Portfolio approaches to net zero

With asset managers, asset owners and public companies increasingly committing to a net zero emissions by 2050, we explore portfolio pathways to reaching this goal.

Portfolio pathways to net zero

A global net zero commitment establishes an aggregate timeline for achieving the well below 2°C target called for in the Paris Agreement. Many country and corporate net zero commitments target 2050, consistent with global targets to avoid catastrophic outcomes from climate change.

The global momentum toward net zero means that there will be a dramatic reshaping of the economy over the next few decades.  As investors look to mitigate the risks associate with climate change and lean into the opportunity set around the transition to a net zero economy, there are several options in terms of portfolio construction.

Highlights include:

01

Spectrum of sustainable strategies

Investing in the climate transition encompasses risk mitigation as well as a wide breadth of investment opportunities.

02

New dimensions in portfolio design

Innovations allow for enhanced integration of climate objectives with portfolio construction.

03

Detailed analytics complementing sustainable solutions

Leverage analytics to precisely evaluate sustainable strategies and identify potential risk factors.

Spectrum of sustainable strategies

Within investing approaches to the climate transition and the pathway to net zero, there are a variety of risk mitigation and investment opportunities to consider. We feel a useful framework for thinking this is from the standpoint of “Reduce, Prioritize, Target”.

  • Reduce: Significantly lower exposure to fossil fuel exploration, reserves, and in general a portfolio with a lower carbon profile. This mitigates risks likely caused by stranded assets re-pricing, increased regulation and costs, and changing consumer preferences.
  • Prioritize: Focusing on climate transition or physical risk reduction by incorporating forward looking data. This can help both mitigate risks and capturing opportunities by investing in companies/countries better positioned to benefit from the transition to a low-carbon economy.
  • Target: Target climate focused thematic exposures or impact objectives. This approach captures opportunities from disruptive technologies and discerns between new winners and losers, supporting and financing the low carbon transition.

Depending on the time horizon for transitioning a portfolio to net zero, as well as the underlying exposures and risk/return parameters, some combination of the approaches can be used to target the optimal carbon reduction while adhering to a portfolio’s broader return targets.

New dimensions in portfolio design

As investors are incorporating various sustainable investments within their portfolios, BlackRock has helped clients evaluate different strategies to help achieve the desired outcomes. One framework is through the development of a carbon intensity efficient frontier. Portfolios constructed along this frontier minimizes carbon intensity per unit of tracking error or active risk.

For example, the carbon reduction option in the below chart represents an illustrative portfolio that helps reduce carbon intensity by 60% with under 100bps of tracking error. From an information ratio perspective, this option also improves the overall risk-adjusted performance of the portfolio.

Carbon intensity efficient frontier

Minimizing carbon intensity per unit of active risk

Minimizing carbon intensity per unit of active risk
Minimizing carbon intensity per unit of active risk

Source: MPI, December 18, 2020 – December 20, 2020. Index returns are for illustrative purposes only and do not represent actual fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Case study shown for illustrative purposes only.  This is not meant as a guarantee of any future result or experience.

Detailed analytics complementing sustainable solutions

Combined with the carbon intensity efficient frontier, BlackRock can leverage the Aladdin platform to analyze portfolios with great granularity. This can help investors better understand active risk exposures and ensure the portfolios are positioned appropriately to target the desired outcome. Based on the previous example, we can analyze the carbon reduction option’s active risk is primarily driven by orthogonal, idiosyncratic risks and there are no meaningful style factor tilts.

As investors embark on their path to net zero, it’s imperative to utilize all resources and tools available to analyze the overall portfolio impact from various perspectives.

Positioning appropriately

Active risk exposures

Active risk exposures

Source: BlackRock, as of March 31, 2021. For illustrative purposes only. Ex-ante risk is defined as annual expected volatility and is calculated using data derived from existing and alternate portfolio holdings, using the Aladdin portfolio risk model. Ex-ante active risk is the standard deviation of the difference between portfolio returns and the specified benchmark portfolio returns. This proprietary multi-factor model can be applied across multiple asset classes to analyze the impact of different characteristics of securities on their behaviors in the marketplace. In analyzing risk factors, the Aladdin portfolio risk model attempts to capture and monitor these attributes that can influence the risk/return behavior of a particular security/asset. The numbers in the Factor Exposures chart above are Z-Scores which are statistical measurements of the number of standard deviations the portfolio's style exposure is away from the estimated total equity universe. The stated scores are in excess of the MSCI World Index.

Calvin Yu
Head of the Client Insight Unit
Kaitlin Bergan
Director, BlackRock Sustainable Investing
Bart Sikora
Director, Institutional Portfolio Consulting
Justin Kohley
Vice President, Institutional Portfolio Consulting

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