More than one fifth of the world’s largest listed companies have committed to net-zero targets, but few have detailed roadmaps to get there. Mirza Baig considers the challenges for investors managing transition pathways.

Read this article to understand:

  • How to turn talk of net-zero targets into action
  • Practical portfolio considerations for analysing decarbonisation pathways 
  • How engagement can promote change

Financial services businesses have just begun the complex businesses of working out how to deliver on their net-zero ambitions, which by extension will require them to understand the intentions and plans to reduce emissions of all the businesses they lend to, invest in or insure. 

It is an enormous challenge, and although there is a clear groundswell towards decarbonisation, it is reasonable to assume no firm has this all figured out.

It is important to be transparent about what still needs to be done to deliver on net-zero

With that in mind, it is important to be transparent about what still needs to be done.

The first issue is the need for a common framework for forward-looking climate models. Many asset managers and asset owners have made long-term net-zero commitments, but to have any prospect of achieving these targets, we need to ensure there are carbon reduction plans in place for 2025 and 2030. This is the only way we can guard against dramatic last-minute, and potentially value-destructive, trading as we approach important milestones.

Mind the gap: Practical steps towards quantifying corporate carbon emission trajectories

To reach our goal, we need a detailed understanding of the carbon reduction and milestone timelines we expect from each of the companies we invest in. This will allow us to assess how much progress could be made based purely on what investee organisations are doing themselves.

We can work out the size of the emissions gap and plan for gradual adjustments to meet the goal

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 reduction target based on their efforts? From that point, we can work out the size of the emissions gap and plan for gradual adjustments to meet the goal.

For example, if we had a 25 per cent carbon reduction target, and company action took us down 23 per cent, we could close the remaining two per cent gap with some minor portfolio adjustments - perhaps switching positions in companies within the same sectors without changing risk metrics significantly.

On the other hand, we might find realistic corporate decarbonisation projections are only likely to cut emissions by around ten per cent at the portfolio level, leaving a 15 per cent gap. In that case, we might need to change company and regional exposures more radically, with material risk and return implications. Figure 1 suggests practical steps to manage corrective action.

Figure 1: Enhancing climate intensity projections

The way forward:

  • Develop asset class and portfolio carbon budgets
  • Integrate sector and regional decarbonisation assumptions
  • Use active management to close the gap
  • Monitor and plan corrective action
Source: Aviva Investors, March 2022

Managing this process in the least disruptive way will require managers to set annual carbon intensity budgets at a portfolio level. This will allow effects to be smoothed gradually over time.

However, our ability to carry this out depends on the quality of forward-looking carbon-intensity models. The immediate problem is that few companies currently disclose what their carbon reduction plans are. For instance, only six per cent of the constituents of MSCI’s All Country World Index have disclosed decarbonisation targets for the next five to ten years.

The industry needs to come together and agree on a better way to build forward-looking carbon models

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 portfolio adjustments may be required further down the road.

What the industry needs, then, is to come together and agree on a better way to build forward-looking carbon models, with assumptions that reflect the way corporate behaviour changes over time. Trends in regulation, technology, and supply and demand dynamics are all vital. These assumptions need to include realistic assessments about how likely it is companies can deliver what they say they will. There is also a lot of work to be done to project decarbonisation pathways for companies who currently make no formal disclosures.

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 climate signals are not effectively or consistently translated into valuations. We can see this issue now in the way debt issued by oil and gas companies has been valued relative to the broader investment-grade debt market.

The next challenge is managing portfolios when climate signals are not translated into valuations

Recent research from HSBC shows evidence of a climate risk premium among European energy companies, which underperformed the broader market by seven basis points in 2021, despite credit fundamentals improving as the oil price rose and leverage came down.1

In the US, it was a different story. Returns from the oil and gas sector were double the broader investment-grade market (see Figure 2), and a significant part of the outperformance was due to spread tightening – the opposite of the European experience. Meanwhile, in Asia Pacific, climate risk had little impact on credit performance at all.

Figure 2: Credit | USD Energy significantly outperformed the broader USD IG Index in 2021 (excess return/duration (basis points))
US$ energy significantly outperformed the broader USD IG Index in 2021
Source: Bloomberg, February 2022

So, although European oil and gas majors are thought to be ahead of peers with strategic climate positioning, risk concerns were almost exclusively restricted to the region.

