Three ways to align portfolios with the Paris Agreement

AXA's Hans Stoter runs through portfolio allocation, issuer selection and climate KPI monitoring for a 1.5°C investment strategy

Investors are beginning to move from climate commitments to action and they must make important decisions about what tools to use and how to deploy them.

There are three key pillars of principles investors and their managers can follow in order to align portfolios with the Paris Agreement and a 1.5°C investment strategy. These are portfolio allocation, issuer selection and climate KPI monitoring.

Portfolio allocation

Aligning capital flows with ambitious climate objectives requires a shift in portfolio allocation. This means augmenting the traditional emphasis on risk and return with additional, climate-focused targets.

Pension funds are at the vanguard of demand for such strategies. Portfolios can seek to mitigate against both the physical and transition risks associated with climate change and integrate specific climate-related objectives in line with investor requirements, such as the Task Force on Climate-related Financial Disclosures, while not compromising portfolio-level risk and return characteristics.

Alongside risk mitigation, portfolios should be structured in a way as to support both decarbonisation and participation in the energy transition.

Decarbonisation can be supported via a positive allocation to carbon industry leaders already aligned with the Paris goals, but also a positive allocation to transitioning companies. Here, engagement policy is key, and active stewardship a prerequisite, to monitor companies’ progress and credibility to move in the right direction.

To find the relevant balance between engagement and divestment on the basis of carbon objectives, it is necessary to consider both past and forward-looking carbon performance, and more generally to get an overall view of how companies are driving their carbon impact.

Ultimately, alignment through portfolio allocation will require the redefinition of traditional asset classes alongside climate dimensions – according to carbon performance of companies and their maturity regarding transition to a low-carbon economy.

Issuer selection

When it comes to issuer selection, there are three broad categories through which to direct positive capital flows: the carbon leaders, the transition leaders and the green leaders.

Identifying investments that meet set comprehensive objectives within each category is key in being able to positively allocate to the best-in-class issuers, as well as establishing minimum climate standards for those lagging the adaptability necessary to benefit from or support the transition. Achieving this outcome means assessing issuers with a diverse set of metrics and identifying how they interact. These range from carbon intensity, both absolute and relative to peers, measures of climate value at risk and future reduction targets, and metrics on the upside opportunity of the climate transition.

Here, a mix of metrics is vital. To focus purely on one, such as carbon intensity, could mean the blunt exclusion of companies which, while they may have high intensity on an absolute basis, demonstrate high transition potential or attractive green technology opportunity.

Climate KPIs monitoring

Achieving alignment via investing also means monitoring and reporting on portfolio climate key performance indicators (KPIs). This must include not just better use of existing metrics but also the development of new tools and analytics. These key dimensions illustrate how aligned the investment decisions are with climate mitigation and the adaptation required to support the Paris goals:

  • Reduce current portfolio carbon footprint in both absolute and relative terms taking into account future carbon emissions reduction potential
  • Maintain exposure to sectors at stake necessary to support the low carbon transition. That means making positive allocations to transitioning companies in traditionally carbon intensive sectors such as transport and energy, supported by robust and demanding engagement to encourage adoption of more sustainable products, technologies or activities
  • Monitor portfolios’ and issuers’ climate forward-looking KPIs such as temperature and low carbon transition credentials
  • Monitor overall environment, social and governance and climate performance, including minimum climate standards

Avatar

Natasha Turner

Natasha is global deputy editor at ESG Clarity, part of the Bonhill Group, and has been a financial journalist for six years. She has been shortlisted for Story of the Year and Investment Journalist of...