With governments struggling to turn words into action on climate change, investors can ensure the private sector plays its part by pushing firms to adopt science-based targets, argues Rick Stathers.

Read this article to understand:

  • Why it makes sense for companies to set science-based targets
  • How firms can amplify emissions cuts by pressuring others along their value chains
  • Why this approach can improve investors’ understanding of the climate impact of their holdings

Time is running out if the world is to prevent potentially lethal global warming. While there were some signs of encouragement at the November COP26 summit in Glasgow, the agreements struck do not appear to go nearly far enough to prevent a further catastrophic rise in emissions.

In any case, experience suggests governments will struggle to turn words into action, unless and until countries are able to spread the burden of tackling the problem in a just and equitable manner. As such, the onus is likely to be on private-sector companies to step up efforts to cut their own carbon footprints. Unfortunately, as with nations, all too often there appears to be an incentive for firms, at least in the short term, to free ride off the efforts of others.

That leaves bond and equity investors with an important role to play in trying to ensure investee companies are transitioning their businesses, and not just for altruistic reasons. Since climate change arguably represents the biggest long-term systemic risk in portfolios today, they have a financial incentive to do so too. Extreme weather events such as droughts, floods, storms, forest fires and heatwaves are already affecting a wide range of companies in every corner of the globe. Over time, all companies will potentially be impacted by such physical risks.

Then there is the danger of assets becoming stranded as the world transitions away from burning fossil fuels in favour of renewable energy. Even companies that appear to have a small carbon footprint are vulnerable; banks, for example, are heavily exposed to climate risks in their loan books.

In recent years, growing alarm over climate change has driven rapid growth in the value of assets managed under an ESG mandate. According to the Global Sustainable Investment Alliance, ESG assets exceeded $35 trillion at the start of 2020, representing 35.9 per cent of total assets under management, up from 33.4 per cent in 2018.1 Bloomberg Intelligence reckons the world is on track to have a $1 trillion ESG exchange-traded fund market and an $11 trillion ESG debt market by 2025.2

Investing in the climate transition is far from straightforward

Nonetheless, investing in the climate transition is far from straightforward. For a start, it requires a good understanding of the climate risks facing equity and bond markets, sub-categories within those, and individual companies. For example, utilities face much higher decarbonisation risk than healthcare companies. But within the utility sector, whereas water companies will face higher physical risk from water scarcity, electricity generators are exposed to greater carbon regulatory risk. At the individual company level, one automaker may be further advanced than another in terms of transitioning to electric vehicles.

There are several potential drawbacks in the way ESG funds traditionally allocate capital. Many managers will often focus on companies that are providing technologies designed to tackle climate change – such as electric vehicle manufacturers, renewable energy providers, firms delivering energy-efficiency solutions or more sustainable forms of agriculture – or others offering ways of mitigating its impact: think manufacturers of air conditioning and drip irrigation systems or healthcare firms.

A scientific approach to measurement

One problem with this approach is that it is naïve to believe companies which provide climate solutions such as these can deliver the required transition on their own. At the same time, fossil fuel companies and other heavy carbon emitters will tend to be avoided. Given that burning most fossil fuels will not be banned in a hurry, all companies, including high-carbon emitters, have a role to play.

Another criticism of traditional ESG investment approaches is that while fund managers may pick the right companies to meet an emissions intensity target, doing so does little to tackle the real-world issue: total emissions from all companies within the fund’s benchmark might still rise.

Nearly all listed companies are under growing pressure to adopt ‘science-based targets’

This helps explain why nearly all listed companies are under growing pressure to adopt ‘science-based targets’ (SBTs) as a means of ensuring they have greenhouse gas reduction strategies in place that are aligned to specific climate objectives.

According to the Science Based Targets initiative (SBTi), a coalition formed in 2015 by the Carbon Disclosure Project, the United Nations Global Compact, the World Resources Institute and the World Wide Fund for Nature, SBTs specify by how much and how quickly companies need to reduce their greenhouse gas emissions. They simultaneously help firms by providing a clearly defined path to achieving this.

