13 January 2022 10 minute read
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Our real assets research analysts explore the whys and wherefores of understanding and managing the carbon footprint of their portfolios.

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Read this article to understand:

  • How real assets differ from liquid markets and offer investors the opportunity to have a real impact
  • Why, to build net-zero portfolios, investors must:
    • Incorporate carbon in their sector allocations
    • Price-in carbon in asset selection and management
    • Anticipate their offsetting requirements
  • The financial and environmental benefits for investors who act decisively now

For businesses, the introduction of mandatory disclosures and increasing public awareness have made understanding and managing their carbon footprint a top priority. Although measures of carbon are still being developed in private markets, they are progressing fast, spurred by several industry and investor initiatives.  

There is already clear evidence of how environmental factors influence sector performance.

In infrastructure, for instance, the yields on renewable assets have compressed compared to the wider market. Equally, greener property assets attract a premium (see Measuring the mythical for more details).1

This trend is likely to accelerate, meaning that even the least climate-aware asset managers will need to incorporate carbon into their investment decisions. It is a key part of their fiduciary duty, and investors should not wait to consider the impact on portfolios before taking action.

1. Managing real assets is complex, but delivers real impact

Why real assets are uniquely placed

In liquid markets, fund managers can tilt their portfolios to achieve certain ESG or carbon objectives by buying or selling individual stocks or sectors based on certain metrics such as carbon intensity. Adjusting a real-asset portfolio in this way would incur significant transaction costs. Furthermore, it might not do anything to improve the environment, and merely push the asset into the hands of other, perhaps less vigilant, owners.

Real asset investors have a tangible opportunity to manage and improve the impact of the assets they own

While some real assets (for example, transport or buildings) are large carbon emitters today, real asset investors have a tangible opportunity to manage and improve the impact of the assets they own, although the cost of doing so may be prohibitive in some cases. Assessing the risk/return profile of these alternative strategies is therefore critical for asset managers to deliver sustainable financial performance to investors. 

Investors and managers with the ability to identify assets to deliver the net-zero transition at the lowest cost are best placed to exploit the opportunities in the market. Moreover, these investors will likely have more direct control over the impact they have on the environment than most public market investors – whether by building new infrastructure, such as renewable energy facilities, battery storage or electric vehicle (EV) charging, or reducing the emissions of assets owned.

Why the long-term outlook is more important than carbon intensity today

Several metrics have been developed to measure the carbon impact of a portfolio. Some can be aggregated at a sector level and guide portfolio construction, although there will be large differences between individual assets.

Figure 1: The carbon impact of a portfolio
The carbon impact of a portfolio
Source: Aviva Investors, December 2021

Carbon intensity data is not publicly available for privately owned real assets and may be difficult to compare.

Emissions vary across the life of the assets

Furthermore, emissions vary across the life of the assets, which static measures do not capture. For example, a new windfarm has three stages: construction, operational life and dismantling/recycling. During their operational life, windfarms emit little carbon and displace more polluting power sources. From an accounting standpoint, these avoided emissions cannot be netted against an investor’s carbon footprint. Nevertheless, they reduce emissions.

Yet, the activity to build, transport and install wind turbines still generate carbon as steel, transport and cement have not yet been decarbonised. So, while renewable energy contributes to the net-zero transition, it is not carbon free. Furthermore, as more renewable power facilities are built, the load factor of each plant will reduce and so will the avoided emissions. This is likely to bring increasing scrutiny on the impact of construction and decommissioning.

Figure 2: Onshore wind development: Carbon footprint and avoided emissions (kgCO2/MWhr)
Source: Aviva Investors, December 2021

While the positive carbon impact of renewable assets decreases overtime, the (negative) carbon impact of properties is also expected to fall. This is because electricity will increasingly come from renewable sources, as well as improvements in the way buildings are designed and managed.

For real asset investors, understanding how the carbon footprint and carbon avoided of their portfolios will evolve overtime is as important as understanding today’s carbon footprint in demonstrating alignment with the Paris Agreement goals.

