Is it time to build net zero portfolios?

• In seeking to invest more sustainably, increasingly, investors are making “net zero” commitments to acknowledge their responsibility, and intent to impede further climate change by reducing their greenhouse gas (GHG) emissions.
• The most direct approach for investors to support the transition to a net zero economy is probably to invest in companies providing climate solutions.
• A net zero approach commonly involves tilting portfolios either away from high carbon intensity sectors or companies, or toward lower intensive ones.
• The risk and reward opportunities created by a net zero approach are produced by the relationship of portfolio holdings to the impact of climate change, and the efforts to address. Applying a science-based scenario analysis approach is one way to find out what a net zero world might mean, while allowing investors to use net zero analysis to limit portfolio risks and spot opportunities.
• Decarbonising your investments does not change global emissions. Funding climate solutions are required for that. However, a net zero approach can still produce benefits for your portfolio, while contributing to the fight to limit climate change.

Creating more sustainable businesses seems to have moved up many companies’ boardroom agendas in recent years. Indeed, many have made “net zero” commitments to acknowledge their responsibility, and intent to impede further climate change by reducing their greenhouse gas (GHG) emissions.

In seeking to restrict emissions, many investors may wonder whether they should, or can, make similar commitments to align their portfolios with the Paris Accords goal of a net-zero carbon economy by 2050.

In backing the transition to a net zero economy, the most direct approach for investors is probably to invest in companies providing climate solutions. However, such ventures will probably account for a fraction of any existing, or future, portfolio.

What is a net zero portfolio?

Like many aspects of this evolving field, there is no single agreed view of what constitutes a net zero portfolio. Or how to arrive at one.

The Paris Aligned Investment Initiative starts to clarify what a “Paris Aligned” portfolio means, stating that “implementing an investment strategy that is consistent with achieving the goal of global net-zero emissions by 2050.” To understand that more clearly, and the implications for investors, the definition can be broken down into two parts.

Net zero as an assessment 

What does a net zero commitment mean? The commitment implies investing in a way that is “consistent” with the global GHG emissions goal of being net zero by 2050. Understanding the pathways to achieve this goal at the level of countries, sectors, and companies can help to decide how to invest. Those on or ahead of these emissions goals might be more appealing (from a climate perspective) than those that are not. Furthermore, assessing the net zero commitments against plans and the progress made to achieve them for these entities, can help to judge climate readiness for investors.

Additionally, achieving the net zero goal to limit global warming to 1.5^C ideally. As a result of this framing, portfolio temperature alignment methodologies and tools are available to assist investors to assess their portfolios against an implied temperature rise.

Net zero as a process

Net zero should be seen as a process of investing, rather than applying it to a prescribed set of portfolio holdings. Most frequently, this involves tilting portfolios either away from high carbon intensity sectors or companies, or toward lower intensive ones.

Flexibility in approach also means that your investments may vary considerably. To maintain a diversified sector allocation for a portfolio, it’s possible carbon intensive sectors may remain as holdings. At the most extreme, fossil fuel producers could be included if they have Paris-aligned net zero plans. While less likely, it does indicate for investors the importance of understanding, or defining, the parameters and process to be used.

Should investors be interested in a net zero portfolio?

From a purely investment standpoint, Paris-aligned portfolios may help investors to avoid risks or to generate alpha. Investors may also have ethical views on how they invest in aiding climate change. However, that falls outside the scope of this article, which focuses on the investment case, rather than ethical one.

The risk and reward opportunities created by a net zero approach are produced by the relationship of portfolio holdings to the impact of climate change, and the efforts to address. This can be seen by considering how specific industries and countries will need to operate to align with a net zero economy.

Additionally, the International Energy Agency (IEA) last year published scenarios for the energy economy and transition roadmaps. The IEA’s Net Zero Emissions by 2050 (NZE) scenario suggests that the annual installation of new renewable electricity capacity needs to triple by 2030 to meet net zero goals. On top of that, fossil fuel demand needs to fall by three-quarters in the next three decades, to less than 20% of total energy supply.

Highlighting the size of the opportunity for companies, and investors, current government funding commitments of $25 billion are dwarfed by the $90 billion thought to be needed for clean energy innovation.

Applying similar science-based scenario analysis like these, investors can use net zero analysis to limit portfolio risks and spot opportunities.

Committing to a net zero world

Climate change is increasingly becoming a key investment factor for investors in how they construct portfolios and allocate assets. While there is no off-the-shelf approach to net zero solutions, the overall intent can be incorporated into any investor’s portfolio. That said, decarbonising your investments does not change global emissions, which can be accomplished by funding climate solutions. However, it can still generate benefits for your portfolio, and contribute to in a wider movement to protect our planet.