Targets are considered ‘science-based’ if they are in line with what the latest climate science deems necessary to meet the goals of the Paris Agreement – limiting global warming to well-below two degrees Celsius above pre-industrial levels and pursuing efforts to limit warming to 1.5 degrees (1.5°C). The process takes a sectoral decarbonisation approach, whereby it analyses each sector’s contribution to current emissions before determining what that sector’s pathway will look like out to 2050. That in turn makes it possible to set each company within any given sector an emissions pathway.

Setting an SBT should enable firms to reduce emissions in an efficient way

By helping firms better understand their own carbon footprint, setting an SBT should enable them to reduce emissions in an efficient way. This understanding is enhanced when the firm goes on to break its emissions down into the three different ‘scopes’, as defined by the GHG Protocol Corporate Standard (see Figure 1).3

Scope 1 refers to emissions made directly by the organisation itself, for example as it operates its furnaces or runs its vehicles. Scope 2 emissions are indirect emissions associated with the purchase of electricity and other types of power, while Scope 3 are all indirect emissions (not included in Scope 2) that occur in the company’s upstream and downstream value chains.

Figure 1: Greenhouse gas emissions through a company’s value chain

Greenhouse gas emissions through a company’s value chain

Source: Aviva Investors, GHG Protocol, 2021

A second potential shortcoming of traditional ESG investment approaches is their reliance on reported carbon emissions data as a means of identifying low-emitting companies. Not only is that information not always readily available, even where it is published companies have tended to focus on Scope 1 and Scope 2 emissions alone. By failing to consider Scope 3 emissions, reported carbon emissions data all too often omits a big contributor to global warming. Except for utilities, companies’ Scope 3 emissions tend to dwarf Scope 1 and 2 combined, as shown in Figure 2.

Figure 2: Source of emissions for different sectors (per cent)
Source: CDP, Aviva Investors’ calculations, data as of December 2021

Virtuous circle: Pressuring value chains

When setting SBTs, firms must include Scope 3 emissions where they account for more than 40 per cent of total emissions. This means that by setting SBTs, companies are not only giving investors confidence they are aligning their own business with a 1.5°C future. Crucially, those that include Scope 3 emissions in their reported data are also putting pressure on suppliers and users of their products to curb their own carbon footprint. For instance, logic suggests that eventually, suppliers which fail to curb their own emissions may struggle to hold on to customers.

There may be merit in having sizeable exposure to companies helping to drive the energy transition

From an investor’s standpoint, there may be merit in having sizeable exposure to companies helping to drive the energy transition. But equally, there is little sense in excluding other companies across all other economic sectors. While the investment case may not always be intuitive for those thinking about climate change, they will still have an important role to play if net-zero ambitions are to be met. Besides, focusing on both transition-ready as well as climate-solution companies broadens the opportunity set and diversifies portfolio risk. This can, in turn, help investors meet their needs for long-term sustainable returns, while accelerating the transition to a lower-carbon world.

Although measuring the financial performance of an investment product is a long-established process, the same cannot be said for assessing climate performance. Among a host of changes needed to get to 1.5ᵒC, fossil fuels need to be phased out and investment in solutions needs to increase.

Investment managers have devised multiple different ways of demonstrating their portfolio’s alignment with climate objectives. Although measuring overall emissions has probably been the most common method of assessing a portfolio’s climate performance to date, this metric offers little insight into what the strategy is achieving. It has several other drawbacks too, not least the near impossibility of comparing the portfolio’s climate performance with that of either a benchmark or a rival portfolio.

Two more refined measures of portfolio emissions have gained in popularity

This explains why two other, more refined, measures of portfolio emissions have gained in popularity. The first method assesses what is termed the portfolio’s ‘normalised carbon footprint’. This measures emissions in tonnes of carbon dioxide (CO2) per million dollars/euros invested. It can be calculated by multiplying the shareholding percentage in each company by that firm’s emissions to give the emissions ‘owned’. This is aggregated at the portfolio level and normalised by the market value of the portfolio, thereby enabling investors to compare investment products and benchmarks.

The second considers the carbon intensity of investments based on a portfolio’s claim on emissions and sales of the companies held within it, aggregated to a portfolio level. By measuring tonnes of CO2 emissions relative to corporate revenues, it once again enables investors to get a rough estimate of the carbon intensity of different portfolios and their benchmarks.

