23 December 2020
There are lots of long-term net zero pledges at the moment but it’s the short-term actions that really matter.
2050 is far enough away that some entities make the big commitment without ironing out all the details, but don’t underestimate how hard it will be to achieve net zero by 2050. The pandemic creates an opportunity for reflection on the right actions to take in the short term.
Covid-19 impact on climate risk
We did see a drop in emissions back in March but it didn’t take long for them to rise back to pre-crisis levels once the economy was running again. Ultimately, we need lower emissions in a fully functioning economy.
Physical risks vs transition risks
Transition risks tend to manifest quickly whereas the physical impacts will play out over a longer time period.
Stewardship vs divestment really matters
There is a need for many companies in today’s economy to continue existing to help the transition.
Climate scenarios are key
TCFD (Task Force on Climate-related Financial Disclosures) has helped create interest in climate scenario analysis. This analysis enables investors to quantify potential climate impacts, though sometimes considering the scenarios is more helpful than the actual result.
There are different scenario tools being used including:
- Bottom up scenarios - useful for investment managers looking at portfolios and how individual companies might be affected.
- Top-down scenarios – looking at the macroeconomic impact. We focus on top down so you can look at the asset and liability impacts together, not parts of the portfolio in isolation.
Scenarios we look at include the Paris targets being met, showcasing significant transition risks and some physical risks; and some scenarios where the targets aren’t met, with lower transition risks and much greater physical risks. Generally we may expect severe physical impacts in the second half of the century, but financial impacts in the next decade. Financial markets can price in impacts many years or decades before they hit the real world – so this is relevant even for shorter-term investors.
What should investors do with the results of the scenarios?
- Analysis pinpoints parts of the portfolio to focus on the most, usually growth assets.
- Speak to investment managers, understand their approach, are they taking these risks seriously? Get substantive answers around the real differences in the way they are investing.
What else are investors doing?
- In area of passive equities, investors are taking action – there are good alternatives to tracking a market cap weighted index.
- Some large investors are making net zero commitments about their portfolios.
Why single out climate risk and not ESG for an alternative passive approach?
Data quality tends to be better for climate factors. For other ESG factors, where the data may not be good enough for a passive approach, an active approach can still add value. One challenge with data is that different ratings providers can give conflicting scores for the same company.
One of the reasons the main rating providers appear to disagree is when the comparison focuses on headline scores. Some of the underlying datapoints are more robust and leaves the asset manager to take a view on how to aggregate them up.
Net zero targets
We are starting to see large investors making net zero commitments about their portfolios. We have been considering how to calculate and achieve net zero for a whole portfolio.
- This is interesting in a pensions context as it raises questions of alignment with pension trustees’ fiduciary duty.
- It will initiate important discussions like how practically do you implement net zero targets?
One thing to take away
Don’t get too excited about these big long term targets that have been set but focus on the shorter term actions that follow through on those commitments. There is no guarantee that a big long-term target will be met by itself.
Most underappreciated thing about investing
As well as climate risk, we are also facing a nature crisis which is underplayed. The natural world underpins our economy and investors should think more about how their investment decisions affect it.
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