Strategies for Decarbonizing Portfolios and Accelerating the Transition – Oxford/24 Report

This paper is part of the Fide Foundation’s GET-2 ESG Think-Tank final report from the 2024 Oxford Congress, titled “Driving Change: Exploring Opportunities and Challenges in Accelerating Sustainable Finance.”

ABSTRACT

The concept of transition finance is being steadily integrated into sustainable investing frameworks, which is critical, given its reach across ESG, Climate, Sustainability and Impact investing. Moving from «brown» to «green» has greater global resonance than simply being «green”.

Since the Paris Agreement the world has evolved a lot, but there is still need to do more to meet Net Zero in 2050 or sooner. Data about current emissions, and funds offering emissions reductions and climate solutions are now common. The next frontier includes setting targets, achieving them, and increasing investments in taxonomy-aligned activities. An investor setting a net zero strategy must be aware of the biases it might incur when selecting its strategy, the limitations in the different asset classes and the real progress of the underlying companies.

Significant financial resources are required to transition to a Net Zero economy, but it is our conviction that achieving Net Zero can complement other initiatives to support resilient economic development and inclusive growth. This economic transformation implies a wide range of risks and opportunities that investee companies could face across short, medium and long-term timeframes. A company with a credible climate transition strategy for example is expected to exhibit lower transition risks, for example by avoiding future stranded assets. At the same time, the company might profit from an increasing demand for products and services with a lower Greenhouse Gas footprint. In this context, investors should seek to influence companies to actively plan for climate transition and a net-zero future through risk mitigation and adaptation but also by seizing the significant climate investing opportunity set.

Appetite for forward-looking climate measures is strong from the market and based on the methodologies suggested by the Net Zero Investment Framework 1.0 .

KEY FINDINGS

Current Focus on Decarbonization

• Emphasis on data and bacward-looking measures
• Investment in funds targeting emissiones reduction and climate solutions

Future Pathway: Forward-Looking Strategies

• Importance of SBTi and Capex to achieve net zero
• Transition requires engagement from the entire economy, not just climate-focused providers

Awareness of Biases

• Considerations include risk/return profiles, sector biases, tracking errors, and reduced diversification due to exclusionary strategies.
• Acknowledging the trade-offs involved in exclusion versus engagement.

Decarbonizing Portfolios: Broader Perspective

• Recognizing that decarbonizing investment portfolios is integral to the overall transition of the global economy.
• Understanding the connection between SBTi science-based targets, governance standards, and current emissions levels.

Interplay of Financial and Climate Goals

• Aligning financial interests with climate objectives is essential for meaningful progress.
• A holistic approach is necessary to address the complexities of decarbonization in investment strategies.

CONTENT

The Paris Agreement and Current Emissions Trajectory

The Paris Agreement, established in 2015, aims to limit global temperature rise to well below 2°C, ideally 1.5°C, above pre-industrial levels. Since then, a lot has been done but much more is still needed to reach the objective to limit the temperature rise to 1,5ºC . This target is based on scientific evidence that exceeding it would lead to severe climate-related risks. The Agreement emphasizes aligning financial flows with low-carbon development, highlighting the financial sector’s role in this transition. To meet the 1.5°C goal, achieving net zero emissions by 2050 with an early peak in emissions is essential.

Despite these commitments, global emissions continue to rise, threatening the remaining carbon budget, which could be exhausted in just five years under current policies.

Science-Based Targets and the Role of SBTi

Science-based targets are crucial for aligning economic activities with the 1.5°C trajectory. The Science Based Targets initiative (SBTi) provides a framework for companies to set these targets, ensuring they contribute to global decarbonization.

As of today, 22% of the listed companies have SBT target approved, but the percentage of companies with some kind of climate targets is higher than 56%.

Looking at market cap, figures are also high. In the big and mid cap universe of the Europe region more than 60% of the universe has SBTi targets approved. Europe is clearly a leader, because in the EUR credit space the figure is also high, almost reaching 50%. Emerging markets, both in listed equities and credit are laggards in this aspect not achieving 20%.

Founded in 2015 by four NGOs, the SBTi has become a global standard-setter, aiming for 10,000 validated targets by 2025. However, governance challenges have arisen, particularly regarding self-validation and transparency. Recent issues include the SBTi Board allowing carbon offsets for scope 3 targets, highlighting the need for stronger governance and diversified funding. Investors, as SBTi signatories, should engage on governance matters.

