Portfolio alignment is a hot topic and key area of focus for the TCFD and COP26 private finance team. But what is it really telling us and how will it influence investment decisions?

The Task Force on Climate-related Financial Disclosures (TCFD) has been looking more closely at the use of forward-looking climate metrics by financial markets. Following a recent consultation process, proposals include changing the 2017 TCFD guidance to recommend for the first time that asset owners measure and disclose the alignment of their portfolios with the goals of the Paris Agreement by using forward-looking metrics.

It has sparked concerns in the industry according to panellists speaking at Sustainability in Practice. Although many investors support the principle of portfolio alignment, they argue measuring and implementing such alignment remains a work in progress. Moreover, adopting portfolio alignment metrics could have undesirable consequences for asset owners around fiduciary duty and costs and trigger divestment over engagement.

Portfolio alignment to net zero goals is an increasing area of focus for the investment industry, said panellist Eva Cairns, head of climate change strategy at Aberdeen. For asset managers, portfolio alignment is now informing decisions as investors seek out transition leaders and climate solutions.

However, she flagged that portfolio alignment can steer investors away from investing in companies that may still be carbon intensive but are on a pathway to reduce those emissions.

“Investing in companies with very strong industry leading targets has more of an impact,” she said.

Moreover, she said the alignment metrics still have challenges around data and regional differences, comparability and transparency.

She counselled on the importance of observing the decarbonisation trajectories of different sectors in different regions and the need for an active research approach that draws on wider inputs and scoring methodology rather than just one temperature metric.

Adam Matthews, co-chair of the Transition Pathway Initiative and director of ethics and engagement at the Church of England Pension Board flagged similar concerns, particularly given the influence of the TCFD on pension fund strategy.

He said temperature-aligned metrics will become credible and decision-useful and will have a role. However, pension funds are not currently in a position to meaningfully use these metrics. Like Cairns, he warned the metrics could incentivise actions like “washing assets out” of portfolios, contrary to responsible investment which means holding difficult assets and working with companies on credible transition paths.

When investors aggregate a single metric across a whole portfolio they run the risk of questionable indications that stimulate wrong actions and unintended consequences.

“We want to get it right,” he said.

Fellow panellist Dominic Tighe who is policy advisor at the COP26 Private Finance Hub which is involved in shaping the TCFD proposals and consultation process as well as a framework for best practice due out in October ahead of COP, defended the process. He noted assets owner demand for forward looking metrics that measure the ambition of companies and distinguish between leaders and laggards within sectors.

He said the TCFD consultation was just a first step to driving consistency in methodology in these metrics to reduce divergence in outputs. He also said asset owners and investors didn’t have to use just one metric or warming score, and that the TCFD outlines different tools.

He reiterated that what matters most is not if an asset is high or low carbon, but if the asset is transitioning quickly enough. He noted TCFD cognisance of the risk of divestment and said the methodology made clear that benchmarks should take account of different sectors and geographies, allowing investors to drive engagement and tilt portfolios.

Tighe reassured that the portfolio alignment metric is evolving and said that recommendations have been reframed since the consultation with a less obligatory tone and without specifying the tools to use.

Still, Matthews urged the TCFD to build confidence in the process and voiced his concerns in the feasibility of large funds using the metrics.

“There are steps for us to work through in terms of how we aggregate this information.”

He said asset owners also need to perform their fiduciary duty and that more dialogue with managers and standard setters like TCFD is essential.

COP26 expectations

Looking ahead to Glasgow’s COP26 Matthews flagged his concerns that policy frameworks may not appear out of the conference.

Although encouraged by the unprecedented focus on finance, he said the policy has to match or the process risked “walking into a brick wall.”

He said pension funds are committed to net zero, engaging with companies but it also depends on regulatory changes.

“There has to be a matching part around policy,” he said.

Cairns also noted the action gap and that zero pledges are not possible without a policy framework.

“I would like to see COP as a tipping point in financial sector ambition on the road to a net zero ambition,” concluded Tighe.

Asset owners’ seeking to achieve net zero in their infrastructure allocations should embark on detailed strategic planning, set interim targets and ensure transparent insight and regular reporting. Strong leadership and clear governance frameworks are also essential – all the while fulfilling fiduciary responsibility to seek superior long-term returns.

IFM Investors’ journey to net zero by 2050 across all its asset classes – infrastructure, debt, private equity and listed equity –  goes hand-in-hand with mitigation of long-term risk, said David Neal chief executive of the investor-owned fund manager speaking at Sustainability in Practice.

Meeting its net zero target has involved setting interim targets over the next decade with IFM now targeting a 40 per cent reduction by 2030. The investor has Scope 1 and 2 emission targets and ensures a rigorous enhanced due diligence process when it buys new assets to ensure the investment team understands the challenges transition and physical risks pose to the asset.

