Scientific Beta: Understanding net-zero investment frameworks
By Frederic Ducoulombier, ESG Director at Scientific Beta
The landmark net-zero investment frameworks aim to assist investors in defining investment management strategies that may be presented as being in line with the most ambitious goals of the Paris Agreement on Climate Change and to encourage investors to implement portfolio alignment in a manner that promotes progress in the real economy.
Thanks to collaborative work hosted by investor coalitions, guidance on how investor climate scenario alignment pledges could be translated into portfolio and stakeholder management practices started to emerge in 2021 with the publication of the ‘Net-Zero Investment Framework Implementation Guide’ of the Paris Aligned Investment Initiative and the ‘2025 Target Setting Protocol’ of the United Nations-convened Net-Zero Asset Owner Alliance.
Here, we briefly discuss the philosophy and practical recommendations of these net-zero investment frameworks with a focus on equity portfolio management.
Capital allocation, issuer engagement, third party engagement
These frameworks identify capital allocation, issuer engagement, and third-party engagement as portfolio alignment tools and channels that investors may use to try and alter activity in the real economy.
Capital allocation is primarily approached as a tool to direct capital towards climate leaders and limit exposure to downside transition risks.
Issuer engagement is regarded as the tool of choice to influence issuers to improve their climate performance. Although not grounded in theoretical models or supported by strong empirical evidence, this stance on investor impact channels is consistent with conventional wisdom in the sustainable investment industry.
Meanwhile, the frameworks correctly identify engagement of other stakeholders, and notably policy makers, as key to promoting an environment facilitating portfolio and economic alignment, but do not grant it a central role.
A top-down approach and long term goals
The Framework provides a top-down approach to alignment from defining a strategy and setting portfolio-level objectives for decarbonisation and investment in climate solutions, to defining an optimal asset allocation, down to assessing alignment at the asset level and improving alignment by portfolio construction and issuer engagement.
The Protocol is concerned with five-year goals and calls on investors to set engagement targets as well as targets in at least two of the three areas it covers, which are emissions at the asset-class or portfolio level, emissions at the sector level, and activities enlarging the availability and financing of climate solutions.
Both frameworks call for the definition of top-level emissions reduction targets to guide portfolio alignment. Investors implementing the Framework must set <10-year targets for emissions (intensity) reduction and allocation to climate solutions that are consistent with conservative 1.5 °C scenarios; these are also encouraged to set five-year targets. Investors implementing the (2022 update of the) Protocol are invited to reduce emissions by 22% to 32% by 2025 and 49% to 65% by 2030, which also aligns with ambitious emissions mitigation pathways.
The risk of greenwashing
Both frameworks underline that alignment should be approached at the sector level to avoid greenwashing, whereby portfolio alignment is performed by cross-sector reallocations that are not called for by the transition pathway and do little to incentivise alignment by issuers.
To endeavour to link portfolio alignment to real world progress, the Framework requires that investors set a five-year goal for increasing the percentage of their assets – in material sectors from a climate change perspective – that may be considered net-zero or aligned or aligning to a relevant net-zero pathway and ensure that 70% of the financed emissions in these sectors are either pathway-compatible or subject to engagement.
Asset-level alignment assessment
Asset-level alignment assessment in the Framework is central and ambitious in scope as it covers all companies in broadly defined material sectors. Alignment is assessed according to detailed criteria balancing current climate performance metrics with forward-looking decarbonisation indicators.
The Protocol calls for (but does not require) the setting of five-year efficiency gain targets at the sector level. These must be informed by sector-specific pathways, starting with the most material sectors for investors within key high-emitting sectors.
Targets may be achieved through capital allocation and/or engagement. With regards to the latter, the Protocol requires investors to either identify 20 large emitters or those responsible for 65% of their financed emissions and to set action targets with a focus on emitters without Paris-alignment commitments or ‘concrete’ mid-term emissions reduction targets.
The frameworks envisage two main ways to incentivise alignment at the level of issuers. The first is capital allocation, whereby the investor allocates its funds in relation to issuer alignment to try to alter issuers' access to capital and send market signals to promote issuer alignment. The second is engagement, whereby the investor attempts to influence issuers towards adopting and following through plans for alignment through dialogue–conducted directly or through collective initiatives–voting policy and shareholder proposals.
Considering that capital allocation contributes to incentivising alignment, the Framework mandates that portfolio construction for passive solutions implement positive weighting in relation to each issuer’s degree of alignment relative to its sector and climate solutions revenues. It also recommends a transparent, alignment-criteria based issuer engagement strategy with clear milestones and an escalation process feeding back to capital allocation.
Thus, it aligns capital allocation and issuer engagement and creates synergies between these investor impact channels. The Protocol downplays capital allocation as an investor impact channel and does not make explicit portfolio construction recommendations. While making engagement its sole recommended investor impact channel, it offers a high degree of flexibility in its modalities, lets each investor define the ambition of engagement targets, and does not require setting targets in respect of the end result sought by engagement, which is issuer-level alignment.
Possible downsides to the framework
The Framework provides a top-down model to translate net-zero commitments into portfolio-level goals and plans, and coherent, synergistic, use of investor impact channels linked to well-defined alignment criteria and monitoring metrics. However, it does not offer much guidance for the setting of targets, especially medium-term targets, or much colour on engagement activities in practice.
The Protocol offers guidance for the setting of five-year targets down to the sector level and in respect of engagement activities. However, it eschews capital allocation as potential investor impact tool and is not particularly demanding when it comes to engagement activities and outcomes.
As a stand-alone framework, the Protocol might thus come across as excessively accommodating of net-zero investor commitments lacking in impact ambition and potential. However, it may be viewed as particularly useful in combination with the Framework’s investor-impact maximisation coherent architecture in that it helps translate medium-to-long-term portfolio-level targets into five-year targets down to the level of key transition sectors.
Given the limited scientific evidence linking investor impact tools, and notably shareholder engagement, to substantial real-world progress, investors wishing to link their net-zero investment commitments to impact should not only consider opting for frameworks and approaches that maximise potential investor impact, but also document the implementation of their impact strategies and endeavour to measure their real-world outcomes.