These great initiatives are much needed to help curb climate change, which is now clearly at the top of the agenda for most of us. However, translating these long-term ambitions into impactful investment portfolios and investor practices is the key challenge for 2021. Currently, only a handful of asset owners have set specific targets.
The critical element is that we set targets in five-year cycles. The asset managers that are part of the net zero initiative need to set concrete targets before the 26th UN Climate Change conference (COP26) that will be held in Glasgow in November 2021. After five years, we will evaluate these targets and set new targets for the next five years. This is also how the countries review their national climate policies as part of the UN climate ratchet mechanism.
There are several initiatives that are trying to give practical guidelines for setting targets and aligning portfolios with the Paris Agreement. In the table below, we have outlined the ones that are currently the most concrete.
The first challenge is the scope of the carbon emissions that are being accounted for by investors. Most investors are steering their decarbonization on the carbon that was emitted by the company in its operations (scope 1) and the emissions produced to generate the energy they procure from utility companies (scope 2). In practice, using only scope 1 and 2 emissions to decarbonize portfolios leads to reducing your weight to utilities and basic materials, as these are sectors with carbon-intensive production processes. This is convenient for investors, because reducing the carbon intensity of portfolios will not have a big impact on the investment universe.
This does, however, clearly underestimate the actual impact of investing in other sectors such as oil and gas, where most emissions occur in the use of the gasoline in vehicles (downstream scope 3). Another carbon-intensive sector is food, where there is a lot of carbon emission in the supply chain (upstream scope 3). My daughter is a vegetarian, not because of the poor animals, but because of the large carbon footprint of meat. That is why it is important to phase in scope 3 emissions that are much more difficult to measure and require good estimation models. At Robeco, we use external providers for gathering that data. Our in-house climate data scientist and sustainable investing research specialists are working on getting this right, and carefully phasing in this data into our carbon accounting.
Analyzing the carbon emissions of last year is effectively taking a snapshot. While it is important to understand the historic trend, it is even more important to understand the decarbonization plans of companies and countries going forward. This element is critical for building Paris-aligned portfolios. It is important to understand how different industries need to decarbonize, by how much and when, and what are the levers for this in terms of technology and products. Investors need to work together with academics to develop these decarbonization pathways for industries, countries and companies.
It is important to realize here is that investors invest in portfolios that are roughly aligned with the global economy. This means that if the global economy decarbonizes at the right pace, investors do not actually have to take much action in their portfolios. But we know this is not the case. If we measure the alignment of current portfolios, this will be above 2 degrees of warming, because the (business as usual) global economy is heading for well above 3 degrees. The risk budget that needs to be taken to make portfolios Paris aligned could therefore change over time. This is something that needs to be carefully monitored.
And then one of the most important questions, I believe, is: does decarbonizing portfolios lead to real world impact? In other words, if we sell high carbon-intensive companies, are we contributing to lower carbon emissions? The answer is, of course, not directly. However, is it clear that in the long run, if more investors do this, then the impact will be there.
What is even more important is to ask is: how is the energy transition best served? We often get the question about engagement versus divestment. And the answer is quite simple. As Adam Matthews from the Church of England clearly put it at one of our SI events, and I couldn’t say it better: “You can stay legitimately invested in a carbon-intensive company if they are setting credible transition plans based upon the science and the economics derived from the Paris Agreement. If they are not, and they try to pull a sort of green curtain over you, you cannot. You need to question and scrutinize that.”
This requires research such as the Transition Pathway Initiative and the science-based target initiatives, and hard work. We do not have all the answers yet, but we definitely need to get on with it! In 2021, we need to go from ambition to measurable targets and actions.