Portfolio approaches to net zero

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.

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

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