Assets are tested versus reference scenarios and Neal told delegates that the level of the firm’s control of the asset is crucial in its ability to wield influence. He added that IFM is phasing out thermal coal.

“It doesn’t have a place in the energy mix,” he said. The firm is also turning its focus to solutions, building up skills to provide capital to the solutions that will drive the energy transition.

IFM owns high carbon but essential assets like airports, pipelines and utilities. These assets will play a critical role in a net zero future and the investor uses its ownership to influence a long-term trajectory of lower emissions.

“When you own assets for decades you can focus on influencing the long term trajectory for the broader benefits,” he said. He said planning for the transition in these industries involves prudence, constraints and rigorous bottom-up analysis.

Fellow panellist Michael Eisenberg, head of ESG integration at the $268 billion New York State Common Retirement Fund said it has a net zero commitment for 2040. Much of the pension fund’s low carbon strategy is focused on its relationships with infrastructure managers. Discussions with managers in each infrastructure sub sector focus on how the pension fund expects the manager to invest. The fact that the fund is already well on the way to meeting its pledge to invest $20 billion in sustainable investments and climate solutions, has given confidence to its net zero pledge, said Eisenberg.

The investors reflected on how a top-down strategy can make execution difficult. For example, at IFM which is an open-ended fund with an increasing number of investors wanting to invest capital, acquiring assets means portfolio emissions go up.

Moreover, when the manager sells assets, these cannot count as reduced emissions. “We don’t want to benefit from reducing emissions by selling the asset; this is not having a planetary impact,” he said.

Restrictions imposed from a top-down policy can also have other manifestations. Many asset owners have a complete exclusion on coal investment, yet excluding coal prevents investment in, for example, a diversified US utility that draws some of its energy mix from coal. Here an alternative emphasis could be on buying these assets and influencing the utility’s transition from coal.

Panellists noted how a board seat opens the door to better data. One area of data exploration should include how to measure avoided emissions, and how some investments lead to emissions avoided elsewhere in the economy. Eisenberg noted practical challenges around data gathering and the interpretation of data.

He said that good data gives a visibility and comfort to net zero targets and outlined the fund’s manager-by-manager and asset-by-asset data gathering processes.

“The management piece is the key element,” he said, adding how the fund’s focus is evolving away from just supporting companies that have pulled “the easy levers,” to next stage investment.

The conversation concluded with a glimpse at a future infrastructure portfolio. Renewables will be a key part of portfolios alongside hydrogen and the infrastructure to pipe it. Existing infrastructure already moving liquid energy might still be in place.

At New York State the focus will be on selling traditional industries and investing in cutting edge transition opportunities; deep dive partnerships with managers that consider the data and science will remain key.

China’s pledge to achieve carbon neutrality by 2060 will require radical change and formidable challenges lie ahead. But as delegates at the Sustainability in Practice event heard, investment opportunities include renewables, electric vehicles and energy storage.

China’s pledge to achieve carbon neutrality by 2060 will require a huge effort by the public and private sector and is an important strategic and politically constructive step, said Jie Lu, head of investments China for Robeco. Speaking at Sustainability in Practice he said China’s promise should encourage other countries to strengthen their own climate ambitions.

China’s emissions have increased three-fold over the last three decades due to fast-paced resource and energy-led industrialisation and he called the government’s promise to cut emissions a “surprise.”

Lu said that China’s success will depend on funding and political will; it will also require political reforms to overcome resistance from vested interests and ensure the transition is smooth and Just.

“China has the ingredients,” he said.

He said that China’s top-down approach will be key to getting things started, raising awareness at the government level and ensuring implementation and strong execution.

He said that the Chinese government is working hard on its Carbon 2030 action plan, that will likely be a catalyst for more regulation, KPIs for local government and regulators, and an expansion of the scope of the carbon pricing system that could include installing fines. He questioned if policy would include divestment because of its impact on growth and social stability.

Investment will focus most on renewables, electrification and nuclear power, and he predicted SOEs playing a lead role with state owned power generators targeting renewable investment. He also noted green financing on the rise in China.

The investor opportunity is huge. The key areas of investment will include renewables where Lu noted that the government’s targets are already increasing and the cost of wind and solar is increasingly competitive relative to coal-fired power. A

fter decades of subsidy, the government is shifting to market-driven support for clean power and “industries can stand on their feet,” he said. Of course, investors have “bad memories” of solar investment, but this time things are different, he said.

China is already the largest market for electric vehicles in a dominance that extends beyond passenger cars to e-buses and the truck market. He predicted that China will allocate significant spending to the charging infrastructure. He said energy storage technology needed to now develop to support the market and predicted that the hydrogen market could potentially account for 10 per cent of the energy market.

