Financial services businesses have begun the complex businesses of working out how to deliver on their net-zero ambitions and play their part in tackling climate change.
Banks, insurers and asset managers are all setting net zero targets – where net zero refers to the balance between the amount of greenhouse gas produced and the amount removed from the atmosphere. This, in turn, requires a detailed understanding of the carbon reduction plans and milestone timelines from the companies they lend to, insure and invest in. Their success (or failure) to achieve net zero targets is therefore directly dependent on what other companies are doing.
For asset managers like us, we need to ask: if we hold the same names in our portfolios throughout a measurement period, how close will we get to reaching our own carbon reduction target based on their efforts? From that point, we can work out the size of the carbon emissions gap and plan for gradual adjustments to meet the goal.
The immediate problem is that few companies currently disclose their carbon reduction plans. For instance, only six per cent of the companies in MSCI’s All Country World Index – which tracks global equities - have disclosed decarbonisation targets over the next five to ten years.
The only way to address the data gap is to make assumptions about what might happen
The only way to address the data gap is to make assumptions about what might happen. Unfortunately, the models that currently exist to help with this are wholly inadequate. If we rely on them, drastic adjustments to the investments in our portfolios may be required further down the road.
The greater the accuracy and robustness of the models we develop, the better position we will be in to deliver our carbon reduction goals, without impeding our ability to deliver on our risk and return objectives.
Addressing mispriced assets
The next challenge is managing portfolios when the measures companies are taking to address climate change are not effectively or consistently translated into valuations. That involves improving the quality and consistency of the data used to measure how much carbon an entity emits.
Secondly, we need a more robust approach to carbon pricing - the cost of the impact of carbon emissions that the public pays for, such as damage to crops. This will allow investors to better understand how companies should be valued.
The role of technology and carbon offsets
Another important consideration is the role technology and carbon offsets – where entities pay someone else to cut or remove a given quantity of greenhouse gas from the atmosphere - might play in a company’s transition plan.
Technology will undoubtedly reshape the future, but we need to be mindful of its limits and the costs
Technology will undoubtedly reshape the future, but we need to be mindful of its limits and the costs.
Engagement versus divestment
Finally, it is important to consider engagement and divestment – talking to entities and withdrawing funds if they fail to act on climate change - and their role in achieving net zero.
Our view is that engagement should always be a starting point, but we need to be smarter and make it more impactful.
Three points to remember
- Achieving the goals required to address climate change requires a much better understanding of how the companies we invest in are affecting the issue and their plans to reduce the greenhouse gases that cause climate change
- That will help us to more accurately price companies and adjust our portfolios to ensure our goals on climate change are being met
- Talking to the entities we invest in to better understand them and to influence their behaviour is one of the best ways of achieving our goals. But we must be prepared to walk away and divest from companies that do not act with the urgency required