An Interplay: Real Economy and Portfolio Decarbonization

In recent years, a wide range of global consortiums has launched investor-oriented net-zero initiatives accompanied by frameworks and recommendations for companies, policymakers, and investors (see Net Zero Target-Setting Methodologies Demystified)¹. Broadly, these frameworks are aimed at decreasing carbon exposure in portfolios (a process known as portfolio decarbonization) by prioritizing emissions reductions in the real-world economy (a process known as real-world decarbonization). The question, then, is how these two processes interact. In this piece, we define these two concepts, discuss how they relate, and unpack what they may mean for investors.

The Decarbonization Processes

Defining Real-World Decarbonization

Real-world decarbonization is the reduction of emissions in the real-world economy. In the investment context, this refers to underlying equity and debt issuers (such as portfolio companies and sovereigns) improving their carbon profile. Investors may seek to influence issuers through various channels, including the following: 

• Engagement with company management teams/boards to encourage better reporting, disclosures, and adoption of decarbonization goals.
• Primary market investments in green technologies/climate solutions (e.g., renewable energy generation and carbon capture systems)
• Policy advocacy with regulators/governments to encourage adoption of energy transition policies and standardized disclosure norms

Defining Portfolio Decarbonization

Portfolio decarbonization refers to an improvement in the emissions profile of an investment portfolio measured by lower carbon intensity, reduced fossil fuel ownership, or higher green/brown revenue ratios, among others. Investors can achieve this in two main ways:

• Cutting emissions by underlying investee companies (through the real-world decarbonization channel).
• Changes to portfolio allocations and tilting towards more companies seen to have superior climate characteristics compared to their peers.

The assessment of climate characteristics can take different shapes and forms. Many such investment solutions are now available in the market, including:

• Low/reduced carbon strategies that curb weighted average carbon intensity.
• More holistic climate investment solutions combining multiple climate metrics, such as EU Paris aligned benchmarks and EU climate transition benchmarks, among others.
• Portfolios with a year-on-year decarbonization trajectory.
• Strategies that divest from high emitting companies or industries.
• Combining the elements above to “mix and match”.

How Real-World Decarbonization and Portfolio Decarbonization Interact

Real Economy Decarbonization Leads to Portfolio Decarbonization

The impact of real economy emissions reduction on portfolio-level metrics is fairly clear; if underlying companies are decarbonizing their own operations, the portfolios that invest in those companies are also decarbonizing over a period of time. This is the main path towards portfolio decarbonization that net-zero frameworks espouse. For instance, the Institutional Investor Group on Climate Change’s Paris Aligned Investment Initiative Net-Zero Investment Framework (PAII), the Science-based Targets Initiative for Financial Institutions (SBTI-FI), and the Net-Zero Asset Owner Alliance’s Target Setting Protocol (NZAOA) all suggest an engagement-focused approach to achieving real economy decarbonization targets. Furthermore, the PAII and NZAOA recommend explicit engagement targets with high-emitting companies to influence adoption of decarbonization plans.

Portfolio Decarbonization Can Drive Real Economy Decarbonization, but the Interaction is Less Direct

Understanding the interaction in the reverse direction is trickier. A recent paper by Kolbel et al (2020) reviewed empirical evidence on the mechanisms of investor impact and concluded the following:

In other words, the authors found literature supporting that real economy decarbonization (engagement) impacts portfolio decarbonization. But for the reverse, there is some supporting literature that portfolio decarbonization (capital allocation) impacts real economy decarbonization, but more evidence is needed. Portfolio decarbonization approaches, in general, alter capital allocations by reducing investments in high carbon-intensive names, and increasing investments in low carbon-intensive names (note that such approaches can be implemented in a sector neutral fashion, so that sector allocations remain similar to the parent index). We note that most public equity and fixed income investments are made in secondary markets. Therefore, changing portfolio allocations only transfers the ownership of those emissions from one investor to another, without having a discernible impact on real economy emissions reductions in our view. That said, if such portfolio allocation changes are made by a critical mass of investors, the stock and bond prices of high carbon intensive companies may be depressed, potentially leading to changes in the cost of capital for those companies. As a result, the composition of the portfolio and over/underweighting of certain types of companies may send a signal to both the companies that are overweighted, as well as to those that are underweighted. To the overweighted companies, it may serve as a signal to continue the climate risk management path they are on, and to the underweighted companies, it may serve as a signal to alter their behaviors and adopt transition plans. Once again, more research needs to be done to provide conclusive evidence about this channel of impact, it is also not possible to predict if such a critical mass of investors can be reached, but the above is a general explanation of the basic idea behind portfolio decarbonization approaches.

