If the world is to achieve net zero, investors’ current approaches to allocating capital must change. We examine the flaws in asset managers’ and owners’ interpretation, which has led them to set portfolio-level carbon targets that will stymie global net zero ambitions.

Monitoring EM countries’ alignment with global climate goals: a new index to track EM climate performance.

The fast view

  • If the world is to achieve net zero at a speed compatible with the Paris Agreement’s goals, investors’ current approaches to allocating capital must change.
  • The approaches’ flaw lies in asset managers’ and owners’ interpretations of net zero, which has led them to set portfolio-level carbon targets that may actually stymie the world’s net-zero ambition.
  • The acute risk in these capital-allocation models is that emerging markets may be starved of the finance they need to transition to net zero. No net zero in some parts of the world means no net zero everywhere.
  • The first step is for investors to get better at assessing whether an investment or portfolio is aligned with a net-zero pathway that works for all the world. We believe core portfolios should move away from a myopic focus on carbon intensity and towards a focus on a transition. None of the current metrics offers a comprehensive tool.
  • The Net Zero Sovereign Index, introduced in this paper, provides, we believe, sovereign- debt investors with the best, independently verified assessment of Paris-alignment.
  • The next step is to create financial instruments that help capital allocators align with real-world decarbonisation. It is crucial that the developed world and global investor community increase funding to finance the transition in emerging markets. Asset owners must commit capital to a transition, and work with asset managers and policy makers to develop common usable standards for transition finance.
  • We hope that this paper and the Net Zero Sovereign Index encourage a deeper discussion about what capital allocators can do to help achieve a real and sustainable path to total net zero. Time is short.

Access No one left behind: Building an inclusive transition for emerging markets

Part 1: Why investors need better tools to assess net-zero alignment

Part 2: How to measure better — the Net Zero Sovereign Bond Index

Part 3: Financing an inclusive transition

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Important Information

This communication is provided for general information only should not be construed as advice.

All the information in is believed to be reliable but may be inaccurate or incomplete. The views are those of the contributor at the time of publication and do not necessary reflect those of Ninety One.

Any opinions stated are honestly held but are not guaranteed and should not be relied upon.

All rights reserved. Issued by Ninety One.

David Blood, head of the portfolio alignment team and co-founder of Generation Investment Management argues that portfolio alignment metrics will be crucial catalyst of the transition to net zero. Here he argues, with Dominic Tighe and Tanguy Séné who are members of the portfolio alignment team, COP26 private finance hub that by establishing standards of best practice, the Portfolio Alignment Report helps these metrics to reach their potential.

The costs of inaction on climate change are catastrophic. With the last five years the warmest on record, the impact on our planet’s ecosystems is accelerating. To hold back this tide, the next eight years are critical. The IPPC’s ‘report on 1.5C’ indicates that the world needs to cut annual global emissions in half by 2030 to limit warming to 1.5C.

To rise to the challenge of climate change, financial institutions and the companies that they finance, need clear pathways to net zero, illustrating the efforts they need to make. Investors need to be able to differentiate from those sticking with the high carbon business model of the past and those delivering the low carbon solutions of the future.

Different sectors of the economy and regions of the world have different decarbonisation options open to them, and so the shape of their pathways to net zero are different. It’s also key that finance doesn’t just shift from today’s high emitters if they have a credible plan to transition to net zero: the success story from Orsted’s rapid reconversion – from an oil driller to offshore wind leader – wouldn’t have been possible without sustained financial backing.

While critical, knowing the pathways to net zero is only the first step. Financial institutions need tools to assess the performance of specific companies against these pathways. These tools, known as portfolio alignment metrics, enable us to distinguish the leaders from the laggards as our economies adjust to a net zero future. That way, financial institutions can both direct capital to the leaders and stimulate the laggards to raise their game with credible transition strategies.

