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Tangible steps to decarbonise portfolios

Portfolio Advisor Team
2022-09-30
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Investors are increasingly looking to decarbonise their portfolios, but moving from intent to implementation is challenging. We explore key issues to consider and outline a balanced approach to start repositioning portfolios towards net zero.

The momentum to curb carbon is accelerating

We expect the transition towards a net-zero carbon economy to speed up in the face of intensifying climate change and regulatory and societal pressure. Investors need and want to be part of the solution as evidenced by initiatives such as the Net Zero Asset Managers initiative or the growing demand for climate strategies. Aligning decarbonisation goals with existing investment objectives, risk profiles and time horizons can be challenging, however. Here we explore what a balanced approach may look like.

Major risk, major opportunity

Climate change now constitutes an existential risk. Even if we manage to reverse course, adverse consequences are now unavoidable, leaving many assets exposed to physical risk. The wholesale shift to a net-zero world also comes with transition risk: Assets of companies unwilling or unable to adapt may be hit by a brown discount — as markets reprice them downwards for increased climate risk — and could ultimately become stranded. At the same time, the sheer scale of the forthcoming transition brings a host of opportunities experienced investors may be able to exploit to generate above-benchmark returns, while contributing to a faster transition.

Key ingredients of a balanced approach

Investors can transition their portfolios towards zero carbon in various ways, but we believe there are common strands that feed into a balanced approach. These include:

Engagement

Although large-scale divesting or restricting exposure to heavy carbon emitters may achieve decarbonisation faster, it can sometimes mean sacrificing returns, while potentially still leaving portfolios exposed to the carbon damage caused by those emitters. We believe active engagement — with divestment as the ultimate option — may translate into similar levels of decarbonisation over time without compromising returns or other economic objectives. Active engagement should also help to accelerate the economy’s overall transition.

Forward-looking goals

Despite significant progress, data remains a significant challenge. Data sets are incomplete, fast changing and mostly backward-looking. A research-based active approach may allow investors to gain a deeper understanding of companies’ forward-looking goals and relative ability to adapt and mitigate.

Key role for science

Climate change is a highly complex phenomenon, with broad-ranging ramifications across the entire economic chain. Having access to up-to-date scientific insights can help investors map the long-term impact on asset values across sectors and regions.

Diversification

A balanced approach will not only seek to reduce both physical and transition risks within the portfolio, but also ensure diversification across the many associated opportunities. This entails combining exposures to established companies and infrastructure with allocations to new entrants and technology.

Aligning strategies with risk profile and time horizon

Within the broad framework outlined above, investors need to put in place the right building blocks for their specific circumstances, answering questions that include not only, what is my risk profile, primary investment focus (growth, capital preservation, income), but also how fast do I want to decarbonise? We illustrate how that may work in practice with two potential exposures for the equity component of a climate-aware portfolio. Both solutions enable investors to focus on the opportunities associated with the transition to zero carbon, while reducing climate risk. However, they come with distinct characteristics that fit different investor profiles.

Longer-term, above-market growth exposure

Targeted exposure to growth companies with an explicit focus on combating climate change may offer increased potential for meeting higher growth and decarbonisation targets. This includes renewable energy producers of course, but the universe is much larger and growing fast, as countries around the world start to tackle climate change in earnest. A significant proportion of those companies will be small- to mid-cap size, but not exclusively so. It essentially encompasses any company that generates a large proportion of its revenues from:

  • Mitigation: addressing the causes and minimising the possible impacts of climate change;
  • Adaptation: aiming to reduce the negative effects of climate change; or
  • Innovation: new solutions that help economies and communities both mitigate and adapt to the effects of climate change.

Figure 1 illustrates the breadth of areas where we see the application of climate-led solutions, many of which will involve new technology or doing things differently. This can lead to unexpected new opportunities away from areas that may have become overvalued. Take, for instance, the well-trodden path of renewable energy producers, where new forms of decentralised energy production and distribution could create attractive new businesses. We expect the list of businesses to expand continually as the reality of climate change starts to bite and capital and investments increasingly flow towards companies that have a credible plan.

FIGURE 1
tangible-steps-to-decarbonise-portfolios-fig1

It is important, though, to recognise that the road towards low carbon will be bumpy. Some companies’ transition plans may be less effective than assumed, many technologies and approaches still need to be tested and the impact of climate change is evolving rapidly; hence, the value of active research and the need for up-to-date scientific input. But even with those vital inputs, this type of high-growth exposure may be too volatile and produce less income than certain investors are comfortable with.

Longer-term, lower-volatility exposure

For those types of investors, more value-oriented approaches with a longer decarbonisation trajectory may be more appropriate. This sort of approach tends to focus more on the decarbonisation efforts of incumbent companies, which have well-established income streams. Many of those companies will be essential to the success of the transition to zero carbon — think, for instance, of certain energy utilities and the investment needed in electric grids to make the transition possible. This type of exposure can potentially allow investors to capture opportunities in sectors that may be underappreciated by the market and, again, diversify away from areas that are at risk of becoming overvalued. Figure 2 illustrates this by way of the International Energy Agency’s1 projections of investment for different forms of energy. It shows that electrical networks are likely to benefit from major investment, even ahead of renewables.

FIGURE 2
tangible-steps-to-decarbonise-portfolios-fig2

The decarbonisation efforts of those types of utilities will be supported by governments, regulators and public opinion, so exposure to those types of assets should help investors decarbonise their portfolios, while still enjoying relatively reliable income streams. Clearly this is a sector view, and active research and climate science input can help identify those utilities that have the most credible plans and are least vulnerable to climate risk. This type of underappreciated development is not limited to the utilities sector, and we expect to see similar scenarios unfolding across virtually every industry and sector.

By incorporating these or similar building blocks alongside existing core holdings, investors can take a meaningful step towards decarbonising their portfolios without compromising returns or other objectives. They can take further steps towards zero carbon over time, as the transition accelerates and available climate solutions expand across asset classes.

Taking tangible steps

Decarbonising the economy is a long-term process, and, likewise, repositioning portfolios will take time, but we believe it is important that investors act now. Our balanced framework offers a road map to guide their zero-carbon journey based on their specific objectives and risk appetite.


1World Energy Outlook 2020, Sustainable Development Scenario, International Energy Agency, October 2020.

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Past performance is no guarantee of future performance and can be misleading. Funds returns are shown net of fees.
Source: Wellington Management

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