Data and Emissions Disclosure. Scope 3 targets

The evolution of decarbonization efforts in the asset management industry has largely centered on data and the development of products aimed at emission mitigation strategies. These strategies focus on solutions designed to reduce emissions and products with specific emission reduction targets, both relative and absolute. When it comes to data, the improvement in company emissions disclosure has been notable, particularly regarding Scope 1 and Scope 2 emissions. Currently, about 70% of listed companies report these measures. However, the coverage for Scope 3 emissions is significantly lower, at just under 50%.

Understanding the challenges associated with Scope 3 reporting is crucial:

• Scope 1 emissions refer to direct greenhouse gas emissions from sources owned or
  controlled by an organization,
• Scope 2 emissions are indirect emissions associated with the purchase of
  electricity, steam, heat, or cooling.
• Scope 3 emissions, on the other hand, result from activities not directly controlled
  by the company but that affect its value chain, encompassing both upstream and
  downstream activities.
• Scope 3 emissions, to accurately report, companies must rely on data from their suppliers, make estimations about the usage of their products, and address the complexities of potential double counting. This complexity contributes to the lower level of reporting for Scope 3, as companies tend to disclose only the most material aspects.

In the context of investments and portfolio management, particularly in the asset management sector, the reporting for Scope 1 and 2 emissions is notably high when measured by market capitalization. For developed markets, this figure approaches 100%, while emerging markets report close to 90%. Data providers often employ methodologies to estimate missing values, resulting in nearly complete coverage of big and mid-cap listed equities. In the credit market, the coverage is also strong, reaching around 90% in the reported and estimated universe. This comprehensive data landscape enables more informed investment decisions aligned with decarbonization goals, but the persistent gaps in Scope 3 reporting underscore ongoing challenges in achieving a full understanding of corporate emissions.

Focusing on Scope 3 emissions reveals a complex landscape. While the combined coverage for these emissions is relatively high, it primarily relies on estimations, as previously mentioned. In fact, estimated Scope 3 data is available for 100% of the main equity indices. Within the asset management industry, there is a growing array of offerings that provide climate targets related to emission reductions, both relative and absolute, as well as climate solutions. This allows investors to construct diverse strategies, such as maintaining a core portfolio composed of funds specifically targeting emission reductions, alongside a satellite approach that invests in pure solutions providers, which can be classified as thematic investing.

However, it’s important to note that these pure solutions providers typically exhibit mid to high tracking errors. This variability means that while these investments may align closely with decarbonization goals, they can also introduce greater risk relative to broader market benchmarks. Therefore, investors must carefully consider the trade-offs between pursuing aggressive climate strategies and maintaining portfolio stability.

Taxonomy

A clear way to achieve the decarbonization of the economy is investments in Taxonomy, being the European Taxonomy the most known and developed. The Taxonomy classifies activities in an objective and scientific way to declare them as sustainable or not. The Taxonomy has three ways of measurement: revenue, opex and capex, being capex the way to decarbonize the future economy. This is due to the clear cause-effect relationship as today capex leads to future increase in taxonomy aligned revenue.

Taxonomy main issue is the current low figures both for revenue and capex in the main equity and credit indexes. The maximum estimated revenues are 10% for the big and mid cap universe in US capital markets, meanwhile in the reported one is around 4% for the Europe equity and EUR credit. For capex, the reported ones are close to 10% in the EUR credit, and almost 7% for Europe equity. As only the European companies are obliged to report these figures, the numbers are obviously biased.

To accelerate the transition some form of incentives needs to have the investments in taxonomy aligned activities, not only in Europe, but in all other regions where it has some or tries to have it. These incentives could come from public policies or from investors demand.

Leveraging Frameworks and Engagements for Financial Institutions

Financial institutions can utilize frameworks like the Net Zero Asset Managers initiative (NZAMI) and SBTi to incorporate science-based targets into their strategies. NZAMI commits institutions to achieve net zero by 2050, while SBTi helps set and validate interim targets.

Decarbonization strategies are critical for investors embarking on their journey toward net zero, necessitating a clear approach that accounts for potential biases associated with various climate-related indices, such as the European Regulation’s Climate Transition Benchmark (CTB) and Paris Aligned Benchmark (PAB). Both CTBs and PABs are designed to invest in portfolios of companies that adhere to specific restrictions aimed at reducing greenhouse gas emissions annually, ultimately achieving net zero by 2050. While both benchmarks require an initial reduction in carbon intensity—30% for CTBs and 50% for PABs—PABs are more stringent, incorporating stricter exclusions such as companies exposed to fossil fuels and highemitting electricity providers.

The more restrictive nature of PABs often leads to reduced diversification and increased tracking error compared to broader market indices, with tracking errors for PABs frequently exceeding 3%. In contrast, CTBs typically allow for some sector inclusion, enabling companies to transition and potentially re-enter the indices if they reduce their emissions, resulting in tracking errors ranging from 1% to 3%. For instance, sector deviations for CTBs tend to remain within ±1%, whereas PABs can see deviations close to 5%, particularly notable in the energy sector, where inclusion is highly unlikely.