One approach for metrics is to translate a degree of misalignment between a company’s emissions projected over time and its net zero pathway, into a temperature score. This answers the question: “If every company acted with the same level of ambition as my company, what could the resulting level of global warming be?”, giving an intuitive sense of alignment with the aim to limit warming to 1.5C.

Our ambition is that portfolio alignment metrics become for climate finance as mainstream as credit ratings are in the bond market.

The new TCFD-commissioned Portfolio Alignment Report, published on October 14, should strengthen the quality and usability of portfolio alignment metrics. In setting out best practice recommendations for constructing these tools, it improves comparability and consistency. Our ambition is that portfolio alignment metrics become for climate finance as mainstream as credit ratings are in the bond market. Different methodologies exist but there is broad agreement on the status of an individual asset. We are not there yet, and challenges remain to mainstreaming.

One of the workstreams under the Glasgow Financial Alliance for Net Zero (GFANZ), that brings together over 300 net zero committed financial institutions, will focus on developing the potential of portfolio alignment metrics further, driving consistency and adoption across the financial sector.

Our hope is that this ongoing work can unlock the full potential of portfolio alignment metrics, as a catalyst of the transition to net zero. Once mainstreamed, these metrics will reflect and drive real world decarbonisation and help us to avert catastrophic climate change.

 

David Blood (Head of the Portfolio Alignment Team, Generation IM), Dominic Tighe and Tanguy Séné (Members of the Portfolio Alignment Team, COP26 Private Finance Hub)

For asset owners wanting to know how to set interim targets for your net zero portfolios, here’s how to do it. Amanda White speaks with Deborah Ng from Ontario Teachers’ on their world-class approach.

Back in January, the C$227.7 billion Ontario Teachers’ Pension Plan made a commitment to a net zero portfolio by 2050. At the time it said it was aiming to set interim targets by the end of Q1 but the fund’s journey is a demonstrable reminder of the difficulty in setting targets for large complex global portfolios. Come September it has now released its interim targets.

Deborah Ng, head of responsible investing at Ontario Teachers’ says the delay reflects the fund’s complexity. OTPP took a collaborative approach with representatives at the most senior levels of the organisation having key buy-in, and it had to incorporate the intricacies of setting net zero targets in a large and growing allocation to private markets.

A net zero commitment was a corporate strategy initiative at Ontario Teachers’. The fund’s net zero taskforce was led by members of the investment executive team, as well as representatives from total fund management and global strategic relationships.

The idea was to get a broad group to work through the interim target setting and get buy-in from the entire organisation. There was a lot of interaction and meetings with the investment teams which Ng says was integral as “they are the most impacted”. It also worked with external consultants to help facilitate some of the work which included extensive interviews with peers.

“It was a collaborative approach that we took across the plan internally and externally. We did a landscape assessment of our peers to find best practice and mostly focused on asset owner peers who had set net zero targets as well as asset managers like Blackrock and Wellington,” Ng told Top1000funds.com in an interview.

“It varied quite a lot with where they were at with their plans, some were at very advanced stages and had targets. A lot of them were top down and we also took a tone from the top approach which unlocked resources and efforts to work towards it on a bottom up basis.”

Setting interim targets

The starting point for OTPP was the International Panel on Climate Change’s recommendation of reducing 2019 levels by 50 per cent by 2030.

The fund landed on interim targets that were a lot more ambitious than that, with a plan to reduce portfolio carbon emissions intensity by 45 per cent by 2025 and two-thirds by 2030, compared to its 2019 baseline.

“We did a lot of scenario analysis, we knew there would be emissions reduction because of the decarbonising world, and we wanted to capture that and add to it,” she says. “All of our businesses are buying electricity from somewhere and with this macro decarbonisation we looked at how much reduction was expected in each jurisdiction and applied that to our portfolio.”

The second step was to spend time with the investment teams and examine where the fund was already looking at opportunities, and what plans there where with the transition of assets.

“There was lots of discussion to understand from an investment strategy viewpoint how investments would evolve from now to 2030,” she says.

