Carbon hygiene for portfolios

Decarbonization is a key aim for policymakers, economies and corporations. But why might investors want to decarbonize portfolios, and how should they do it? In my newsletter this week I discuss a recent report we’ve published on the subject, which investigates:

·         The importance of defining decarbonization measures and objectives

·         Asset class decarbonization data, exclusions and switching

·         Possible impacts on portfolio structure and investment risks

Decarbonizing the economy is essential; not just to combat climate change and threats to nature, but also to keep the foundations of our global economy intact. So decarbonization is, and will remain, a key environmental objective. The Paris Agreement commits countries to net zero emissions by 2050. Economies, governments, and companies are now in transition towards more sustainable, lower carbon-emitting economic and business models. This is decarbonization – both a process and an outcome.

But there are ongoing discussions as to what role portfolios of liquid investments should play in the decarbonization process. We have to distinguish between two important aspects. Investors may be less concerned about primary markets (where new equity or debt is issued). But investors in secondary markets (where portfolio management happens) will be interested in a firm’s decarbonization progress from a risk/return perspective, even if their direct impact on the firm’s actions (e.g. via equity voting rights) is limited.

Deutsche Bank Private Bank has recently published a report on “decarbonizing” investment portfolios, which you can read here.

With decarbonizing portfolios, the devil really is in the detail. The report looks at:

1. Why it is important to carefully define the emissions measure, so investors can select and manage investments in a portfolio as well as part of reducing absolute levels of emissions.
2. The time perspective: why investors need to consider projected as well as actual carbon emissions levels, as part of establishing decarbonization pathways (see graphic).
3. The type of target: how binary (hit/miss) emissions targets need to complemented by benchmarking so we can measure progress and validate portfolio components.
4. Data availability on carbon emissions and its implications. Better data on equities and corporate debt mean that these asset classes are likely to be at the heart of a decarbonization strategy.
5. Why choices of investment vehicles may require compromises. “Passive” vehicles can, for example, be designed to follow a specific decarbonization pathway but include unwanted sectors.
6. How investment “exclusions” (of industries/sectors) can be a blunt tool, can affect portfolio performance and may be counterproductive in encouraging the sustainability transition.
7. Understanding the limits on switching (replacing individual investments with better decarbonization metrics) due to the lack of alternatives or portfolio management considerations.
8. How investment screening can reduce the available investment universe and skew portfolio composition – meaning that some room for flexibility may be advisable.
9. Why decarbonization will require different short-term management of financial risks but could help reduce longer-term transition risks, e.g. around stranded assets.
10. The importance of optimizing portfolios on an ongoing basis to keep pace with real-world decarbonization and changing regulations.

What do I take from this report?

Investors have multiple reasons to want to decarbonize portfolios, not just altruistic. But they need to understand how to do it – and the likely investment implications.

This article is also published on the author's blog. illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.