These exclusions can significantly impact relative returns, especially in volatile market conditions. For example, during 2022, when the energy sector performed exceptionally well due to geopolitical tensions, the PAB underperformed relative to the CTB by nearly 3.5%. Therefore, investors who prioritize tracking error, investment opportunities, and aiding transition may find CTB benchmarks and similar products more appealing than PABs in the listed equities space.

The fixed income landscape, while less developed in this context, is beginning to see more indices and products, predominantly in the form of PABs. Current evidence suggests that while sector deviations in fixed income may be comparable to equities, tracking errors remain minimal, and long-term returns do not differ significantly except during periods of heightened stress.

An innovative initiative from the Platform for Sustainable Finance in the European Union introduces the EU Taxonomy Aligning Benchmarks, which includes two versions similar to CTBs and PABs. Notably, it lacks an initial carbon intensity reduction requirement, allowing high-emitting companies committed to transition a better chance of inclusion. Additionally, it mandates a 5% annual increase in capital expenditures for companies with high levels of taxonomy-aligned activities, aiming for full taxonomy alignment by 2040 for all capex securities.

While it remains to be seen how this proposal will be implemented, its potential to minimize tracking error compared to core indices, alongside incentivizing investments in taxonomy, presents an intriguing path for investors seeking to balance transition efforts with financial performance.

Active ownership is vital, where investors engage with companies to encourage the adoption of science-based targets. The debate between exclusion and engagement is significant: while exclusion can decarbonize a portfolio, it does not affect the real economy. Engagement enables investors to influence companies, driving actual emissions reductions.

Key engagement topics include:

• Ensuring credible net zero commitments
• Effective governance with board oversight
• Transparency in target disclosure

When successful, these engagements contribute to decarbonizing the real economy. With the focus in transition investors might help companies that are now high emitters to change and to adapt to be able to be net zero by 2050 or sooner, providing the funding they need for this journey as well as establish a dialog through engagement.

Global Transition: A Reality Check and Opportunities

Despite various pledges and investments, the global transition to a low-carbon economy is insufficient. Low-carbon energy sources are growing but not displacing fossil fuels, which continue to dominate energy demand.

Asia, representing about 60% of the global population and CO2 emissions, is crucial for the transition. However, it faces a climate finance gap, requiring an annual investment of USD 1 trillion for effective mitigation and adaptation. For meaningful decarbonization, substantial investment and engagement in Asia’s transition are essential.

Conclusions and Proposals

The world needs more investments to reach the goal of limiting the temperature rise, and to do so, the whole economy must transition. Incentives need to be in place from public sources, investor demand and consumer behaviour in a world scale.  

Final investors need to know that tilting to decarbonisation could result in different risk/return profile, and take into account that this theme is still developing so that future adjustments and additions of new features might be needed, as well as that any climate target will ultimately depend on the real progress of the underlying companies.  

Emission reduction targets, taxonomy aligned investments and engagements are ways how the asset management industry might help to transition to a low carbon economy. Companies with credible climate targets and investments in taxonomy aligned activities must be supported and not penalized by its starting point.  

Conclusion and Call to Action 

Decarbonising portfolios is not just about aligning with climate goals but also about driving systemic change in the global economy. By setting science-based targets, engaging with investees and initiatives like SBTi and NZAMI, and strategically investing in regions like Asia, investors can play a transformative role in the global transition towards a low-carbon future. The journey is fraught with challenges, but with robust governance, active engagement, and strategic investments, the financial sector can significantly contribute to achieving the Paris Agreement’s ambitious goals. 

In particular, investors should: 

1. Engage with SBTi on Governance: Investors should push SBTi to improve its governance to ensure independence and transparency. 

2. Invest in Asia’s Transition: Given Asia’s pivotal role in global emissions, targeted investments and engagement in the region are crucial for meaningful decarbonisation. 

AUTHORS

Oxford/24 Final Report:

This paper is part of the Fide Foundation’s GET-2 ESG Think-Tank final report from the 2024 Oxford Congress, titled “Driving Change: Exploring Opportunities and Challenges in Accelerating Sustainable Finance.” Held at Jesus College, Oxford on September 18th, 19th, and 20th, 2024, the Congress brought together world leaders in finance, regulation, and sustainability. This comprehensive report consolidates key insights from the event, offering strategic recommendations to financial institutions and regulators on transitioning to a low-carbon economy and reaching net-zero greenhouse gas emissions by 2050. 

The full report can be found at: https://bit.ly/oxf24-report