One of the nuances here was that the broad indices in public equities were very emissions intensive and driving a lot of the fund’s intensity exposure.

OTPP’s strategy overall is to invest more in private markets and high conviction positions in public companies so the portion of the portfolio that was high intensity, broad-based market investments, would be declining over time. In addition, Ng says, the sectors that were of interest to the deal teams were not the high emissions sectors.

“Understanding the investment strategy helped us to understand the targets,” she says.

More in private markets

Ontario Teachers’ currently has 50 per cent of the portfolio in private markets, and that is expected to grow by as much as $70 billion over the next five years as they lower their allocation to fixed income.

“From an investment standpoint we will be increasing private assets over time and our private equity portfolio is very low intensive compared to public equity,” Ng says. “Part of [net zero] strategy is as we pivot more to PE will be able to achieve some of those reductions.”

As a direct investor, the fund will also use its role as an owner of businesses to set portfolio companies on a clear path to implement Paris-aligned net-zero plans and meaningfully reduce emissions.

“We invest a lot directly, and sit on boards, so we can use that influence to help facilitate improved practices and decarbonisation,” she says.

Part of the net zero plan is to significantly grow investments in companies that generate clean energy, reduce demand for fossil fuels and build a sustainable economy.

Sections of the private equity team have been pivoting towards sustainable energy such as sustainable fuels, bio energy and battery storage.

The fund has also set up a team called VERT – the virtual, energy and renewables team – which is a cross-collaborative team made up of representatives from every asset class.

“This group is working to develop an over-arching total fund strategy for how we find investment in clean energy technology, so they are on the cutting edge,” Ng says. “We are trying to understand the areas of interest, our capabilities and what is most investable. We didn’t want to create a new standalone team, we already have the talent, this is a forum to accelerate that and look at opportunities.”

 

Green bonds and transition assets

OTPP has a debt issuance program as part of its total fund management program and has signalled its intention to grow its green asset base. It will issue green bonds and invest the proceeds in climate solutions and sustainable companies.

In addition it intends to address transition assets, recognising their importance in the net zero pathway.

“We can buy higher emissions investments and through our efforts help them to decarbonise faster than they planned or could before and that’s an important area for net zero. There is so much focus on emission reduction what we see happening is the easiest way to meet a target is to sell an asset. There will be times when our footprint doesn’t go down as much because we are taking on a high emissions investment, but we will be taking it down in future years. Most importantly, these efforts lead to real-world emissions reductions,” Ng says, adding it is developing a taxonomy to help define that.

OTPP is an anchor investor alongside Temasek in Brookfield’s global transition fund, co-led by Mark Carney, which will scale clean energy as well as invest capital to transform carbon-intensive businesses. PSP and IMCO are also investors.

 

Operational plans

Ng says a lot of the net zero steps are operational items. Things like how to allocate the targets across the organisation and asset classes, how to define transition assets and measure them in a meaningful way.

“Measuring our green investments is another definitional challenge. We are leveraging our green bond framework, but we also need to understand and measure our entire exposure to green assets and how much that is changing over time,” she says. “We also have to get the deal teams focused and working on private companies to help them moving. We have already done work with portfolio companies to measure their carbon footprint. The work ahead is now we’ve measured it what are the opportunities for reducing those emissions?”

While the fund has been working on the net zero interim targets for the past six months, Ng says the work has just began.

“2025 is not very far away and it will take support from the investment teams to reach these targets. They are aware of targets and are on side but sometimes they need help on getting started so we are working with them on things like how to have the conversation with your portfolio companies. We are looking at what we need to equip the team with to execute this.”

The last piece of the roadmap is on the policy advocacy level to work at the industry and regulatory level to promote policies that are conducive to a transition to net zero.

“As much as we are an influential investor there are much bigger pools of capital out there so standards and regulation also important lever that can create positive change across the entire market .”

