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Why portfolio temperature ratings should be taken with a pinch of salt

“It’s more of an art than a science”, says author of new report, The Alignment Cookbook

Last week, CDP hit the headlines with its new portfolio temperature-printing methodology. Amundi, Europe’s largest asset manager and the first to employ the new rating system, was given a 2.7°c stamp for its Amundi Funds Global Equity Sustainable Income, taking into account Scope 1, 2 and 3 emissions. Not a bad result.

The strange thing was that the fund’s top holdings included Total, the French oil & gas company. At RI, we were puzzled. 

When we asked CDP, the non-profit told RI: “The method is based on forward-looking, science-based targets, which means that some companies in traditionally higher-emitting sectors – like Total –  may have lower temperature scores than expected for their sector.” It didn’t comment on whether Amundi paid CDP to use its new temperature rating.

The response did not clear up the confusion, and raises questions around to what extent it is prudent to base ratings that relate to financial risk on distant targets that may never be attained, or even be attainable. 

Fortuitously, last week also saw the launch of a report outlining this new trend for temperature ratings, and going some way towards explaining why the results might be so counterintuitive, and why investors should be wary of taking the temperature ratings at face value.

Over the last year or so, increasing numbers of investors have been ‘taking their temperature’ and there has been a boom in tools and methodologies measuring portfolios or companies against a temperature trajectory. The report in question was commissioned by the French Ministry for the Ecological Transition and WWF in response to these proliferating methodologies – and the level of transparency and comparability (or not) around them so far.

While the range of approaches has been explored in reports before, this bumper 174-page publication is a real deep dive into the “ingredients” (the report is named The Alignment Cookbook), or building blocks of these temperature-taking methodologies – the steps that they have in common, as well as the many points at which they diverge.

The paper, produced by Institut Louis Bachelier in partnership with I4CE, is based on a hefty wad of data from methodology developers Arabesque, Carbone4 Finance, CDP, EcoAct, Urgentem, I Care & Consult, ISS, MSCI, Carbon Delta, right. based on science, S&P Trucost, the 2°Investing Initiative and Sycomore AM. 

It finds that all the temperature alignment methodologies it looks at – it counts 11 on the market and more being developed internally – have the same four broad steps: 

  1. Measuring the climate performance of a company or portfolio
  2. Choosing one or several decarbonisation scenarios to which the portfolio will be compared
  3. Converting the decarbonisation trajectories from the scenarios chosen in step 2 to temperature alignment benchmarks that are comparable for the specific companies or sectors or portfolios under consideration
  4. Comparing the results of step 1 and step 3 to produce results which are expressed through an indicator, such as an implied temperature rise metric.

Between these four steps, however, there are “many, many, many methodological choices that can be made”. That’s according to report author and former Kepler Cheuvreux and Trucost analyst Julie Raynaud.

During an online launch event for the report, Raynaud said: “It's very important to understand and to consider the range of tradeoffs that methodology developers face because of data availability. So what is best from a theoretical perspective may not be easily applicable in practice today with our current state of knowledge and data disclosure.”

One of these tradeoffs, she explained, is forward-looking data. The forward-looking data that is available – for example capital expenditure, company-level decarbonisation targets, or extrapolation – all “answer a slightly different question”. Some developers choose one, some choose a combination, and some choose not to use forward-looking data at all and instead to use the climate performance of companies and portfolios today. 

As detailed on page 149 of the report, the conditions under the CDP-WWF Temperature Rating for a portfolio to be aligned with two degrees are to “be invested in companies whose emission reduction targets have the appropriate coverage [of Scope 1-3] and are in line with the required emissions decarbonisation rate under a selection of IPCC scenarios”.

The report suggests, then, that a more accurate articulation of the question CDP’s methodology is answering would be: “Have the companies in my portfolio set ambitious-enough Scope 1, 2 and 3 targets and to what degree do they translate, based on sector and scope-specific precautionary temperature benchmarks derived from IPCC?” 

Other research questions identified for the other methodologies considered include:

  • “How does the current Scope 1 and 2 GHGs emission intensity (per revenue) of the companies in my portfolio compare with what it should be in 2030 and 2050 under different sector-scope specific temperature trajectories?” – for Arabesque

And

  • “Is my portfolio invested in companies that decarbonise at a sufficiently fast rate, over 2012 and 2025 (T+5), based on companies’ targets, assets’ investment and retirement plans and sub-industry historical trend extrapolation?”  – for S&P Trucost

Forward-looking data is just one example of a series of trade-offs methodology developers have to make. Other uncertainties lie, for example, in measuring the carbon performance of companies; in choosing the scenario; and in calculating the decarbonisation benchmark. 

Raynaud suggested: “This calls into question the desirability of translating the results of such an assessment into a single metric that may give a false sense of certainty to the uninformed reader.”

Inevitably, the depth and range of these uncertainties makes comparability an issue, too. A case in point is made when the report takes the Euronext Low Carbon 100 Europe and the French stock market index the SBF 120, and looks at how the two indices fare when assessed against the different methodologies for the years 2018 and 2019.

While all the methods found the SBF 120 was not aligned with a two-degree trajectory and most methods found that the best index for alignment in 2019 was the Low Carbon 100,  in 2018 the Euronext index was found to be both the best and worst, depending on which methodology was used. 

Raynaud explained that France-headquartered multinational Veolia, in which the Low Carbon 100 has a 3% stake, is the most variable company in the sample across all the different methods. “Why is that? Well, Veolia is split into three businesses, and for two of its businesses – water and waste – there are no sector-specific decarbonisation benchmarks. So it's quite difficult to assess Veolia's [alignment] with the current scenarios and data on hand,” she explained.

“Second, a large share of Veolia's global emissions – over 30% in 2018 – comes from methane, and most methodology developers, for simplicity and data granularity reasons, use the International Energy Association scenario, which is expressed in carbon.”

So, what’s the lesson here? The report steers clear of choosing a favourite, or most relevant, methodology. “There is a lack of clear and transparent methodological framework for temperature alignment assessments – at the moment it's more of an art than a science,” Raynaud explained. “Even if the implied temperature rise metric could be considered an interesting option for communicating the results, it is still very important to be very transparent and to be aware of the many limitations that are embedded within this type of metric.”

Rather, Raynaud would say it’s more important that investors weigh up what is most relevant for them.

“I think the lesson for investors is to really try to understand what you are buying [and] what specific question it answers,” she said. “I think investors need to understand this, and also disclose this, when disclosing an implied temperature rise or alignment metric in their report.”