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The heat is on: how investors approach net zero
For the world to reach net zero by 2050, institutional investors must apply a sustainability mindset to portfolios. The challenge is reducing carbon emissions while meeting return obligations
Gerold Koch and Philip Tso 15 Jul 2022

“Or sooner” is the phrase appended with increasing frequency to company statements about goals for net-zero greenhouse gas (GHG) emissions by 2050. This target is essential if the world hopes to create a net-zero economy by 2050 where the GHGs produced are balanced by those removed from the atmosphere.

The Intergovernmental Panel on Climate Change warns that a net-zero economy is the only way to avoid runaway climate disaster and the devastating consequences. Unfortunately, science says we are already experiencing climate change, but can still avert the worse. While we are on track for global warming of double or more of what was agreed in Paris, we could still rein this back to the relatively safe level of around 1.5 degrees Celsius if emissions peak by 2025 and are slashed 43% this decade.

This means quickly cutting GHGs across all sectors and nations, which is why “or sooner” is being appended to sentences discussing climate ambitions. Institutional investors are also using the term with increasing frequency and large asset owners like insurance companies and pension funds are a driving force. Such investors have an investment horizon that often extends well beyond 2050, so are keenly interested in ensuring portfolios retain value well into the future.

However, what is quickly realized when translating net-zero ambitions into practical investment rules is that climate-damaging emissions are intricately intertwined with other sustainability questions. For example, biodiversity is clear cut: it suffers from climate change and pro-biodiversity measures should help reduce GHGs.

But other areas are more complex. Take the social aspect of environmental, social and governance (ESG) criteria: the massive restructuring required to create a net-zero economy means some industries must transform dramatically. This will require new skills, which means significant redundancies among today’s workforce, with negative impacts rippling throughout the wider community.

How can such a major disruption be designed to be socially acceptable? The concept of a just transition addresses how the transition to an emission-free economic system can be fairer for all stakeholders worldwide.

Challenge

The question is how to best set portfolios on the path to net zero? One (theoretical) option is to keep the current allocation and then shed non-net-zero holdings in 2049. The flaw is that this is counterproductive to achieving climate goals since every ton of carbon dioxide (CO2) emitted remains in the atmosphere for millennia, further contributing to global warming.

Furthermore, assets that are not net-zero-capable will not abruptly lose value in 2050. Instead, capital markets will anticipate the risks, causing investments to increasingly leak value the closer the timeline creeps towards 2050, a trend already observable.

Basics: starting point and methodology

The challenge for institutional investors is to meet annual return obligations to clients with a marketable return/risk profile while treading the path to net zero. Before diving into net zero, investors must establish their starting point and define a course of action. After all, while calculating a company's carbon footprint is arduous, the complexity multiplies for a portfolio spread across different asset classes.

The first step is transparency. After many workshops with clients on this topic, we recommend aggregating the financed emissions of all investment positions on an individual position basis using data reported by emitters where possible or emissions data from climate experts. A baseline year must also be established (such as 2019, before the start of the Covid-19 pandemic).

Target setting protocol

The Target Setting Protocol of the United Nations convened Net Zero Asset Owner Alliance has become the guiding framework for portfolio decarbonization. According to the protocol, interim targets are to reduce the carbon footprint of portfolios by 22% to 32% as early as 2025 and by as much as 49% to 65% by 2030.

These ambitions can only be achieved with extensive intervention in investment guidelines and policies. In addition, investors should engage with the companies in which they invest so those companies create credible, science-based targets and strategies for achieving carbon neutrality.

Investors should also finance the transition to a carbon-neutral economy through investments in energy efficient technology or renewable energy. This can be done through project financing or investing in green bonds.

Scenarios for risk and return

A critical question concerns the influence low-carbon and other ESG strategies have on the risk-and-return profile of a portfolio. Using strategic asset allocation strategies, different scenarios for risk and return can be simulated. Of course, the disclaimer applies that past data does not guarantee future success, although it does provide crucial insights into the sensitivities of a portfolio.

We recently simulated a client’s investment portfolio of global equities and fixed income for the past five years using four ESG approaches: low carbon and three styles, ranging from light to medium to dark green, that apply ESG categories with varying degrees of rigour (ESG quality, UN Global Compact, arms, coal, tobacco) and apply both exclusion criteria as well as a selection of ESG leaders. We then compared these styles to the original portfolio.

The surprise was that all four scenarios had minimal differences in risk, measured as volatility, compared with the standard allocation. However, all ESG approaches generated higher returns compared with the non-ESG portfolio. The dark green style is the most striking, showing a 1.5 per centage points higher annual return over the last five years. Of course, the database is not long enough to draw statistically significant conclusions, but it is another indication that ESG and returns need not be contradictory.

Developing alternative courses

In any case, most clients want to take a broader approach to ESG than just decarbonizing portfolios. Therefore, we believe a path to achieve net-zero interim targets should consider four sustainable aspects:

  • ESG quality of issuers
  • positions in controversial industry sectors or with controversial business practices
  • carbon footprint and intensity
  • climate risks.

At risklab, the advisory unit of Allianz Global Investors, we have developed a system to analyze portfolios based on these criteria. Known as the Sustainability Analysis, Research and Advisory Hub (Sarah), this provides insights into alternative courses of action for liability-driven investments (LDI) within the context of the overall portfolio, alongside equity and fixed-income investments.

In one example, we used Sarah to develop a mixed-strategy scenario for a real-world LDI mandate investing purely in bonds. It was based 85% on a corporate bond index targeting CO2-focused exclusions, with 15% of green bonds mixed in. The carbon footprint of the overall portfolio was reduced by 9.4% with a 0.4 percentage point higher annual return. This was achieved with a longer duration and, consequently, slightly higher volatility. The share of ESG-related controversial activities halved.

The conclusion is that asset owners can follow a decarbonization path confident that it is possible without significantly denting the risk-return profile of their portfolio. Many of the clients we have spoken to are determined to do this – and do it as soon as possible – which is good news for the climate.

Gerold Koch is the head of sustainable investment advice at Allianz Global Investors’ risklab; and Philip Tso is the company’s head of institutional business for Asia-Pacific.

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