 

 

 

Ahead of COP26, Allianz’s Oliver Baete and Enel’s Francesco Starace join a panel discussion at the PRI’s annual conference on what policy makers urgently need to achieve.

Two leading executives voiced their hopes ahead of next week’s COP26 but also their concern that the climate conference won’t bring the change that is needed to tackle the environmental emergency.

Speaking at the PRI’s digital conference in a panel session ‘A Net Zero Future: Credible Ambition and Solutions,’ Oliver Baete, CEO, Allianz, the Munich-based insurance giant and founding member of the UN-convened Asset Owner Alliance, urged COP policy makers to urgently eliminate fossil fuel subsidies that still exist in so many countries – including his native Germany.

“It would be a great step if we could eliminate these subsidies,” he said.

He also called for urgent progress on enforcing transparency, particularly in the private sector and in government-owned assets. He argued that the lack of ESG transparency in these sectors could create a shadow market, impossible to scrutinize. He also urged policy makers to do more to shape a just transition. Developing countries, emerging from the pandemic and navigating the energy transition need support from developed countries.

“It needs to be fair,” he said, adding that developed nations “have created the problem” and now have an obligation and motivation to support emerging economies.

For Francesco Starace, CEO, of Italian energy giant Enel, the biggest win from the conference would be a global carbon price. He said technicalities like whether the price should be based on a cap-and-trade system or taxation, mustn’t side-track from the bigger goal of putting a price on carbon.

“This is the missing part,” he said. “We need to achieve a carbon price.”

Panellists were joined by Hiroshi Shimizu, president, Nippon Life Insurance, a new member of the Net-Zero Asset Owner Alliance who stressed the importance of corporate engagement and better disclosure.

Starace also voiced his concerns about a disorderly transition, urging COP governments to do more to prepare for the years ahead. He said that disorderly transitions created inequality and losers; those that were slow to move will fall into the second category. He said governments need to “tell the truth” to companies and employees so they understand the transition and said that small adjustments are preferable to one seismic shakeup.

“It is much better to have a series of small earthquakes rather than nothing, and a big one at the end.”

Reflecting on the energy crisis in Europe, he said it showed how the market is structured for the short-term. Volatility would be dampened if we bought and sold sizeable quantities of energy over longer five to 10-year horizons, he said.

He said that Enel is preparing for the transition, embarking on a huge investment initiative stretching over the next 10 years to decarbonise.

It will treble renewable generation, install millions of charging points for electric vehicles round the world, and phase out coal.

“We have the technology and the money; the limiting factor is policy,” said Starace, adding that policies are the deciding factor as to whether countries slow down, or accelerate decarbonisation. The other factor is skills and manpower.

Baete also urged politicians to do more to explain to their populations the challenges that lie ahead. Asking people to pay for the cost of climate change through additional taxes will become increasingly difficult.

“You can’t, always, just add the cost to the end consumer,” he said, calling for “intelligent policy” that doesn’t “just penalise people when they use their cars.” He concluded that although there is very strong public support for the transition, research shows people are not prepared to commit more to finance it.

“We need to resolve this dichotomy,” he said.

Baete added that the pandemic has led to a short-term focus at the expense of long-term planning to combat climate change. He said the changing economics of insurance and risk raised the spectre of misallocating capital over the next decades. He also noted that much of the change today has been driven by the private sector.

Reflecting on greenwashing, Starace warned of the dangers of companies not decarbonising, opting instead to compensate via carbon offset initiatives.

“Zero is a clear word,” he said. “The whole issue of compensation and carbon offsets needs to be well understood, otherwise we risk the equivalent of bitcoin in the carbon market.”

Of course, some industries can’t get to zero and offsets and sinks are important, but it must be science-based, concluded Baete.

Consulting firms at the centre of driving change around diversity disclosure in asset management turn the focus onto their own organisations with a commitment to reporting by the same standards. President of Verus, Shelley Heier, who is the driver of the IIDC explains the impact.

In late 2020, we issued a call to action to our fellow institutional investment consulting firms to unite around the importance of gathering diversity data on asset managers.