2. How can investors build a net-zero portfolio?

Today, many investors are establishing their baseline carbon footprint. In future, large companies in many jurisdictions such as the UK will have to demonstrate how they will reach net zero,2  which may require portfolio adjustments. The implications of the carbon value impact should be assessed at a sector level for portfolio construction and at an asset level for underwriting.

Modelling the carbon impact of strategic allocations

Despite data limitations, sector allocations can, and should, consider all aspects of the long-term carbon impact. This approach can be both qualitative and quantitative.

A view on the attractiveness of relevant investment sectors can be developed

From a qualitative standpoint, a clearly articulated view on the attractiveness of relevant investment sectors can be developed. This can be more nuanced than sector inclusions/exclusions. Instead, such views may define the parameters under which assets in a given sector are attractive, as well as the likely evolution of investment appetite over time.

As an example, investment appetite for road transport may be linked to EV charging, regulatory support for transport decarbonisation, as well as other environmental and social impact considerations. Investors can use qualitative assessments to engage with investee companies and borrowers with the goal of helping them improve their environmental performance.

In terms of quantitative metrics, investors can compare carbon intensity and transition risk per sector over their investment horizon. Integrating these value impacts into their views of sector risk and return can help build more resilient portfolios.

Pricing carbon in acquisitions and asset management

While sector views support sector appetite and portfolio allocations, they are not sufficient to decide which assets to buy, sell or how to manage existing assets.

Instead, institutional investors and asset managers are likely to ask themselves more practical questions:

  • How exposed is my portfolio to the consequences of global warming?
  • Is it aligned with my net-zero strategy?
  • How is regulation (current and/or expected) impacting markets and assets?
  • What is the obsolescence risk?
  • What should I do to improve my portfolio’s carbon footprint and how much will it cost?
  • What is my likely payback on the environmental spend?

A prime consideration is physical risk, in other words whether the asset could be impacted by the physical impact of climate change, which depends heavily on the asset location. Wherever possible, long-term climate change models can be used to assess this risk.

Transition risk - the risk of obsolescence linked to net zero - must also be considered. Simplistically, the decision tree faced by investors can be illustrated in Figure 3.

Figure 3: Transition risk decision tree
Transition risk decision tree
Source: Aviva Investors, December 2021

As carbon intensity data is not widely available, answering quantitative questions can be complex. While new standards are yet to emerge, investors may have to build their own measures, and/or use market proxies to measure the alignment of an asset to the net-zero trajectory, as well as the cost and revenue implications on each asset.

Investors may have to build their own measures of the alignment of an asset to net zero

Once measured, potential climate costs and benefits must be added to ‘climate-agnostic’ financial metrics and included in business plans. An example is illustrated in the case study at the end of this article.

In real estate, the carbon impact of individual assets can be even more differentiated, driven by the usage and fabric of each building, as shown in Figure 4.

Figure 4: Energy intensity of commercial property assets
Source: Better Building Partnership Real Estate Environmental Benchmark 2020

Significant expenditures are required to align the energy efficiency and carbon intensity of buildings with a net-zero pathway. Such investments are necessary to reduce obsolescence risk. They may also improve the value of assets, although the quantification of such a green premium remains elusive.

Incorporating the cost of aligning assets to the green transition is critical

Other real asset markets, such as transport infrastructure, data centres or district heating, face similar transition challenges. Incorporating the cost of aligning assets to the green transition in the business case for new acquisitions is critical to ensure future returns are accurately estimated.

For asset owners, understanding how to reduce the footprint of assets in their portfolio, and at what cost, is equally important. While the green premium derived by cleaner assets is difficult to quantify, this should not deter managers from identifying which assets are more exposed to transition risk and what investments are required. 

Why investors should plan offset strategies today

Ultimately, given the current state of technology, even best-in-class real assets will continue to generate some emissions through their lifetime. Once emissions are minimised, the question of how to offset the balance must be addressed.

One option is to buy credits generated by a project elsewhere. The voluntary carbon offset market is growing, but still in its infancy with limited visibility on future long-term volumes and pricing.

