9 June 2021
“Net Zero” has become one of the big movements of our time with c76% of the UK public now being aware of the term (a remarkable proportion). It is also one of the most pressing current themes in the investment world among asset owners that we speak to and investment managers.
For more on thinking about Net Zero as an asset owner click here.
The phrase Net Zero naturally focuses the mind on emissions, but they are not the only part of a Net Zero strategy, and often not the most important.
Alignment is a helpful measure as it is arguably easier to define and measure today than emissions, partly because other organisations have done the hard work for you. It is also more forward looking and broader than today’s emissions.
One key reason that asset owners adopt Net Zero targets is to help manage some of the shorter term risks and opportunities from climate change, particularly transition risks such as carbon pricing and carbon tax. The idea is that companies who are better aligned to a low carbon transition today will be subject to less regulatory risk if more aggressive measures are brought in later in the 2020s.
Reported emissions have a few disadvantages as a measure: they are subject to change when additional companies begin to report, or make changes to their reporting, eg due to mergers or acquisitions. So reported emissions can increase for counterintuitive reasons. Another issue relates to “avoided emissions”, eg emissions generated by manufacturing wind turbines or building insulation can result in much lower emissions elsewhere, but the original emitter usually doesn’t get credit for this.
Emissions is a one-dimensional picture; low-emitting companies could be subject to high climate risks whereas high-emitting companies in crucial sectors (eg steel) could be important to the transition and subject to lower climate risks than the emissions footprint would suggest.
An over-focus on emissions can also lead you down the road of offsets, which are often questionable, especially for asset owners.
From an asset owner’s perspective, managing the transition requires a more nuanced picture than just emissions – that’s where alignment comes in.
What is alignment?
Well, I guess the clue’s in the name…
It is a judgement of how well a business plan is aligned with a low-carbon transition.
If companies are not aligned and/or not thinking strategically about the low-carbon transition, they are likely to be more exposed to climate risk, even if emitting less greenhouse gas (GHG) today because they are naturally in a lower-emitting sector.
Conversely, if companies in vital but carbon-intensive sectors (eg steel) are thinking strategically about the transition, this could represent good investment opportunities as well as being aligned with a sub 2° world even if they still have a large carbon footprint today.
But how can we know?
Good news: others do the hard work so you don’t have to…
A number of independent organisations make publicly-available assessments of listed companies’ business alignment based on disclosures, such as:
These typically focus in on key sectors – here is an example of the current alignment picture across material sectors according to TPI:
Let’s look at alignment by taking material sectors:
- Oil & gas
There’s a huge difference between Chevron and Shell, or Aramco and Total, and you can see this in TPI’s or CA100+’s assessment of their transition alignment. Oil and gas companies are some of the highest carbon-footprint companies on the planet, but five of them (including Shell) are judged by TPI to be aligned with countries’ Paris pledges (a weaker level than full alignment with Paris goals).
But how does your asset manager view it? Can they tell you how many companies in your portfolio are aligned?
Most people would agree that steel remains vitally important, but it is among the most carbon intensive sectors today. That’s both a risk and opportunity, depending how you see it, and alignment helps you unlock that difference.
Taking data from TPI on carbon management scores, there are some steel companies that are managing carbon risks well, and some who remain completely unaware that climate change is even a thing. I know which I’d rather be invested in – do you?
Another essential and carbon-intensive sector and one of the more interesting from an alignment perspective because of the variety. Some businesses have effectively repositioned as renewable energy firms whereas others are much further back in recognising a transition. E.ON and Iberdrola have reduced the carbon intensity of the energy they provide substantially already and are judged by TPI to be aligned. Some other utility firms are well above Paris-aligned intensity levels without credible targets to get there.
An easy question to ask your equity or bond manager is: how many companies in my portfolio have commitments that are aligned with the Paris Agreement?
As always, there are some limitations to be aware of in this data. The independent organisations assessing this have focused on the most material companies in the most material sectors, which makes sense as after all c100 companies have emitted c70% of corporate emissions. So it makes sense for asset owners to think much harder about these “material sectors”. Data is currently available from TPI and CA100+ for between 100-400 of the larger listed companies in material sectors. Some data providers have extended the concept to all listed companies, but you may need a data licence. So you can’t expect this analysis to run across your whole portfolio, but it doesn’t need to, focusing on the most material sectors does the heavy lifting.
How do you do it?
From an asset owners’ perspective , it is very simple to collect data on the current exposure of the portfolio to these transition-sensitive sectors, whether you own equities directly or through asset managers. You could do this yourself, or ask your consultant such as LCP to do it on your behalf.
You can then assess these exposures against the benchmark, and importantly assess the percentage of your holdings in key sectors that are aligned, and use this figure to set targets eg for 2025 and 2030. It could look something like this:
Source: LCP, June 2021
Over time you can visualise the proportion of your portfolio coming under alignment like this:
Source: LCP, June 2021
We have plenty of experience putting these frameworks in place for clients, reach out and contact our experts if you’d like to hear more.
As Net Zero grows into one of the most powerful movements of our time, and certainly the most powerful investment theme in decades, we believe we’ll see a maturing of the approach taken toward measuring and reporting on it. We think this will, for now, centre increasingly around alignment, as well as emissions.