Yesterday it took place Pictet’s Climate change Action conference, as Climate change is more and more relevant for governments, companies, financial institutions and our clients, for whom we have an investment framework. In fact, clients have been particularly interested in mitigation, which requires solutions regarding decarbonization.
A framework for investing in “Net-Zero” leaders
Keep in mind that the August report of United Nations‘ Intergovernmental Panel on Climate Change warned of the state of climate emergency in the face of one degree global warming above pre-industrial level, caused by human activity. In fact, climate feedback mechanisms mean that even a increase of just 0.5º can have very significant cascading effects. For example, if there were a 3ºC increase, there would be one hundred million people displaced by the rising sea levels.
Now governments, by the Paris Agreement, set to reach COP26 in Glasgow with more ambitious commitments for 2030 and 150 countries have provided updated carbon emission reduction targets for global warming no greater than 1.5°C. That is, 80% of the world’s GDP. But with current targets global warming may reach 2.4ºC by the end of the century, according to Climate Action Tracker Warming Projections Global Update. Even taking into account the best scenario it would be 1.8 °C. Fortunately, the Glasgow Climate Pact requires countries to review and strengthen their targets by the end of 2022.
Net Zero Asset Managers
The fact is that governments, the civil society and the private sector are increasingly aligned with respect to the same objective. It is noteworthy the commitment reached at COP 26 by the Net Zero Asset Managers Alliance, with more than 400 members, representing 130 billion dollars in assets, including asset owners, managers, banks, insurers, service providers and consultants. In addition, for the first time, a COP agreement mentions accelerating efforts towards “phasing out coal power and ending inefficient fossil fuel subsidies”. Also, 40 signatories (70% of the global economy) have agreed to accelerate investments in technologies and make them more affordable and attractive by 2030. This includes energy, transport, carbon capture and storage, energy efficiency, green hydrogen and sustainable agriculture.
Half of the emission reductions will come from technologies under development
Specifically, the International Energy Agency estimates that half of emissions reduction needed to reach net zero globally by 2050 will come from technologies currently under development. It estimates that requires tripling investment in renewable energy to four trillion dollars/year by 2030, with 993GW addition of wind and solar capacity, complete cessation of sales of internal combustion engine cars by 2035 -with 56 million sales of electric vehicles by 2030- and the phasing out of energy produced with coal and oil sources by 2040.
In fact de-carbonization affects practically all sectors, thus the need for a Net Zero investment portfolio.
Opportunities include renewable energy. The costs of generating renewable energy, wind and solar, have decreased considerably over the years and are increasingly competitive compared to fossil fuel energy sources and global governments are taking steps to support them with their net-zero emissions commitments. To this is adds companies focused on energy efficiency in transportation (electrification and intelligent mobility), buildings -these represent 29% of world’s final energy consumption-, which includes building materials and insulation, efficient lighting, data centres and energy management. Also, improvements in industrial manufacturing processes include software for prototyping and simulation. Aside, smart and electric mobility are driven by cost competitiveness, greater awareness of air pollution and stricter regulations. Add to this energy storage technologies in batteries, smart grids and energy semiconductors, e critical in the transition to a low-carbon economy.
Physical and transition risks
So this involves taking into account physical risks –such as extreme weather– and transition risks, related to obtaining energy and consumption. Thus, according to the journal Nature, 60% of fossil fuels will remain unedited and will have to be transformed into losses on companies’ balance sheets. At the same time, it implies investment opportunities in the leaders of this transition, that is, the companies that have advanced in the objective of being carbon neutral by 2050, as well as solution providers, with opportunities present in certain thematic funds.
Identifying “Net Zero” Leaders
To identify “Net Zero” leaders, it is very important to have complete and reliable data. To this end, we carry out ESG integration in the financial analysis of companies, including physical and transition risks, excluding high-risk activities and companies exposed to controversies. It is about investing in companies that can have a positive impact, without forgetting potential negative impacts. In terms of climate relevance, we exclude financial sectors and look at companies whose scope 1, 2 and 3 carbon emissions, especially those that emit more than two million tons, taking into account that scope 3 emissions include supply chains and product use and constitute the majority of the emissions of many companies, often undisclosed and requiring assumptions, with significant variation in data provider estimates. We also look at intentionality, that is, is climate change is part of the strategy, objectives and governance, with scenarios and history of last three years in reduction of emissions. Additionally, we take into account how companies measure the achievement of de carbonization objectives and the quality of their reports.
ESG fund analysis framework
We start by checking existence of commitment of the fund manager, if it adheres to international standards, if has ESG principles and its resources and products. We also analyze the investment process and the existence of exclusions, exercise of active ownership and dialogue with companies in which invests as well as its monitoring and reporting. The result of this quantitative and qualitative analysis is an ESG score, which determines leading and lagging managers, whose evolution we observe over time. This proprietary score has some relation, although not systematic, with the SFDR classification of the European Union, which is taken into account.
As for funds, we look at four pillars, similar to the analysis of individual stocks. We do ESG due diligence, if the fund is classified under Section 9 SFDR and the exclusion policy. Then we look at the relevance regarding climate change, which has to be one of the main objectives. We also look at the composition of the portfolio and in case of funds oriented to Net Zero leaders and solutions, we check the exposure to negative impact sectors on climate and if there is dialogue with the companies, as well as alignment with the taxonomy of activities related to climate change. We also take into account the intentionality, which we consider when the manager is signatory of the Net Zero Asset Managers Alliance with intermediate reduction emission objectives at portfolio level and active dialogue with companies in which it invests. In addition, funds have to provide climate-related metrics according to the main standards.
The simplest measurement tools is binary, i.e. the percentage of components of the fund’s portfolio aligned with the Paris Agreement, climate science and existing industry frameworks. A more complex approach involves measuring the emissions forecasts of portfolio components against a climate scenario reference. The EU Climate Reference Regulation requires portfolios to be decarbonised at an average rate of 7% per year for a global scenario of a 1.5°C increase in temperature. These models can use scenarios taking into account different decarbonisation rates by sector and region. In addition, implicit contribution models take into account the alignment of each component of the portfolio with a temperature. For example, a score of 2.5°C in a company indicates that it exceeds the global carbon budget.