New research finds that aligning investment portfolios with a net-zero climate pledge is problematic because it risks short-term performance in service of long-term environmental protection.
“The fact that someone could believe that investing in a way that addresses climate change improves risk-adjusted financial returns is insufficient,” conclude authors Tom Gosling and Iain MacNeil in the paper published last week.
The academic paper “Can investors save the planet? NZAMI and fiduciary duty” in the Capital Markets Law Journal, discusses how banks, asset owners, asset managers and insurers famously came together at COP26, the United Nations Climate Change Conference in Glasgow, to announce the formation of the Glasgow Financial Alliance for Net Zero (GFANZ). In addition to the net-zero target, signatories pledged to “align their investments with the much more challenging goal of ‘limiting global warming to 1.5 C with limited or no overshoot’” and whether the framework adopted by asset managers in reference to climate will truly make a difference.
The authors, in previous writings, have discussed “the fiduciary duty financial institutions owe to their clients” and how commitments to net-zero may or may not create conflicts in this area. The argument of why net-zero organization of a portfolio falls within the purview of fiduciary management is that “climate is a systemic risk, and mitigating it improves risk-adjusted returns at the portfolio level … the optimal trade-off for financial risk-adjusted returns is likely to be considerably higher warming than 1.5 C, as this target incorporated many factors that are inevitably ignored by financial markets, including just transition and non-financial aspects of our environment and lifestyle. Clients are interested in factors beyond financial returns, including the live-ability of the planet, but collective action problems mean that clients do not get to choose a clear trade-off between financial returns and climate outcomes.”
The authors conclude that, “No argument seems to resolve signatories’ emerging problems with fiduciary duty. The only fiduciary duty cover seems to be extremely clear and informed client mandates that support investment aligned with a 1.5 C scenario, regardless of the likely trajectory towards 2 C, and regardless of the costs of this approach for clients. It seems implausible that asset managers will be able to get this clarity for anything other than a minority of the assets they manage.”
Author Gosling is an executive fellow at the London Business School and at the European Corporate Governance Institute in Belgium. Author MacNeil is the Alexander Stone Chair of Commercial Law at the University of Glasgow.
The NZAMI commitment
Under the Net Zero commitment, signatories pledge to support the goal of net-zero greenhouse gas emissions by 2050, in line with global efforts to limit warming to 1.5 C. They also commit to support investing aligned with net-zero emissions by 2050 or sooner.
NZAMI recognizes three methodologies for setting net-zero-aligned targets: the Paris Aligned Investment Initiative Net Zero Investment Framework; the Science Based Targets Initiative for Financial Institutions; and the Net-Zero Asset Owner Alliance Target Setting Protocol.
These framework methodologies provide for “portfolio emissions calculated as the aggregated share of emissions of portfolio companies, weighted according to the holding of each security by the asset manager; measured either as aggregate emissions or emissions intensity. Engagement with policymaker to target to move portfolio companies, especially amongst higher emitters, to net zero alignment, increase the share of portfolio companies that are themselves net zero aligned, increase commitments to fund companies and technologies essential to the transition and to produce net zero aligned products, including engagement with other market participants to bring this about,” the authors wrote.
The authors propose five strategies for achieving net-zero goals in portfolios, starting with portfolio decarbonization.
“In this approach, a target is set for reduction in the portfolio’s carbon footprint in line with the overall carbon trajectory for 1.5 C. To meet the 1.5 C goal, the carbon intensity of GDP needs to reduce by around 15 per cent per annum to 2030, so portfolio decarbonization needs to meet this path. This is achieved by progressive divestment from higher emitting assets.”
The authors contend that this strategy does not go far enough to ensure the 1.5 C goal: “An investor that in good faith believed that portfolio decarbonization is a good risk management strategy probably faces a low risk of being sued for failure to meet the duty of care. But that good faith belief is critical, and there are good reasons to believe that many investors may not be able to hold that belief. Indeed, the strategy is more akin to an active investment bet on a single (arguably unlikely) scenario of overwhelming government intervention and severe (explicit or implicit) carbon pricing to limit warming to 1.5 C.”
The authors also argue that this strategy effectively becomes a progressive divestment strategy and wrote, “Unless taken to extremes, the implications for portfolio returns are limited, probably amounting to less than 5 per cent in valuation terms compared with holding the market in a slow transition scenario. Over time, if more investors adopted this strategy, the crowding into a declining pool of 1.5 C-aligned investments could itself distort valuations and reduce returns.”
The authors also consider sector tilting, focusing on minimizing risks to a portfolio associated with a 1.5 C transition by underweighting sectors most likely to be impaired by the energy transition. They find limitations with that approach, writing, “There is little evidence that sector exclusions will drive any change in real-world emissions.1.5 C”
The third approach considered is tilting within sectors, which differs from the prior strategy by maintaining a neutral sector weighting but divesting from companies most exposed to the event of a 1.5C transition. Studies referenced in the paper “have shown that tilting within sectors creates stronger incentives to change than divestment. … Although the real-world impact of this approach is, at least theoretically, more meaningful, the corresponding scenario risks are higher. The more impactful a strategy is in terms of reducing emissions in the real world, the riskier that strategy is likely to be in the event that the world does not, in fact, reduce emissions.”
The authors also discuss investing in companies already aligned with a net-zero future. Investable companies in this approach either have high adaptation potential, regardless of what scenario emerges, or will simply follow the transition in primary energy sources as power is decarbonized (or not), with few strategic implications.
The last strategy the authors explore is impact investing, ESG integration and active ownership. Active ownership sees that investment philosophy overlaid on policy engagement and aligned lobbying requirements. ESG integration involves incorporating material environmental, social and governance information, including that related to climate, into the investment process in a way that maximizes risk-adjusted returns. Impact investing involves investing in climate solutions in a way that has an additional impact on climate action; for example, investing in high-risk technologies linked to carbon capture or sustainable agriculture. These strategies, the authors conclude, contribute toward achieving the 1.5C goal, but they do not guarantee its success.
The paper concludes that, “in practical terms, the risks of being found by a court to be in breach of fiduciary duty for following [net zero] strategies are likely to be small. The more likely a strategy is to deliver real-world change in carbon emissions, the more likely it is to give rise to fiduciary concerns. Strategies that are more impactful in the real world are not consistent with that duty in the absence of an explicit authorizing mandate from clients.”
Continuing in this critique, the authors contend that low-carbon strategies are more akin to active bets on an “inevitable policy response” that introduces carbon pricing to drive the world towards a 1.5 C scenario, in terms of these asset managers’ NZAMI membership. They add that the greatest risk to asset managers as a NZAMI signatory is the reputational or legal risks of not living up to commitments made.
Ultimately, the authors caution, “We believe that asset managers should be extremely careful about the claims they make for portfolio decarbonization approaches, whether in relation to their real-world emissions impacts or risk-management properties, given our assessment that they generally do not exhibit much of either.”
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Tags: Capital Markets Law Journal, COP26, ESG, Iain MacNeil, Net Zero, Net Zero Asset Alliance, NZAMI, Tom Gosling