Investing in a Net-Zero Emissions Transition

Institutional investors, in growing numbers, are announcing their aims to reduce portfolio emissions to net-zero. The drivers are two-fold: the near-term risks and opportunities presented by the low-carbon transition already underway, plus the expectation that a 1.5°C climate scenario will allow investors to consistently meet return objectives over multiple decades. But behind the flurry of recent announcements to set alignment targets, how is investment in the transition tracking? What approaches are investors adopting? What’s working and what obstacles remain?  

Institutional investors—or asset owners responsible for pension, insurance, endowment, or wealth management funds—collectively manage trillions of dollars globally. They invest in companies, real estate and infrastructure assets, all exposed to climate change. To deliver financial returns to beneficiaries over decades, a climate scenario with the lowest physical damages is in their long-term best interests. Avoiding the worst impacts of climate change requires the transition to net-zero emissions by 2050 or earlier. But this creates its own set of challenges for institutional investors as they seek to manage short to medium-term risks and opportunities, while continuing to meet beneficiary expectations and fiduciary duty obligations.

Approaches Being Adopted

While there is no single approach investors are adopting, many focus on four key portfolio activities, guided by agreed investment beliefs, policies, and processes to frame their decisions. This is consistent with the Task Force on Climate-related Financial Disclosures (TCFD) framework, which expects disclosure on Governance, Strategy, Risk Management and Metrics & Targets categories. The Investor Agenda’s Net Zero Investment Framework also conforms to this approach, with an additional focus on the target setting and alignment process.

  • Integration: Integrating or embedding climate-related metrics and considerations within decisions on portfolio asset allocation, construction, and company exposures to maximize returns and minimize risks over different time periods. This includes climate scenario analysis, transition planning, and physical damages analytics.
  • Active Ownership or Stewardship: Utilizing voting rights effectively at company meetings and setting clear expectations for companies and policymakers, through engagement letters and meetings, to act in line with investor best interests and timeframes.
  • Thematic Investing: Investing in the transition solutions as opportunities for investment returns and a positive impact in their own right, but also because those solutions should assist other portfolio companies to transition more successfully.
  • Screening: Monitoring for high carbon and low transition capacity companies or assets to help support integration or active ownership steps, or sometimes to decide on restrictions or exclusions definitions that require selling certain companies or sectors.

Decisions on how to set the portfolio implementation course can sit with asset owners and in-house teams or, more likely, with appointed specialist asset managers. The investment ecosystem also includes competing consultants and proxy voting, data and reporting providers, all seeking to solve asset owner emissions and transition challenges. There is, however, regular collaboration to facilitate the systemic change required, in the form of investor forums that share learnings and best practice frameworks. These include the PRI, The Investor Agenda, and Climate Action 100+ plus recent additions – the Net-Zero Asset Owner Alliance and the Net Zero Asset Managers initiative, which together represent investors in the UN’s Race to Zero campaign.

Progress and Obstacles

Investors are now demonstrating that they can ACT to transition portfolios using all the levers available. For example, Mercer’s transition advice collates multiple metrics from different providers in an Analytics for Climate Transition (ACT) tool, ranking companies and portfolios into a transition capacity spectrum to support emissions reductions, active ownership, and allocation to transition solutions. This is being employed with dozens of investors globally, who are no longer simply monitoring emissions intensity relative to a benchmark or selling solely based on historic emissions.

The most meaningful investor progress in the last twelve months is in the number of investors now publicly committing to a target to actively reduce emissions and allocate to companies and assets best positioned to enable a successful transition. Progress in actual portfolio changes to back those commitments has benefitted from the clarity and relative simplicity that a net-zero emissions target provides. Climate scenario analysis still has a role to play in preparing for the uncertainty that remains and capturing transition plus physical damages possibilities, but the complexity of climate scenarios has not proven to be conducive to short-term investor decision making.  

Investor decision making also reflects company data improvements to include forward-looking transition metrics and green revenues – not just past emissions. Data aggregators like MSCI, ISS, Sustainalytics, and FTSE can now provide more sophisticated tools that mean even quantitative strategies can be created to reduce portfolio emissions, allocate to companies delivering solutions, and remain within acceptable tracking error or volatility thresholds.

The short to medium-term investment case for return opportunities outside of fossil fuels has also become more robust, thanks to technology, pricing, and policy developments. Investors are successfully investing in opportunities that meet sustainable or low-carbon criteria across global equities, fixed income, real estate, and infrastructure already and we only expect that will grow as solutions emerge across sectors and supply chains. Investors are increasingly moving beyond the obvious wind and solar energy alternatives, to, for example, what is needed to electrify everything, particularly transport, and reduce the embodied carbon in construction. And “nature-based climate solutions” are getting a lot of new attention. 

Active ownership progress is evidenced in voting results from recent meetings, such as big oil’s recent “Black Wednesday” boardroom overhaul, and in the Climate Action 100+ company benchmark and progress report. The CA100+ collaboration has been successful in sharing resources for investors, reducing the number of requests and meetings on companies, and delivering more consistent investor expectations.

It’s not all smooth sailing, however, and obstacles remain. Policy hurdles must be overcome to shift subsidies and incentives from fossil fuels and instead support technology-based solutions like green hydrogen and carbon, capture and storage (or use) that are yet to emerge at commercial scale. The 2021 Global Investor Statement to Governments on the Climate Crisis clearly outlines investor expectations for governments and the gaps to be closed ahead of November’s global meeting.

For investors keen to have decisions supported by quantified data, technical obstacles also remain in relation to data methodologies, their consistency, and application. As of now, net-zero targets are typically only set for Scope 1 and 2 emissions, and only for carbon. Scope 3 emissions still rely heavily on estimates that vary widely. However, even avoiding time on untangling the inevitable double counting in diversified investor portfolios, more reliable Scope 3 data will give a more comprehensive view on the sectors creating the energy demand rather than simply focusing on supply.

Methane is also next on the data list. Carbon emissions are about 75 percent of greenhouse gases, and therefore the obvious place to start. But methane can’t be forgotten, as it represents another 15 percent of global greenhouse gases and is meaningfully more impactful on global warming, with natural gas, agriculture, and landfill waste being large sources.

An important consideration in “net-zero” emissions, as opposed to zero emissions, is also what will be counted in netting off remaining emissions after all possible reductions have been made. What will actually remove emissions from the atmosphere and how can we be confident we are not double counting offsets and greenwashing calculations? 

A final obstacle for many investors is the significant change management requirements in each organization for making climate-related considerations standard across roles and functions, with training and additional resources needed. That is the case for investors of all sizes, so it will be particularly important to find a way to address this for the thousands of investors looking to translate what leading global investors have demonstrated is possible.

The momentum over the past 12 to 18 months leaves many of us with much optimism. The foundational approaches for investors are well established. The recent acceleration has been driven by the clarity in the net-zero target, data improvements, and the return opportunities that make portfolio change possible. The remaining obstacles are surmountable, with time being the greatest challenge we all face. Investors, companies, governments, and individuals must all act today to achieve the net-zero target by 2050 or sooner—and actually eventuate the best-case climate change scenario.