Still, despite the opportunity investors have concerns allocating more money to China because of the impact on their own net zero ambitions.

“How can investors allocate in size to China while fulfilling our climate objectives? It makes our climate scenarios worse” said Jen Bishop, head of asset allocation, at the United Kingdom’s £20 billion Coal Pension Trustee which invests onshore in China in public and private equity allocations. Panellists also discussed how the scramble for new tech to effect energy transition could intensify already strained US China tensions.

Lu said he noted greater ESG scrutiny in China including government pressure on SOEs to invest in renewables. He urged investors to have a “developing mindset” when they invest; noting that many companies have an ESG mindset; that their “scores are good” and they deserve credit and notice.

For sure, stewardship of “old economy” companies is hard. These companies do not have the same incentive to engage with foreign investors as those in the MSCI index.

“A lot of them need to be educated,” he said.

The biggest challenge for investors will be on the governance side, as well as market and political risk. The recent destruction of China’s private education sector is a red flag.

Lu concluded that investment required political savviness, and came with real fears of things changing overnight. However, he said that for knowledgeable investors Chinese policy is easier to navigate.

“It is clear what they like and don’t like.” He said investors should find comfort from the political tail wind behind sustainable investment because this is something they want to do.

Nature is increasingly viewed as an economic asset, or natural capital. Identifying the natural capital assets that can be used most effectively to offset carbon, such as land and forestry, can provide a real advantage in the path to decarbonising investment portfolios.

Trillions of economic value is dependent on natural resources or natural capital of which biodiversity is a vital component, said Sarah Bratton Hughes, head of sustainability, North America at Schroders speaking at Sustainability in Practice. She said that the loss of biodiversity is undermining the achievements of the UN’s SDGs and incorporating natural capital into financial assessments is an increasingly important step in sustainable investment.

Factors driving biodiversity loss include changes to our use of land and the sea and the exploitation of natural resources, climate change and pollution.

“Biodiversity loss is on a par with previous mass extinctions,” she said, adding that the economic loss is also staggering and ranges from impacting crops to triggering floods. The impact of biodiversity loss will be acutely felt in sectors like food and construction, she predicted adding that companies also face a physical risk and regulatory risk from destroying biodiversity.

Investors should quantify companies’ externalities and how they impact natural capital. Investors should also look target companies meeting their decarbonisation targets and creating solutions to climate change and the energy transition.

Bratton Hughes said that Schroders partners with Natural Capital Research which has developed natural capital models using AI and mapping technology to ascertain the underlying biodiversity or natural capital value of land used, for example, as a forestry store or soil sequestration.

She noted that rather than divesting from high emitting portfolios like real estate, some investors are choosing to offset that by investing in biodiverse land.

“We have worked with investors to map out countryside to ascertain areas for a forestry and timber store and have been able to find best value for those clients,” she said.

Asset owners can work productively with asset managers to address biodiversity challenges via reallocation and engagement. Asset managers can collaborate with companies to protect biodiversity and also move and influence policy, she said.

“We are still at a time where there is no broad policy from a global perspective.”

She concluded that a groundswell of sustainable investment drivers combining institutional and retail demand were behind momentum as well as the economic piece focused on the risk of climate change. She said that although biodiversity investment was still at the beginning it was increasingly an opportunity.

Going forward, policy and data will drive the impetus while measuring biodiversity will lead to greater engagement on biodiversity and changes to asset allocations.

Real estate accounts for nearly 40 per cent of energy-related carbon emissions but cutting emissions to net zero in the sector is highly complex. Investors should focus instead on cutting emissions by refurbishing properties and avoiding new builds.

Reducing emissions in real estate portfolios is a growing challenge for asset owners, particularly since greener building are already beginning to show better returns via tenant demand and higher values. Focusing on refurbishment is key to success, said Zsolt Kohalmi, global head of real estate and co-CEO Pictet Alternative Advisors speaking at Sustainability in Practice.

Revealing statistics point to the challenge ahead. Buildings account for nearly 40 per cent of energy-related carbon dioxide emissions, according to UNEP’s 2020 Global Status Report; 90 per cent of buildings in Europe were built pre-1990, and around 45 per cent of emissions occur during the build. Moreover 80 per cent of today’s buildings will still be with us in 2050.

Statistics that suggest the most proactive strategy for asset owners seeking to cut emissions in their real estate portfolio involves refurbishing old buildings rather than investing in new real estate.

“The reduction has to come from refurbishment,” said Kohalmi, adding that it is possible to cut emissions by 30-70 per cent by refurbishment. One of the challenges in the process comes from the fact there are few common measurements or standards around embedded carbon emissions in real estate.

