Annabel Timberlake, Associate Director in the Financial Services Team at Carbon Intelligence, explains how investors can mitigate their emissions on the road to net zero. This article first appeared in the June 2022 edition of the Redburn Review.
The latest IPCC special report on 1.5˚C presented compelling evidence that to limit global warming to the level specified in the Paris Agreement, the world needs to halve its greenhouse gas (GHG) emissions by around 2030 and reach net zero by 2050. The reality is emissions must peak in 2025. Yet last month, the World Meteorological Organisation published a report detailing how four climate change indicators – GHG concentrations, sea level rise, ocean heat, ocean acidification – all set records in 2021. The impact presents severe physical and transition risks. Glaciers across all continents are rapidly thinning, snowfall in the Alps has been the lowest for twenty years and Italy’s agricultural lands are becoming a ‘salty wasteland’. The Po River is so dry the groundwater extracted by farmers is saline, putting hundreds of thousands of livelihoods at risk.
Whilst COVID and war in Ukraine have diverted attention, it is widely accepted we have reached a critical point. Crucially for readers of the Redburn Review, the Paris Agreement articulates the critical role of financial institutions in accelerating the transition to net zero through capital allocation.
In April 2021, The Glasgow Financial Alliance for Net Zero (GFANZ), formally awarded the baton to the financial services industry to transform investment in a net zero economy. Ex -Governor of the Bank of England, Mark Carney, observed, “Through GFANZ, the core of the financial system is mobilising to play its essential role in global climate solutions. But financial institutions cannot achieve this systemic change alone. We will work with companies, multilateral and development finance institutions, non-governmental organisations, and wider civil society.”
The collective net zero targets the industry sets and delivers on through reducing emissions will put pressure on every corporate it finances, and their supply chains. Financial institutions will leverage the shared influence and responsibilities of aligning incentives and eliminating barriers to emissions reductions. However, the changes needed to alter the planet’s climate trajectory can only happen if the entire financial system makes ambitious commitments and operationalises with near-term action.
Whilst Paris and GFANZ have mobilised financial services, pressure is circling from all sides. Retail money is increasingly discerning, with inflows into sustainable funds setting records in 2021. This not only reflects expanding supply, but also the enthusiasm of the retail investor to own such funds. Schroders Global Investor Study 2021 reported that 40% of investors aged 18-50 viewed sustainable funds as attractive because they are more likely to offer higher returns. Whilst there is noisy debate on the relationship between investment returns and sustainability, there is rising acceptance that a company harming people and/or the planet whilst creating profits is unsustainable long term.
External pressure is also being applied by asset owners, who are starting to demand from asset managers that their mandates be assessed against net zero alignment. As of 10 May 2022, there were 72 signatories to the Net Zero Asset Owner Alliance (NZAOA), including major European pension funds. An increasing number of asset owners have set their own net zero commitments so by definition their asset managers have to understand and help them to realise their targets.
Peer pressure and regulation are steering voluntary climate action reporting towards becoming mandatory. Standards setters and regulators are driving transparency. The UK, France and Japan are leading the G7 on climate-related financial disclosure rules, followed by Canada and the US. The momentum is obvious. In little more than a year, GFANZ has grown to encompass over 450 major financial institutions from 45 countries controlling assets above $130tn. Members represent every segment of the financial-sector value chain – asset owners, insurers, asset managers, banks, investment consultants, exchanges, rating agencies, audit firms, and other financial service providers.
Helpfully, we now have common standards for quantifying the emissions of financial institutions, and their impact on climate change and your industry’s portfolios. Measuring scope 3, category 15 emissions (those associated with investment activities) evokes added expectation and scrutiny on the industry’s ability to manage them via setting portfolio-level decarbonisation targets. However, given a plethora of confusing jargon, acronyms and reporting options, it can be hard to see the wood from the trees. Where do you start?
Most asset managers and corporates do not have the expertise, resource or in-house processes to measure emissions and set credible targets, let alone the confidence to define plans on how to achieve them. Framework adoption is complex and relies on the alignment of an asset manager’s target, ambition and portfolio construction with the associated opportunities and challenges of adoption.
The Science Based Target Initiative (SBTi) is the gold standard. Its financial sector framework is considered more stringent than the Paris Aligned Investment Initiative (the Net Zero Investment Framework 1.5 (NZIF)) where the percentage of AUM included is discretionary – albeit asset managers who adopt the NZIF are expected to set a climate-solutions target alongside their decarbonisation target. Overall, these frameworks construct an ecosystem of interdependent requirements and recommendations across asset owners, asset managers, investees and borrowers.