Climate-minded investors' portfolios would be penalised in terms of performance for factoring in climate

What are the implications for climate-minded investors? If they had integrated climate considerations into their portfolio construction process, they could have gone overweight European names relative to the sector (due to their climate positioning) or underweight the entire sector, regardless of geography. In both scenarios, they would have likely underperformed in 2021. Essentially, their portfolios would be penalised in terms of performance for factoring in climate – until that point when transition and climate risks are realised.

By that time, it’s simply too late.

Addressing pricing anomalies

So, how can we address this mispricing? The first consideration is improving the quality and consistency of climate accounting. Companies are making strides in this area and becoming more transparent about how climate factors might impact cashflows, asset valuations and liabilities under different scenarios. We hope greater compliance with the Task Force on Climate-Related Financial Disclosures guidelines will help address some of the gaps.

We need to adjust our tolerance of short-term underperformance

Secondly, we need a more robust approach to carbon pricing, so externalities connected to emissions are fully internalised and priced in by the market. We also need to adjust our tolerance of short-term periods of underperformance, so climate-aware investors are not forced to make tactical, sub-optimal investment decisions based on near-term commodity or economic cycles.

The role of technology and carbon offsets

Another important consideration is the role technology and carbon offsets might play in a company’s transition plan. The chart in Figure 3 is taken from an Australian company’s roadmap to net zero, but it is typical of what is being produced in other markets. The use of hydrogen, carbon capture and storage (CCS) and nature-based offsets often appear in net-zero roadmaps.

Figure 3: Reliance on new approaches on the path to net zero
Reliance on new approaches on the path to net zero
Source: Santos, December 20202

Technology will undoubtedly reshape the future, but we need to be mindful of limiting factors and the scaling up required to deliver decarbonisation needs. For instance, at the end of 2020, there was only enough capacity to capture around 40 million tonnes of carbon dioxide per annum around the world. That capacity would need to be scaled up around 140 times by 2050 to meet industry needs.

Most companies also include green hydrogen in their decarbonisation pathways, yet the total market size was only $1.8 billion in 2021. This is a drop in the ocean compared to what is required.

While we hope technology develops rapidly and society finances its deployment, there is high risk associated with current projections. Once again, this does not appear to be properly factored into long-term risk assessments, particularly in high-emitting sectors. Given we need a near 50 per cent reduction in emissions by the end of the decade, a more balanced approach is required. We need greater focus on emissions reductions happening now, as opposed to those proceeding with business-as-usual and hoping new approaches will miraculously solve problems in the future.

Engagement versus divestment

Finally, it is important to consider engagement and divestment 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.

Firstly, we need to communicate clearly. We cannot issue broad statements about the need for climate strategies; we should be more granular and detail specific actions we expect around carbon pricing, capital expenditure, management incentives and so on.

We need to be bold enough to walk away if companies are non-responsive

Secondly, we need a more robust, objective way to assess how companies are progressing. Third, we need to be bold enough to escalate our concerns after a reasonable timeframe and walk away if companies are non-responsive. This requires firm commitment: if a company in our climate engagement escalation programme3 does not achieve a minimum score in our assessment framework or cannot demonstrate significant improvement from the base year, we will divest our holding.

The final point is that engagement is usually presented as an equity story, but that is not what it could or should be. During the peak of the pandemic, we saw companies come to the debt market more than twice as often as they tapped equity markets. The trend was even more pronounced in industries with challenging decarbonisation pathways ahead of them – in utilities, transport and even banks. Creditors now have a real opportunity to impress their ESG expectations through engagement as part of the issuance process. The reason this has not happened so frequently to date is not about influence or opportunity; it is about culture and willingness. We all have a role to play changing this.              

Confronting uncertainty

Net zero is a vast and ambitious goal, and we know the journey will be tough and uncertain

Net zero is a vast and ambitious goal, and we know the journey will be tough and uncertain. We need better carbon-intensity projections to help us navigate; to ensure climate considerations are reflected more accurately in valuations; to focus on practical actions to reduce absolute emissions and ensure we engage tirelessly to convey our priorities.

Ultimately, the health of the planet and our own success depends on how well we manage the delivery.

Related views

Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

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