Our focus was not simply on data at the firm ownership level, the traditional metric of evaluating diversity, but on leadership and investment team levels as well. As a result 24 consulting firms, representing $32 trillion in assets, are now members of the Institutional Investing Diversity Cooperative (IIDC).

The IIDC holds two core beliefs: first, that diversity of investment teams leads to better results and, second, that diversity in our investment industry can be realized only if investment firms cultivate diverse talent and offer opportunities for advancement at all levels. This means developing diverse talent in portfolio management and analyst roles where future leaders and owners of asset management organizations will come from.

One year into this initiative, our data partner eVestment reports that 947 asset managers have provided diversity data on nearly 9,000 products.  This is over 37 per cent of the active products in their traditional manager database.  Membership in the IIDC has grown from 17 original founding members to 24 today, and more are engaged in discussions to join.

To further underline the importance of diversity data, compel the asset management industry to provide their data, and meet asset owners’ increasing appetites for this data across their vendor landscape, we at the IIDC have agreed to apply the same diversity reporting standards to ourselves. All IIDC members will gather and report on their diversity profiles using the same definitions that have been set for asset managers. While asset managers will focus on investment product teams, consultancies will report on diversity of ownership, leadership, and investment professionals.

Reaching agreement with 24 independent consulting firms was not easy and was likely representative of conversations happening in the executive offices of many asset managers as they grapple with if and how they provide their diversity data.

First, getting the data is hard! Small firms don’t have the HR systems to track employee census data in this way. Large firms have very complex HR systems and changing them is incredibly complex. The data we want is different from the EEOC’s. It will be a big task to get the data, and it will take time to do it well.

Second, this is scary! How will the data be used? Will this result in binary decision making? “We know we have a lot of room for improvement but we’re in a non-diverse region” or “given the size of our firm it will take a long time to move the dial, will we be blacklisted in the near-term?” The concerns shared in our IIDC meetings tended to end with something like “but we are actively making the right changes in our recruiting practices, our inclusion efforts, and our pay practices, and we believe these will result in real change.”

Yet in spite of these concerns, all our conversations reaffirmed that a more diverse investment management industry – asset managers and consulting firms alike – is a valid goal which can be achieved by doing a better job at attracting, retaining, and promoting diverse talent. Because we shared this vision, we were able to bridge our fears and the many logistical challenges we face by acknowledging that we need to start somewhere. Therefore we agreed to not worry about rigid application of this standard yet, and just like we are with asset managers, engage in telling the what and how along with the numbers. Providing more transparency on practices and being willing to be measured is an important first step in progress.

In the future, we will provide asset owners a good bookmark for where our industry diversity was in 2021 and how much progress we have made since then. This measurement of progress and emphasis on the teams impacting investment performance will require our industry to invest more significantly in the recruitment, retention, and cultivation of diverse talent. As they say, you get what you measure. We have to start measuring to get the progress we need.

Shelly Heier is president of Verus.

To access the consulting firm diversity template visit www.iidcoop.com.

 

 

In a discussion on the changing relationship between asset owners and managers when it comes to integrating ESG, panellists including PGGM’s Arjen Pasma at this year’s PRI Digital Conference emphasised the importance of collaboration, long-term goals and being very specific in mandates.

Arjen Pasma, chief risk and compliance officer at PGGM Investments which has around 50 per cent of its €266 billion ($322 billion) portfolio with external managers including large private market allocations, said success of ESG integration with managers depends on specific details within the mandate, and asset owners reiterating their long-term objectives.

At the same time, he warned against asset owners placing tight restrictions on their managers as it will impede performance.

“It’s about being specific about the type of behaviour you want from the manager and the type of voting you like,” he said, adding that specifics should include compensation, alignment of interests and details on how managers should report.

Mandates should also include specifics on collaboration and shared endeavour around, for example, sharing data and engagement.

