Developing a Decarbonizing Roadmap in an Effort to Achieve Net Zero
Climate change continues to have a profound impact on the environment and global economy. With the unique challenges and opportunities presented in moving towards net zero, institutional investors are facing many unique challenges and opportunities in decarbonizing their portfolios.
Veena Ramani, Research Director, FCLTGlobal and Yasir Mallick, Senior Portfolio Manager, UBC Investment Management Trust Inc will provide their insights pertaining to decarbonization as institutional investors create a pathway to reducing their private market portfolios carbon footprint while aligning with their fiduciary objectives.
Veena: Climate change is now well understood as being a material investment risk and opportunity which is leading to some of the greatest shifts in asset allocation that we have seen in the last 50 years. Yet, given the unique nature of the impacts many investors struggle with how to manage climate risks, take advantage of opportunities and deliver strong returns to their clients. Many investors have started with a bottom up strategy – trying to get a sense of the current carbon footprint of the portfolio. But knowing that number doesn’t necessarily tell you what levers to pull to change the picture.
Two important challenges stand out to me in this context:
- The time horizons in which investors are looking to make returns. Where investors are constrained to balance climate change and financial results in the short term, the options available to them for portfolio construction are limited to techniques like divestment or exclusions. This could however lead investors to miss out on meaningful investment upsides as companies transition as well as no net real world decarbonization outcomes.
- Lack of consistent, comparable and decision useful disclosure and data from companies. This means that investors are still hampered in their ability to assess the extent to which their investments are being used drive meaningful change within companies, and building on this, their own portfolio climate impacts.
Yasir: There are three main challenges we’ve seen that are worth noting. First, it is critically important to have agreement or consensus from governing bodies on the overall financial investment objective of the fund, such as a required return. From that starting point it can be better understood how other objectives whether it is decarbonization, divestment, or a focus on broader responsible investing objectives may impact the fund’s ability to achieve the financial objective in the short- and long-term. In addition, there needs to be an appropriate market-based benchmark that reflects the responsible investing wishes of our stakeholders.
Second, the speed at which different stakeholder groups expect the investment portfolio to transition to the decarbonization objective can vary considerably – this is borne from the general frustration that the broader global community has moved very slowly on addressing climate change and the world is now at a tipping point. This frustration borne from a lack of progress on the climate change movement is understandable, however it can lead to a desire to move very aggressively in the areas that have less of a real world impact on the crisis at hand but where activism can yield more immediate visible changes – such as the investment portfolio holdings.
Last, we should recognize the increasing challenge of decarbonizing portfolios once the low-hanging fruit has been picked. Many steps can be taken to make immediate reductions in the carbon profile of the portfolio with limited impact on the efficiency of investment implementation. Yet each additional reduction and move to decarbonize becomes increasingly difficult without actions from others (including government/policy-makers, other investors, investment managers, financial intermediaries, etc.). Reporting on progress in a measured way becomes challenging as stakeholders can see significant changes in a short period of time and then expect that momentum to continue. In this way your early success can become a disadvantage in future years where incremental reductions are less impactful.
Veena: Many investors focus on greenhouse gas emissions as the critical indicator when selecting assets that would contribute to their own climate change goals. Yet, an exclusive focus on that single indicator could lead to “carbon bean counting”, and the investor is incentivized to “green” their portfolio at the cost of returns in the medium to long term, and potentially real world decarbonization outcomes.
Rather than considering emissions in exclusion, investors could consider the climate transition strategy of the asset in question, and importantly, the extent to which the assets climate transition strategy is linked to its long-term value creation plan. This would allow for capital allocation that supports not just climate change solutions, but also legacy industries that need to transition, and position themselves to take advantage of the value addition that results.
Veena: FCLTGlobal’s Climate Transition Conversation Starter identifies a series of questions that companies can ask themselves, or that investors can ask companies on how climate change impacts every aspect of their long-term strategic plan. This framework could help investors identify which companies are best positioned for long-term resilient performance and real world decarbonization. These questions in the framework touch on every aspect of the company’s long-term strategic plan. These include considering how climate change affects:
- The corporate purpose, or the company’s reason for being
- The organization’s external operating environment
- Implementation plans, long term goals and KPIs
- Capital allocation plans
- Risk management plans
- Corporate governance systems, including accountability and implementation plans
Developing a strategy that incorporates these elements will go a long way towards building investor trust in corporate climate ambitions. To that end, in addition to developing a strategy, investors should encourage companies to identify the right metrics that will reflect progress on the strategy and develop a robust plan to communicate the strategy to investors and other stakeholders.
Yasir: We are still early in the data measurement period and believe that frameworks such as TCFD will help spur data and analytic improvements in both public and private markets. The challenge for us is navigating this evolution and making sure that our reported metrics in one period are comparable with the next and, if not, being able to explain changes in measurement frameworks as they occur.
As the calculation and methodologies for measuring portfolio-related emissions can be technical and are still evolving, a lot of informational value is lost when stakeholders simply look at a specific number without the context or understanding of period-to-period changes in measurement methodology. Very similar to risk information, the exact number is often less meaningful than the direction of travel and overall trend over time as a communication tool.
Veena: As they look to decarbonize their private market portfolios, some investors may look to on funds that are exclusively oriented towards clean technology or green options – and building on that, exclude or divest from legacy or carbon intensive sectors. As noted earlier, while this may result in short term decarbonization outcomes, investors may lose the investment upside as the companies in question transition their business models and value creation approaches.
Private equity funds could also play an important role in driving the climate transition in their portfolio companies – especially given their expertise as change agents and driving performance outcomes. However, there are a few structural issues that need to be addressed first.
- Short Fund time horizons. The investment horizon for PE funds is typically between four to seven years, which may not be sufficient time to help companies develop robust integrated climate and business transition plans and set them on a path to decarbonization.
- Misaligned Fund incentives. The process of engaging in a business transition or transformation may result in short term impacts on fund returns as capital is reallocated to support transitioning efforts.
- Limited Disclosure. Private companies disclose on their climate plans and performance at much lower rates than public companies. While there are a number of new efforts aimed at boosting transparency on issues like climate and diversity, these are still at the nascent stage.
Bumpy Decarbonization Pathway. As companies evolve on their transition journey, they may need to make investments that may result in a short-term increase in carbon emissions.
Yasir: It’s important to remember that investors that are working toward non-financial targets, such as net zero goals are operating with increasing portfolio constraints that the broad investment universe still is not. A portfolio that is lagging its benchmark or lagging peers creates short-term risk that can impact an investment team and impact the commitment to the non-financial objectives of our stakeholders. Further, the advancement toward non-financial objectives is continuously driven by peer risk whereby stakeholders look at other institutions and measure progress relative to others.
Therefore, when an institution plans to announce long term non-financial targets, it is important to ensure a clear framework exists, a long-term plan is outlined, and that this framework and plan is continuously reinforced to ensure consistency in the communication of the firm’s progress relative to its goals.