In the race to Net Zero, investors cannot only focus on their portfolios when setting targets

In brief: Portfolio decarbonization appears to be an easier way to align with Net Zero targets, but it can limit investment in the places that most need it, such as emerging markets.

• With the responsible finance market buzzing about its role in mitigating climate change and risk, there is a divide among stakeholders about what “Net Zero” in finance should include
• Emerging markets — which need $95 trillion for a Just Transition — are especially likely to fall out of favor in ‘portfolio decarbonization’, which could dry up investment where it’s needed most
• Some approaches to ‘portfolio decarbonization’ are methodologically simpler than what the UNFCCC Race to Zero and SBTi guides toward, but they come with some in-built limitations that may inhibit the financing needed for transition to a low-carbon economy

A flurry of attention in the last week focused on rehashing questions about the immediacy of financial risks from climate change on investment compared to other risks. There was a quick, clear and consistent response from across responsible finance that indicates significant consensus on the way forward. Climate change, according to this consensus, is no longer a question of “should we” but of “how can we most effectively” mitigate climate risks in finance and the impacts of climate change more widely.

However, under the surface it’s not clear that this consensus is as robust when it comes to what investors’ and financial institutions’ proper role is in responding to climate change in a second-best world. Building this consensus is particularly important for emerging markets, where higher-emitting sectors start further away from alignment with the most ambitious pathways to 1.5° C, and in economies with fewer ‘green’ investable assets available today.

A recent paper by several prominent people in responsible finance outlined “an approach that has already been adopted by several asset owners and asset managers”. They describe a roadmap focused on ‘portfolio decarbonization’ that appears to rely on the assumption that Net Zero in the real economy is unlikely to succeed.

The authors provide a seemingly robust and simple methodology to align portfolios with Net Zero derived from the remaining global carbon budget consistent with a 1.5° C pathway. The purpose is to estimate the least disruptive way for investors manage a portfolio so that it — if not the wider economy — conforms to the Net Zero premise that the world’s remaining carbon budget (which at today’s high emissions would only last another 8½ years) is stretched out to be exhausted only in 2050, when the global economy is assumed to reach net carbon neutrality.

At the center of the assumptions underlying the paper is that not all companies or sectors may be willing and able to set targets consistent with achievement of global Net Zero by 2050, despite the dire consequences this is almost sure to unleash. In such a world, the paper outlines what asset managers and asset owners could do to keep their portfolios aligned with the unrealized global ambition. The authors are clear in the assumption behind their methodology:

“The premise of our analysis is that even if companies are not fully aligned with carbon neutrality, then at least investors should strive to be aligned by gradually reducing their carbon footprint through divestment of high-carbon emitters.”

At its core, the approach is reflective of the tension within efforts on climate change in the financial sector. The issue up for debate is ‘fight or flight’, and the methodology merely provides a map for investors drawing their easiest path of retreat if or when they decide to throw in the towel on engagement in support of the transition. In the words of the authors, “Corporate decarbonization commitments are in their infancy and the projected carbon reduction trajectories are still highly unreliable.”

Regardless of which of these ‘critical’ perspectives on finance towards Net Zero one embraces, each is based on efforts limited to a focus on here-and-now returns and financial risks without regard to long-term or non-financial consequences. The complaint at the heart of the past week’s furor about whether to reduce the focus on climate risk is much more transparent in its view on the financial risk generated by climate change, but it and the paper outlining portfolio decarbonization metholodogies both rely on an unlikely assumption that investors and financial institutions can ‘contain’ or shield themselves from the impacts of climate inaction.

This flies in the face of the growing chorus from UNFCCC Race to Zero and the SBTi, who have emphasized repeatedly, including recently, clear prescriptions for financial institutions, asset managers and asset owners to take a real economy (not portfolio) Net Zero perspective. Each of those reports provides guidance on the types of scenarios where divestment is appropriate; for example, where investees are unable or unwilling to develop science-based Net Zero trajectories. But it’s also clear that it’s a second-best outcome to be avoided until other approaches have been pursued vigorously.

In lieu of divestment, an alternative preferred outcome for financial sector stakeholders calls for an increase, not a decrease, in financing & investment made available for high-emitting sectors with the greatest transition need. This increase in finance isn’t inconsistent with the long-term goals for Net Zero because it comes with the condition that the recipients should have a credible pathway consistent with the global Net Zero by 2050 objective.

One of the major reasons for this preference for a focus on real economy Net Zero rather than portfolio decarbonization is that ‘the market is not the economy, and the economy is not the market’ as the adage goes. Capital markets investors’ field of view is sometimes limited by the constraints of what is investable to them. These blinders presume that if a high enough share of investors shun a particular company or sector, this will incentivize the issuers to respond by trying to win back those investors rather than pursue alternatives.

In particular, the paper on developing a Net Zero portfolio in a non-Net Zero world posits that for companies at risk of divestment by responsible investors, “knowing aligned investors’ divestment trajectory helps [them] adapt and avoid exclusion, thus pushing the entire sector to perform continuously better. […] In other words, the [transparent, rule-based] exit process creates a structural competition within each sector towards a low-carbon economy”. If a market-based approach to Net Zero could be achieved this smoothly, it would be wonderful, but it is unlikely for most companies to see the incentive structure working only in a single virtuous direction.

However, it is equally plausible that some high-emitters, especially if given long forewarning of a divestment decision by a subset of investors, would see the cost of avoiding the divestment as higher than other options. If the thresholds for investor divestment in the future were set far enough in advance and there were enough investor capital on a similar trajectory, this could have the perverse incentive of raising the value of cheating on the metrics used to fall on the good side of a hard dichotomy.

Not all options available to investees facing divestment would rely on behavior that flouted rules and regulations. For example, instead of transitioning their operations to be consistent with the remaining use of the global carbon budget, they could divest the problematic operations to other investors not facing the same investor constraints. Or they could pursue opportunities to leave public markets for private markets also in search of investors not as concerned about Net Zero alignment.

This may seem to be a trivial argument about investors’ designs of their Net Zero implementation, but it has significant real-world implications that are especially relevant for emerging markets. Many emerging markets have seen relatively small inflows as a proportion of global ESG assets (less than 10% by one estimate), with investors citing lack of data or limited availability of ‘green’ assets.

Despite limited investment by ESG investors in emerging markets, the need is huge. One recent estimate pegged the total investment in emerging markets to achieve a successful and Just Transition at $94.8 trillion by 2050. Without success in financing these needs in emerging markets, no investor’s assets will be untouched by the impacts of climate change, regardless of whether the portfolio is aligned to Net Zero or not. And that is the most important thing to focus on if we are to have a chance of mitigating the economic, financial and human consequences of climate change.

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