- Institutional investors interested in aligning their portfolios with net-zero decarbonization pathways may find that figuring out how to do so is not an easy task.
- Investors may choose to tilt investments toward low emitters or emissions improvers or — recognizing each approach’s potential advantages and limitations — combine both approaches.
- Investors have four strategic levers to incentivize companies to lower their carbon footprints: shifting capital allocations, pursuing active stewardship, financing of low-carbon solutions and advocating public policy changes.
While investors around the world are committing to bring the carbon footprints of their portfolios to net-zero by 2050, figuring out how to do so is not a simple matter.1 For example, the United Nations’ Intergovernmental Panel on Climate Change (IPCC) says this would mean decreasing the greenhouse-gas (GHG) emissions associated with a portfolio by between 5% and 15% per year.2 What alternatives do investors have to implement this objective in practice? In this blog post, we examine three options for investors.
Net-Zero Implementation Option 1: Tilting Toward Low Emitters
A straightforward way to implement a net-zero portfolio-decarbonization pathway could be to tilt investments at each rebalancing toward low emitters — companies with low GHG intensities (see exhibit below).3 This shift from high or average emitters (e.g., a coal-based utility) to low emitters (e.g., a software and services company) would reduce the emissions footprint of a portfolio relatively easily over time.
Portfolio with Periodic Rebalancing Toward Lower Emitters
Source: MSCI ESG Research LLC
But such a reallocation of capital may not support efforts to decarbonize the broader economy, especially the high-emitting, hardest-to-abate sectors, such as utilities, energy and materials, which tend to shift some of their costs related to their emissions to third parties. For instance, emissions of a polluting company may later result in increasing losses for reinsurers that have to cover the cost of damages caused by increasingly frequent extreme weather. The financial impact and occurrence of these externalities are difficult to predict, making it unlikely that investors can “hide” from them. Given externalities’ widespread nature, investors have three other levers they may choose to employ to address these externalities directly: 1) stewardship or engagement, 2) advocating public-policy changes, such as imposing a price on GHG emissions, or 3) investing directly in low-carbon solutions.
By tilting toward low emitters, investors can divest completely from high emitters or, alternatively, incrementally decrease their holdings over time. The latter approach allows for the opportunity to engage with high emitters and drive them to reduce emissions.
Net-Zero Implementation Option 2: Tilting Toward ’Emissions Improvers’
A second net-zero implementation option could be to tilt investments toward “emissions improvers” — those companies that may be high emitters now but have ambitious, comprehensive and feasible targets to decarbonize their operations and products over time (see exhibit below).
Stylized Portfolio with Rebalancing Toward ‘Emission Improvers’
Source: MSCI ESG Research
Assessing and comparing emissions-reduction targets across companies, scopes and technologies are not easy tasks. One way for investors to implement forward-looking views into their portfolio-construction process is to consider the temperature rise with which the company’s practices and targets align. Even so, difficult questions around accountability for achieving targets, the use of offsets as a decarbonization option and the possibility of carbon-removal technologies’ becoming widespread need to be addressed.
Recent history suggests that finding companies that are reducing their emissions has been easier said than done. From 2016 through 2020, we found that less than a quarter of MSCI ACWI Investable Markets Index (IMI) constituents decarbonized by at least 10% per year, making it virtually impossible to build broad global equity portfolios of such companies during this period.4 However, this pool of companies may increase as more companies commit to net-zero targets.
Net-Zero Implementation Option 3: A Combined Approach
Net-zero investors can also pursue a blended approach, where they could tilt toward emissions improvers where possible and toward low emitters where not (see exhibit below).
Stylized Portfolio with Combined Rebalancing Approach
In this hypothetical example, the first rebalancing is toward emissions improvers; the second rebalancing is toward emissions improvers and lower emitters, as some companies expected to improve their emissions failed to realize their targets; the third rebalancing is again toward emissions improvers, as the remaining companies continue to improve and more companies set ambitious and feasible climate targets. Source: MSCI ESG Research
Investors Have Options Beyond Allocating Capital
Capital allocation is only one lever available to investors to drive emissions reductions in their portfolio and in the economy. Other levers, such as stewardship and engagement, advocating regulatory changes and investing directly in climate solutions, could help reinforce the effects of capital reallocation. We find that these levers haven’t been used at sufficient scale. A more consistent and coordinated investor effort across all four economic levers may help accelerate change.
This article first appeared on MSCI.com (https://www.msci.com/www/blog-posts/constructing-net-zero/02768215423) on Sep 30, 2021, with contribution from Guido Giese, Executive Director, MSCI Research, Zoltán Nagy, Executive Director, MSCI Research and Chris Cote, Senior Associate, MSCI Research. This article and all of the information contained in it, is the property of MSCI Inc. or its subsidiaries (collectively, “MSCI”). It may not be modified, reverse-engineered, reproduced or redisseminated in whole or in part without prior written permission from MSCI. All rights in the article is reserved by MSCI.
1 See the Net-Zero Knowledge Hub for a list of alliances and initiatives.
2 “Global Warming of 1.5˚C.” Intergovernmental Panel on Climate Change, 2018.
3 We define emissions intensity as metric tons of GHG emissions divided by millions USD sales.
4 Giese, Guido, Nagy, Zoltan, and Cote, Chris. “Net Zero Alignment: Objectives and Strategic Approaches for Investors.” MSCI Research Insight, September 2021.