Another option to offset emissions is investing in carbon-negative technologies, otherwise referred to as in-setting, which gives investors more control and visibility on the price and volume of future offsets.

Nature-based solutions offer an interesting avenue

Nature-based solutions, including forestry and peatland, offer an interesting avenue. Forestry projects already account for the biggest share of carbon offsets. Directly investing in the sector can provide more control, although scalability of investments remains an issue.

Other carbon-negative solutions will evolve. Most are early in their development and lacking a strong investment signal (such as carbon capture and storage), or at an experimental stage (direct air capture).

Yet, with all forecasts pointing towards a materially higher cost of carbon in future, offsetting carbon via new real asset investments offers the enticing prospect of further portfolio diversification as well as real environmental impact.

3. Key takeaways

  • Through the responsible investment and management of infrastructure and real estate, investors have a real opportunity to reduce emissions and help the transition to a net-zero world
  • To do so will require detailed understanding of the carbon impact of different sectors and assets, today and over the coming decades
  • Such analysis can help investors minimise the carbon footprint of their portfolios and deliver on their net-zero ambition. The early detection of winners and losers should also reap benefits in terms of portfolio returns
  • Achieving net zero will also require investment in carbon-negative technologies. Quantifying and planning these investments now can increase investors’ confidence regarding their future carbon trajectory

Case study: Aligning broadband portfolios to net zero

Developing better broadband connections, including through fibre, is at the core of many countries’ strategies to reduce social inequality. From an environmental standpoint, fibre networks are relatively low-carbon emitters while in operation due to their long life and low maintenance.

Furthermore, rural networks can reduce the need for commuting long distances to work. However, building and laying down networks generate emissions. An analysis of all these factors is required to map out the carbon impact of each individual network.

Figure 5: Comparing the carbon emissions of three fibre broadband networks (tCO2)

The three illustrative networks in Figure 5 are expected to avoid more emissions than they create over their lifetime. However, network C emits far less. Understanding what drives this difference can help investors improve the performance of owned assets and better price risk on new investments.

Source: Aviva Investors, December 2021

Incorporating carbon into sector allocations using transition value-at-risk

Using the CRREM model,3 it is possible to estimate the future pathway of different real estate sectors and compare these to the required emissions pathway to achieve net zero by 2050. Assets will naturally decarbonise as the power sector relies more on renewables, but not enough to reach net zero without substantial investment. The increasing divergence between each sector pathway and forecasted decarbonisation is illustrated in Figures 6 and 7.

In Figure 8, we have used our internal assessment of carbon prices to calculate the net present value of this divergence (transition risk) today and in five years’ time. As the chart shows, transition value-at-risk is relatively modest today for most real estate sectors but could increase markedly over the next five years.

Figure 6: Carbon pathway divergence (£ / sqm)

A similar analysis can be done for renewables, comparing carbon emissions of each technology with forecasted future grid emissions. In Figure 8, we have used the balanced net-zero pathway presented by the Climate Change Committee4 – which assumes fast decarbonisation of the UK grid – as the reference case.

This shows renewables have a positive, but decreasing, impact. Investors may have different views of sector impacts, depending on their assessment of technology, carbon prices and the trajectory of the economy. But developing an internal view on a consistent basis of the transition risk of each sector can help investors construct portfolios that are most suited to their decarbonisation objectives.

Figure 8: Comparing transition value-at-risk by sector (per cent)

Source: Aviva Investors, December 2021

Source: Aviva Investors, December 2021

Figure 7: Transition risk (per cent)

Source: Aviva Investors, December 2021

References

  1. Laurence Monnier, ‘Measuring the mythical: Quantifying the green premium in real estate’, Aviva Investors, July 21, 2021
  2. Robert Plummer and Beth Timmin, ‘COP26: UK firms forced to show how they will hit net zero’, BBC News, November 3, 2021
  3. ‘Carbon risk real estate monitor global pathways’, CRREM, 2021
  4. ‘The sixth carbon budget: The UK’s path to net zero’, Committee on Climate Change, December 2020

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