The investment community is showing an increasing commitment to playing its part in reducing carbon emissions, particularly by decarbonising investment portfolios – aiming to limit the global temperature rise to 1.5°C above pre-industrial levels by 2050. ‘Net zero’ portfolios have become a popular way to think about achieving this, drawing on a number of different approaches, including:
- outright exclusions,
- divestment,
- buying up green investments via Environmental, Social & Governance (ESG) labelled bonds,
- focusing on investing in “best in class”, with a developed markets bias.
Missing the bigger picture
All these strategies have their merits and limitations, and clearly are not mutually exclusive in their application. But, whether they are fit for purpose needs to be assessed against the goal investors are seeking – real economy outcomes – and not just portfolio level outcomes.
For instance, systematically excluding entire sectors or countries will result in capital being directed to a narrow set of geographies, industries, and companies, potentially creating price bubbles in areas such as renewable energy or issuers with the lowest current carbon footprint.
Exclusion of those companies in high carbon intensity industries, especially those with more complex transition trajectories, means they will be starved of ESG-conscious capital, increasingly narrowing their funding opportunities to investors that are not focused on their carbon footprint. Whilst the exclusion approach will result in low carbon portfolios, it will not deliver actual reductions in emissions in the real economy – perhaps to the contrary.
Companies with low emissions receiving excess financing will feel less urgency to keep improving and companies/ industries screened out of portfolios could also have little incentive to change if they, by default, cater increasingly to an investor base less/not concerned with ESG.
Outright exclusion also denies capital to those issuers with critical need who want to transition, and ignores the role active stewardship can play in engaging with laggards. Most importantly, this approach doesn’t comprehensively tackle the problems the global economy is facing, particularly in Emerging Markets (EM), such as poverty, low income, and lack of access to financial and basic services. These conditions make the global economy more vulnerable to climate change and will need to be addressed for a successful transition.