Carbon Metrics Key to Investors’ Net Zero Path
Invesco, AP4 evaluate various methods to quantify portfolio emissions, reflecting investors’ appetite to move away from a purely backward-looking approach.
Choosing the right metric to measure portfolio emissions is crucial to investors’ alignment with the Paris Agreement, and should reflect their chosen goals and strategy.
This is according to a study by global asset manager Invesco and Sweden’s fourth national pension fund, AP4, who recently partnered up to explore the road to net zero for institutional investors.
Acknowledging investors’ growing focus on achieving carbon neutrality, the two entities assessed the risks and opportunities associated with Paris-aligned temperature-keeping strategies – providing a framework and insights for asset owners and managers seeking safeguard their portfolios from climate risks.
“Through client discussion we have heard many institutions are interested in moving away from the pure backward-looking perspective that is the standard in the industry today towards an approach that is forward-looking,” Tim Herzig, Portfolio Manager at Invesco Quantitative Strategies, told ESG Investor.
“Reasons are manifold but include better risk management, earlier identification of stranded assets, and the realisation that Paris Agreement goals are in jeopardy. We simply don’t have the time to wait for companies reporting CO2 emissions with what is often a delay of many months.”
The report aims to guide investors on how best to approach climate alignment, highlighting the potential impact of integrating it into portfolio construction.
“In our view, investors are dependent on companies’ decarbonisation in order to be able to reach their own net zero targets,” said Julia Ripa, Senior Analyst at AP4. “Therefore, an important tool for investors is company engagement, and to keep supporting companies in their transition journey towards net zero.”
The analysis compares different metrics and gives suggestions on which data to select based on investor type and goals, aiming to equip them with a more comprehensive understanding of these tools and their potential applications in climate-aligned strategies.
“There is a lack of guidance and knowledge on how to address temperature alignment in portfolios,” said Ripa. “This report acts as a tool for investors to navigate different types of datasets, and how the choice of measurement method affects alignment with the Paris Agreement.”
AP4 and Invesco said their collaboration highlighted their mutual commitment to addressing climate change and supporting investors in their pursuit of carbon-neutral investment strategies.
“Climate change is one of the greatest challenges of our time, with major expected impacts on the environment, biodiversity, ecosystems and ecosystem services,” the report said. “Countries, sectors, companies and individual people will also be affected.”
Beyond the Paris Agreement, AP4 also supports Sweden’s “more ambitious” environmental objective of achieving net zero greenhouse gas emissions by 2045. In line with this, the pension fund has cut carbon emissions in its listed equity portfolio by more than half since 2010, representing a 65% decrease.
It now aims to further halve its emissions by 2030 compared to 2020 levels – with the long-term goal of achieving net zero by 2040.
“We apply low-carbon [optimisation] strategies in the global equity portfolio that reduce exposure in each sector to companies with high carbon emissions or fossil-fuel reserves,” AP4 said in a statement.
“The strategies are based on historical emissions as well as forward-looking data to verify that companies’ operations are aligned with the Paris Agreement, and how various levels of carbon pricing may impact [their] margins. The results affect divestments in our portfolio.”
Choosing the right method
As investors increasingly strive to reposition their portfolios in line with net zero goals, a plethora of datasets have emerged to estimate temperature alignment of individual assets and portfolios, as well as guidelines to decarbonise portfolios.
Existing frameworks currently used by investors include the Net-Zero Asset Owner Alliance’s Target-Setting Protocol, as well as the Institutional Investors Group on Climate Change’s Net Zero Investment Framework, updated earlier this year.
AP4 and Invesco’s report focuses on two metrics designed to measure progress towards global climate targets: Implied Temperature Rise (ITR), and Carbon Budget Divergence.
The paper offers insights into how the metrics can be effectively used in portfolio construction, optimisation, and communication. “Our goal is not to prescribe a single ‘best’ approach, but rather to equip investors with the knowledge to choose and apply the most suitable metrics for their specific investment strategies and objectives,” the authors said.
Although ITR has previously been criticised for being overly based on assumptions, it has enjoyed increased interest due to its easily understandable outcome – delivering a measure directly comparable against the Paris Agreement, Herzig explained.
“The selection of the right approach and methodology partly comes down to intended use – high-level measurement and communication would lean towards ITR, while in-depth analysis is provided by Carbon Budget Divergence – but also intended outcome,” he added. “The Carbon Budget Divergence measure might be more suited for investors who care about real-life absolute emissions, and hence materiality of the approach chosen.”
While ITR has gained prominence among investors, Carbon Budget Divergence is less commonly used as a standalone metric. One of AP4 and Invesco’s goals was to explore the concept of using Carbon Budget Divergence as a metric in its own right – rather than solely as an intermediate step in calculating ITR.
“We examine the circumstances under which focusing on Carbon Budget Divergence may provide more decision-useful information for investors compared to ITR,” the report noted. “We delve deeper into the methodologies behind these metrics, explore their respective strengths and limitations, and discuss how they can be applied effectively in different investment contexts.”
The two metrics are rooted in the concept of ‘carbon budgets’ – which designates the cumulative amount of greenhouse gas emissions permissible to limit global temperature rise to a specific level – but differ in how they present the information.
While Carbon Budget Divergence provides a direct measure of emissions overshoot or undershoot compared to an allocated budget on an absolute basis, ITR takes the relative divergence expressed in percentage and translates it into an estimated global temperature rise – offering a more intuitive, albeit potentially less granular output, the report noted.
“The ITR metric is great for communication to stakeholders and much easier to interpret, but many investors should benefit from analysing the Carbon Budget Divergence metric more thoroughly,” said Ripa. “Climate-intensive companies tend to be highlighted by this metric and yield the best and worst scores. This enables investors to select companies that are material for the energy transition, while divesting from high-emissions companies.”
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