In the knowledge no one size fits all, the Task Force on Climate-related Financial Disclosures (TCFD)-aligned reporting is a good start. It is becoming the ‘go to’ template globally. The International Sustainability Standards Board (ISSB) will base its reporting standard on the TCFD’s. This guides the identification, assessment and disclosure of risks and opportunities the climate will have on your business. By October 2021, the Task Force had more than 2,600 supporters spanning 89 countries and nearly all sectors of the economy, including 1,069 financial institutions responsible for assets of $194trn. These firms can benchmark themselves against institutions demonstrating leadership on climate action.
Many fund managers start by putting their own house in order. This mobilises internal stakeholders and brings accountability. What is the emissions footprint of your offices and employees? What about your business travel? From boiler room to board room, taking control of your Scope 1 and 2 with material Scope 3 categories engenders buy-in and advance within an organisation.
However, by far the greatest impact sits in a fund manager’s investment portfolio. This usually accounts for c95% of financed emissions and explains why financial services have such a critical role to play in the transition. Ultimately, fund managers have a choice: do they simply decarbonise their portfolios, or do they accept the GFANZ call to arms to have real world impact? Simple maths shows that migrating portfolios to less carbon intensive businesses demonstrates a decarbonisation trajectory. But in so doing, an investor limits their real-world impact because they have lost the ability to influence those businesses the financial services sector has been awarded the agency to change. Moreover, the investor then joins a crowded and overvalued marketplace, making it harder to differentiate, with implications for their fiduciary duty to their own investors and future capital raising.
The contrasting asset manager uses stewardship to exert influence on portfolio companies to align their own business models with the goal of net zero by 2050. They lead the portfolio company through a carefully defined range of criteria helping it to decarbonise in alignment with Paris, meaning, by definition, the portfolio they manage is aligned with those goals. These asset managers enable their investors to shape outcomes by pushing portfolio companies for greater disclosure and demanding detail on how companies will drive net zero strategies and deliver investment returns. They embed proprietary datasets and increase resource and training to build their own data sets; and they engage with the entire organisation – reporting, risk, oversight, etc – not solely the executive committee and strategic decision makers.
Opportunities abound. Green portfolios are springing up everywhere. Innovative funds involving public and private assets are striving to capture funds flow, take leadership and to stand out from the crowd. It is widely accepted the greener the asset the higher the value. Little surprise therefore that flows into Article 8 & 9 funds have substantially outpaced non-ESG, despite the latter representing nearly twice the number of funds.
With such proliferation, greenwashing is receiving increasing scrutiny and asset managers must tread cautiously and credibly in this transition terrain. Internal stakeholders and regulators are calling companies out for publishing misleading statements. For example, Deutsche Bank’s DWS was recently targeted by public prosecutors from Frankfurt, federal police, and officials from the German financial regulator BaFin. This occurred a year after a similar probe by the US SEC prompted by allegations from a former DWS executive. There is an increasing level of scrutiny, so if you seek outside assistance it is essential you can trust the quality of work.
Industry trends are becoming outdated almost as soon as they are announced. 35% of AUM was the average number reported by the NZ asset managers target disclosure report in October 2021. This had increased to 39% by the May 2022 report. There has been criticism this percentage of AUM does not signal the level of ambition required to achieve a net zero-aligned economy, especially given the discretion inherent in adopting target frameworks. Vanguard and BlackRock evidence the vast spectrum with 4% and 77% AUM respectively initially committed.
The latest targets mean that, collectively, approximately $16trn – of $42trn managed by asset managers who have set targets – is committed to be managed in line with realising net zero by 2050, and subject to targets consistent with a fair share of the 50% global emission reduction by 2030. Firms need to look at their peers. Have they been deliberately conservative, or are their targets suitably ambitious? New adopters will seek low hanging fruit in a portfolio to make confident short-term progress against targets. There have been instances of asset managers initially only including AUM in particular regions, or in sectors where there is a high proportion of investee companies who are already net zero-aligned.
2030 is only eight years away. Yet during a recent webinar held by Carbon Intelligence advising asset managers on how to go about setting net zero targets, close to six hundred investment professionals were asked to choose from a series of options on their net zero journey. There was no consensus. Almost as many had not started to track their emissions and had no public commitment to net zero as those who were well on their way. Although the jargon, complexities of reporting and multiple frameworks can be confusing, the direction of travel is clear. What is voluntary today will become mandatory in the future. Creating your roadmap to net zero is not easy, but as with most tricky problems the way to solve them is to put pen to paper and get started.
About this article
This article was written by Annabel Timberlake, Associate Director in the Financial Services Team at Carbon Intelligence and first appeared in the June 2022 edition of the Redburn Review.
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