Implications for Asset Allocation

Investor responses to climate change highly depend on client preferences and long-term objectives. These objectives can take different shapes and forms. For example, if the investor prefers to pursue climate risk management as a dominant element in their portfolio, potentially driven by a belief that climate risks are not fully factored into asset prices, then that investor could choose portfolio decarbonization strategies. These strategies may integrate climate metrics that indicate transition risk (see Net-Zero: An Investor’s Implementation Guide), or physical risk. This can be implemented with varying levels of rigor, depending on risk budgets, strength of convictions, climate metrics being targeted, and other factors.

If the investor wishes to pursue real-world decarbonization as a primary objective (analogous to an “ESG impact” or “ESG output” approach), various approaches are possible. Two examples at the most extreme degrees of potential impact include:

• Pureplay engagement: Solely buying shares of large emitting companies, engaging with their boards and management teams, and effecting change from within.
• Pureplay capital allocation: Solely investing in portfolio decarbonization strategies in liquid markets (public equity and corporate fixed income), with additional allocations to climate solutions in the illiquid space (private equity or venture capital). The goal of this approach is to use price action to send a clear signal to companies seen to have inferior climate transition plans compared to their peers.

However, these extreme options utilized in a mutually exclusive manner are unlikely to be acceptable for the majority of investors that also have fiduciary obligations and need to balance their desire for climate action with protecting long-term financial interests for their stakeholders. As a result, a “middle of the road” option could include a mixture of the following approaches:

• Remaining invested in broad public equities (both indexed and active), and pursuing engagement with investee companies, and
• Carving out an allocation to portfolio decarbonization approaches and illiquid investments in climate solutions companies.

Under this approach, the investor remains invested in companies seen to have inferior climate transition plans but engages with their management teams to drive change. In addition, the allocation to portfolio decarbonization approaches serves as an additional tool by helping to send a clear message to these companies with weaker climate risk profiles.

How SSGA Can Help

We aim to support our clients in implementing a wide range of climate risk mitigation solutions depending on their respective objectives and preferences. We offer climate-related capabilities in four key areas: Data Analytics, Investment Solutions, Asset Stewardship, and Reporting.

In particular, for clients who want to pursue real-world decarbonization via engagement, climate stewardship has been a priority for us since 2014, and we have published guidelines on our disclosure and oversight expectations (see State Street Global Advisors Climate Stewardship). For clients seeking investment solutions for portfolio decarbonization, we offer active and passive climate investing approaches that can be implemented across equities and fixed income.

We also offer extensive analytical and reporting capabilities that include carbon emissions-related assessments (including metrics aligned with the Task Force on Climate-Related Financial Disclosures), other climate data (including fossil fuels and green/brown ratios), as well as climate scenario analysis via third-party tools. Please reach out to your Relationship Manager for further details.

Conclusion

Investors continue to own or consider owning portfolios bound by a wide array of net-zero frameworks. It is a challenging landscape for investors, with differing implications for asset allocation depending on the primary objective. A key question that still remains to be conclusively answered is how portfolio decarbonization strategies can be viewed in the context of an investor’s overarching goal of real-world decarbonization.

We have discussed how these two concepts interact and provided food for thought around how investors who wish to add a net-zero strategy can make informed decisions when establishing a climate aware strategy. For most investors who wish to add a net-zero strategy, the path is likely to incorporate aspects of engagement, as well as capital allocation approaches to varying degrees. State Street Global Advisors is committed to helping its clients achieve their individual ESG/sustainability-related goals and preferences and act as partner in navigating this, at times, challenging field.