A multi-asset approach to navigating net zero
Multi-asset investors: Moving from climate pledges to practice
The Paris Agreement seeks to reduce emissions to limit the global temperature increase. This is often equated to transitioning to a “net zero” global economy by 2050. Investors globally are focusing on decarbonization. In March 2021, 22 asset owners with US$1.2 trillion in assets committed to cutting their portfolios’ carbon emissions to net zero by 2050.1 Because so few companies are currently aligned to net zero, we believe it’s impractical to build a diversified net zero portfolio. Rather, aligning a portfolio requires a multi-year pathway. Despite potential benefits to those who are early to the era of climate investing, aligning multi-asset portfolios to net zero comes with unique challenges and is achieved by evolving the integration of ESG considerations into the investment process. A framework is, therefore, our preferred approach as opposed to a single investment decision. This framework should facilitate change but be flexible enough to adapt to the portfolio’s progress in meeting decarbonization targets.
Key points
Different carbon metrics have different uses for investors
We evaluate various approaches to forward-looking metrics and identify an approximate “decarbonization rate” at the asset class level for multi-asset portfolio constructors.
Interim milestones are important
The portfolio pathway to 2050 is long. We propose incorporating interim milestones and conducting annual reviews to ensure the portfolio is evolving consistent with its chosen pathway or adapt as needed.
Implementation can draw on diversified building blocks
Strategies that align with the Paris Agreement can include building blocks across index, factor and alpha-seeking strategies. We propose re-allocating to certain asset classes with more explicit climate goals.
Carbon metrics across asset classes
To build a portfolio that is aligned to the objectives of the Paris Agreement, we start by assessing various carbon metrics including absolute emissions and emissions intensity. For illustrative purposes, we review absolute emissions and emissions relative to enterprise value for a strategic asset allocation for a UK Defined Contribution pension scheme. We find that the two approaches are complementary. One striking observation is the absolute emissions. Getting this to net zero is a huge task. Intensity allows a more considered view as it adjusts for the size of the underlying companies on a like-for-like basis. We also observe some key implications for multi-asset investors: firstly, no asset class is the same. Different asset classes will have different pathways. Emerging markets, for example, are associated with a higher emissions intensity than developed markets. However, these carbon metrics should serve as a monitoring function rather than an input to dictate investment decisions. these metrics only show part of the picture: a historic snapshot of how these asset classes look today and therefore what the starting point is for the investor. We therefore advocate the use of these metrics for reporting and monitoring purposes. Using forward-looking metrics alongside these will be crucial in the design of the investment strategy.
A growing number of companies are publishing plans to decarbonize. Reflecting this view in portfolios can help us map the expected pathway of the portfolio and compare this to the pathway required by the Paris Agreement.
Evolving portfolio monitoring to include “decarbonization milestones”
The design of an overarching strategy to align with the Paris Agreement will vary as a function of the portfolio’s asset allocation and investors’ different risk/return objectives. Therefore, there will be no “one size fits all” approach, although there is a common framework that multi-asset investors can apply to their portfolios. Firstly, we advocate setting interim milestones between now and 2050. The Net Zero Asset Managers Initiative, for example, has proposed setting interim targets for 2030 in order to reduce the uncertainty associated with achieving the appropriate “decarbonization pathway”. We also propose an annual review to ensure the portfolio is on track. This will be in part to ensure that companies who have set targets are meeting them and if not, to set a remediation process (such as through engaging with the company). It is also an opportunity to monitor whether there are new companies setting targets, since this may increase the level of confidence that the decarbonization rate can be met at the overall asset class level.
An implementation plan that assesses a range of building blocks
In order to build diversified portfolios, we blend index, factor and alpha-seeking strategies. Each building block has its own characteristics and complements the others. Investors can select building blocks that explicitly align with the Paris Agreement. Understanding how each asset class fares today and combining that with forward-looking decarbonization rates guides investors towards which asset classes are most crucial to replace today. Those that are not replaced may still be influenced by a clear voting and engagement policy. We use indexes in portfolio construction to access broad market exposures in a cost-efficient manner. Some screened approaches that eliminate exposure to certain business areas or optimization strategies that seek to enhance the sustainable features within a stated tracking error. Next, factor portfolios invest in broad and persistent drivers of return. Like indexes, factor portfolios can align to the Paris Agreement by systematically incorporating minimum standards for decarbonization and more. Finally, we can use alpha-seeking strategies to access exposures which contribute to the transition with the benefit of potentially brining emissions down and generating alpha.
1. Institutional Investors Group on Climate Change, March 2021.
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