Equity investors tackle carbon vs climate objectives

Oct 25, 2021
Essential to clarify climate-related beliefs and goals

With the asset management industry now firmly focused on climate change, investors must strike the right balance between cutting portfolio emissions today and investing with the aim of reducing emissions in the real economy tomorrow. 

Climate-aware equity strategies are receiving particular attention from asset owners such as pension funds, insurers and endowments: approximately a quarter of new equity manager searches conducted for institutional clients by bfinance during the last year have explicitly targeted a reduction in the portfolio’s carbon intensity, and nearly one in six required net-zero alignment. 

Yet not all climate-aware strategies are created equal. Although there is a rapidly evolving menu of strategies from which to choose, the potential outcomes are extremely different. In order to identify which strategies will best fit an investor’s needs, it is essential to clarify climate-related beliefs and goals. 

Investors’ objectives are evolving

Among investors, we find a variety of different objectives relating to carbon and climate. Three types in particular stand out. The first is a reduction in carbon emissions, where the objective is to achieve a cut in carbon footprint in absolute terms or relative to a benchmark. The second is climate risk management, where the objective is to manage and mitigate exposure to physical and transitional climate risk, usually in addition to reducing the carbon footprint. The third is impact, where the ultimate objective is to achieve positive environmental outcomes aligning with the low-carbon economy. 

Overall, it appears investors’ attention is now shifting away from focusing primarily on carbon emissions and toward the more forward-looking climate risk-oriented approaches.

There is a range of factors driving investors toward developing objectives around carbon and climate. Regulatory pressure is ramping up and compelling investors to – at the very least – consider their carbon exposure and ask whether it may present potential issues. Stakeholder management and reputational risk have also been key drivers for investors that are aggressively cutting their portfolio carbon footprint.  

Investment outcomes over the medium and long term are top of mind, too: as the world transitions toward a low-carbon economy, successful investors will be those that successfully capture forward-looking climate risks and opportunities to improve resilience and returns.

Understanding equity strategies

Once investors articulate their climate-related goals, it becomes somewhat easier to map the landscape of available strategies.

For investors focusing on carbon reduction, there are several passive and active solutions that aim to achieve below-benchmark or absolute reductions in emissions through exclusions and tilts. The strategies represent an effective way to materially reduce portfolio carbon footprints and mitigate exposure to high emitters, predominantly considering carbon emissions and fossil fuel reserves.

Emissions data, however, is backward-looking and static and does not consider a company’s commitment to adapting to a low-carbon economy. Arguably, this approach limits the investor’s influence over companies that will be more relevant to the transition, and (therefore) their potential to contribute to the transition to a low-carbon economy. 

To combat this challenge, there is a rapidly growing universe of both passive and active products that we classify as ‘climate risk’ strategies. These combine carbon emissions data with forward-looking data, such as a company’s net-zero trajectory and commitment. Such strategies are intended to enable investors to manage climate risk while capturing opportunities created by climate change. 

It is important to note that these climate strategies may result in higher carbon footprints than the strategies in the prior group – especially in earlier years – as they can hold companies that may be high emitters but demonstrate a commitment to transitioning to a low-carbon economy. Other challenges may include short track records and an evolving regulatory and fund taxonomy that can make it difficult for investors to compare strategies. 

Hurdles notwithstanding, we view this group as offering a viable opportunity for investors that seek to align themselves with the transition to the low-carbon economy. 

Finally, we see an ever-growing group of equity managers that go further and seek to deliver impact: measurable environmental outcomes alongside financial returns. These strategies provide a more concentrated focus on companies that can provide solutions to the existing environmental challenges, and often focus on themes such as the clean energy transition, water, biodiversity, sustainable forestry, sustainable agriculture, and so on. 

Engaging with companies on impact progress is a critical part of this type of strategy. Investors seek tangible outcomes that can be quantified and communicated to stakeholders. Although measurement is not straightforward, the methodology and metrics surrounding ‘impact’ are improving rapidly. 

Taking a cautious approach

We view investors’ growing focus on climate risk and the ongoing evolution of investment strategies in this space as an extremely positive shift – for risk management, for investment opportunity and for the planet at large.

First and foremost, however, investors must carefully clarify their overall objectives and philosophy. In doing so, we must understand not only whether those objectives are contributing positively or negatively to the global climate change agenda but also how they will align with the potential investment and measurement approaches that are now available.

Sarita Gosrani is director of ESG at bfinance

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