies that already have relatively low carbon intensity.
If, on the other hand, the investor wishes to pursue real-world decarbonisation as a primary objective, they might incorporate both engagement and capital allocation approaches.
A balanced approach would be to remain invested in broad public equities and fixed income (both indexed and active), and pursue engagement with investee companies, while also carving out an allocation to portfolio decarbonisation approaches and illiquid investments in climate solutions companies.
Where does this leave us?
For most investors, the path is likely to incorporate aspects of engagement, as well as capital allocation approaches to varying degrees.
When working with clients, we find that no two strategies are exactly alike, and perhaps one of the most important elements is the ability to tailor.
But we have seen more engagement on this issue in recent years than ever before. A decarbonisation investment strategy has gone from a specialist, esoteric concern to something many investors expect by default.
The world’s attention is focused on immediate announcements made during Cop27.
However, beyond the headlines, it is worth keeping in mind that the allocation of private capital was highlighted as one of the key contributors to changes needed to meet set climate goals by 2050.
Investors have a role to play.
Carlo Funk is the EMEA head of ESG investment strategy at State Street Global Advisors, a member of The Gulf Capital Market Association