SBTs: Filling in the blanks

Unfortunately, although recent years have seen more and more portfolio managers adopting one of these metrics, they too have shortcomings. Unlike financial data, there is little regulatory or mandatory oversight of emissions reporting at a global level, and many companies still provide little or no data.

Since value-chain emissions are not represented in performance data, investors must rely on models to fill in, or estimate, unreported emissions to undertake portfolio assessments of carbon emissions metrics. That leaves the data subject to a large margin of error given that Scope 3 are the most significant source of emissions for most industries.

Carbon intensity can be susceptible to market forces

There are other caveats to consider; for example, carbon intensity can be susceptible to market forces. An oil and gas company would see its carbon intensity rise and fall as oil prices go up and down, despite its absolute emissions remaining constant. Different business models, for example high volume and low margin versus low volume and high margin, will be assumed to be equally comparable on an intensity metric as well.

There is also the challenge of avoiding double counting, for example the emissions of both an energy supplier and its customer, despite them often being the same molecule of CO2. At this early stage in the development of portfolio climate metrics, beyond providing rough estimates of the direction of travel and the performance of a portfolio relative to its benchmark, they are of limited value.

This is where the use of SBTs comes in. Understanding how companies are managing risks and developing climate resilience across their value chain not only aids the identification of transition-ready companies; by pressuring investee companies to adopt SBTs, portfolio managers can help ensure their capital-allocation decisions have maximum impact on the effort to tackle climate change. After all, they are even putting pressure on companies they don’t have stakes in to become more carbon efficient.

The number of companies setting SBTs is growing exponentially

While the idea of SBTs may still be in its infancy, the number of companies setting them is growing exponentially. According to the SBTi, within five years of its launch it was working with more than 2,000 businesses and financial institutions around the world to help them reduce emissions in line with climate science. As of November 2021, 1,045 companies spanning 60 countries and 53 sectors with a combined market capitalisation of $23 trillion had committed to targets in line with 1.5°C of warming.4

Figure 3: 1.5°C and net zero are now becoming the SBTi standard
Source: Science Based Targets, 20215

SBTi believes the ambition is “paying off”. It says there is evidence companies that have set SBTs are delivering emissions reductions in line with this.

“The 338 companies in our analysis collectively reduced their annual emissions by 25 per cent between 2015 and 2019 – a difference of 302 million tonnes, equivalent to the annual emissions of 78 coal-fired power plants,” it stated in a report published in 2020.6

Nowhere to hide for laggards

The hope is that as more and more companies set SBTs, others will be pressured into following their lead. After all, as this happens, those refusing to set targets will begin to stand out, potentially putting them at a competitive disadvantage.

Just as with other methods of comparing a fund’s climate performance though, SBTs are not perfect. For a start, carbon accounting is relatively opaque and subject to manipulation. As for the SBTi itself, it has yet to devise a framework for setting targets for some of the world’s biggest emitting sectors such as oil and gas, steel, cement, and transport.

Most companies are likely to have to set SBTs by the end of the decade

However, it is important to recognise the concept of SBTs remains a new one. The pressure for action to curb climate change will only intensify, meaning most companies are likely to have to set SBTs by the end of the decade.

While for the time being SBTs may only provide information on the direction of travel, as more and more companies adopt them, they are likely to become a closely watched metric. From an investors’ perspective, measuring a fund’s exposure to companies setting SBTs should begin to offer reassurance about the impact their investment is having and a yardstick to easily compare different investment opportunities.

Furthermore, unlike other, more traditional carbon metrics SBTs are forward looking. As for carbon accounting, it would be natural to expect it to become steadily less opaque as the scrutiny over company statements intensifies.

Given the economic damage excessive global warming threatens to wreak on pretty much every business, engaging with investee companies to set SBTs is not only in the interests of fund managers and their clients looking to have a positive impact, it also makes sense for investee companies.

By setting SBTs, the private sector will arguably be doing the best it can

By setting SBTs to align their value chains with their own business, they may see increased innovation, reduced regulatory uncertainty, strengthened investor confidence, and improved profitability and competitiveness. In doing so, the private sector will arguably be doing the best it can to fend off dangerous global warming.

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