“Our AUM isn’t huge; it is only possible to achieve by partnering with others.”

In Australia, the balance of power between asset owners and managers has shifted to asset owners increasingly shaping and driving mandates said Angela Emslie, a member of A$56 billion HESTA’s impact committee. Given the sophistication and influence of the country’s vast super funds collectively managing some $3.3 trillion, asset owners now call the shots when it comes to integrating ESG into mandates.

“They are mandate makers not takers; if asset owners can’t get what they want, they will internalise investment management,” she said, speaking during a debate at PRI Digital.

Still, Australia’s asset owners haven’t always wielded the power. Emslie said that when HESTA first engaged with managers on sustainability some 20 years ago, the conversation only centred on the fund’s fiduciary duty to members and beneficiaries as stewards of their capital. Conversations on voting and ethics and the need for long-term sustainable investment followed, as did selecting and monitoring managers on ESG. Now the conversation is about building a bridge to real world outcomes, she said.

“The evolution of responsible investment has sped up over the last 18 months. It’s an idea whose time has come. ESG is mainstream and asset owners who don’t take it seriously are left behind and open to operational risk.”

Signs of change

Fellow panellist Sara Bernow, partner at McKinsey & Company agreed mandates once framed around risk and return now take into account responsible investment, sustainability and the expectations of all stakeholders. Transparency and ESG performance have become central to mandates. She noted how asset owners and managers are collaborating in this space and customizing mandates, creating specific and tailored investments that take asset owners sustainability preferences into account.

“We see innovation and partnership in this space.”

Panellists reflected on the need to “empower” asset owners in their relationships with asset managers, demanding ESG progress and holding them to account.

Collaboration

Collaboration between owners and managers was a key theme picked up by panellists. Doug McMurdo, chair of the United Kingdom’s Local Authority Pension Fund Forum, the industry body for the eight pooled funds with a combined £350 billion assets under management, said local authority funds had shown the power of collaboration in the investor backlash to Rio Tinto’s destruction of a an Aboriginal site in Western Australia that resulted in senior executives at the company stepping down.

In another collaboration, local authority pension funds are now working with Brazilian asset managers to address dam failures, putting pressure on Brazil’s mining sector.

PGGM’s Pasma added that collaboration ensures a bigger seat at the table, resulting in better engagement, particularly evident in private equity.

“Not so long ago it was very hard to negotiate anything in terms of ESG in private equity; now private equity firms are opening up.”

He said the industry should also come together to help shape regulatory change. “The last thing we want is 35 different reporting standards.”

Tensions

But panellists acknowledged tension in the relationship. Asset owners need to ensure asset managers are proactively moving on engagement and stewardship and delivering financial value to underlying beneficiaries for the long term. McMurdo voiced his concern that asset managers are still acting in the short term in a conflict with pension funds long term priorities.

Moreover, he said that “all too often” financial institutions and companies use the TCFD as a “cover,” not giving asset owners the information they need.

Another block to effective asset owner engagement with managers lies in the fact many funds have large passive allocations.

“You can’t do effective engagement with 4000 companies; how can you give these companies enough attention? If you want to engage, you need to rethink about how you invest your money,” said PGGM’s Pasma, highlighting that many Dutch funds have large passive allocations.

He suggested asset owners work with fewer external managers.

“Don’t partner with 300, partner with 100.”

He also advised on investing time in strategic relationships forged around beliefs, risk tolerance and a clear delineation of roles between the asset owner and manger.

At PGGM, the current focus is on getting the right ESG governance internally with trustees that can then align with asset managers. Pasma noted caution amongst trustees to engage around ESG, yet said being “a good ESG investor” involves taking an active stance, shaping active policies and accepting risk. Both trustees and asset owners need to step up and be more transparent, he said.

“You can’t hide behind benchmarks.”

HESTA’s Emslie noted that asset managers are still primarily incentivised around alpha. Rather than thinking about “what the world does to companies” she urged managers to think about “what companies do to the world.”