Encouragingly, a green premium is starting to emerge. Kohalmi said that buildings with a higher ESG standard are obtaining higher rental values.

“Going forward you will pay a premium if a building has improved its sustainability rating,” he said. “Refurbishment is not easy, but it is our best path to making an impact on overall emissions and creating climate resilient future.”

The pressure on the sector to decarbonise coincides with wider challenges for real estate in the wake of the pandemic and the shift to working from home. Office spaces able to offer communal areas and space where employees can gather to share ideas rather than fixed desks will do best, predicted Kohalmi.

“We are seeing a shift between the new and old economy in real estate,” he said. Elsewhere, the pandemic has accelerated trends already visible in logistics and retail. The jump in online shopping made “a tough ride” for owners in retail and has proved positive for investors in logistics.

Fellow panellist Karen Lockridge, director, ESG investing, Canada Post Corporation Pension Plan who manages a $3 billion allocation to real estate agreed in the business case for refurbishment, noting statistics pointing to tenants paying a premium and cost savings around energy efficiency.

Both agreed that refurbishment is an opportunity but also vital for risk mitigation.

“There is a downside risk of not acting,” said Kohalmi. He also noted that unlike most trends which tend to emerge first in the US, demand for green real estate is more pronounced in Europe than the US.

“It will rebound in the US in due course,” he predicted.

Achieving net zero in real estate is complex. But significantly reducing emissions is achievable and worth fighting for.

The conversation concluded with a recognition to the fact new builds rather than refurbs will remain the focus in emerging market real estate.

“The focus has to be on how we can improve the way we do new builds like work around creating more sustainable cement,” said Kohalmi. “We have to accept there will be more new builds and become more sustainable when we build,” he said.

Bridgewater’s Carsten Stendevad and PGGM’s Jaap van Dam discuss the need for more clarity and better communication in sustainability and explore how investing for impact is re-shaping investment strategies.

ESG investment needs to answer two key questions, says Carsten Stendevad, co-CIO for sustainability at Bridgewater, the world’s largest hedge fund.

Speaking at Sustainability in Practice he says those questions are: does ESG investment impact financial performance – and does it have an impact on real world sustainability outcomes?

Only clear communication on these two critical points (and the answers may well be negative) will help counter growing criticism that the financial markets should not be tasked with solving the problem of climate change.

“Critics are right in pointing out that too often ESG puts forward simplistic arguments. We need to strengthen our approach,” he said.

He said ESG investment does not always provide better returns and impacts. In some areas, ESG investment does improve returns and in some cases the impact is important, but in other scenarios the impact is marginal.

“It may even be negative and being honest and clear about this is critical for ESG investment,” he told online delegates comprising some 250 registered asset owners representing a collective $13 trillion AUM from 33 different countries.

He said when ESG integration doesn’t boost returns, important questions about investment objectives are imperative. If investors are only integrating ESG for risk and return, they don’t have to get involved in “knotty” arguments about justifying ESG. In contrast, investors with non-financial objectives need to state them clearly.

Fellow panellist Jaap van Dam, director of strategy at Dutch pension asset manager PGGM agreed that ESG investment needed to be clearer about its purpose. He said the concept of purpose often gets a mixed response and ESG meets resistance in jurisdictions where fiduciary duty is a primary concern like the US, and to an extent, the UK.

He also counselled on the importance of highlighting ESG’s “journey to improve,” noting that compared to the past when investment was wholly two dimensional the focus on risk, return and purpose is now taking on more weight in some portfolios.

It led the conversation to so-called three-dimensional portfolios – an area Bridgewater has shifted to now, where impact is considered as deeply and rigorously as risk and return. Stendevad urged investors to build out their investment process – like they have in the past around risk – to capture, manage and measure impact. It involves new processes comprising data collection and portfolio construction, he said.

“At Bridgewater we are committed to this journey to build out a new dimension. Only when you have done this can you answer questions around returns.”

Stendevad said that it was important not to have theoretical arguments around what is possible. Instead, investors should do the work, build the processes and spend time putting together portfolios first.

Van Dam said that for many investors sustainability is not first and foremost when they are designing portfolios but more an afterthought, adding “this is something we have to change.” It is difficult to build sustainable portfolios with historical portfolio construction tools, however.

In three-dimensional portfolios impact sits alongside risk, and all types of capital can be placed on an impact spectrum, said Stendevad.

At one end impact investment can reveal additionality and causality attracting different types of capital like VC and green tech. At the other public, liquid market investors can also invest for impact.

“It is not just high-risk capital that is needed,” he said. Impact is a spectrum and all capital plays a role.

He added that investing in public markets for impact allows investors to support companies that may not be sustainable today but are on a journey. Active owners need to get on a journey with companies to tilt impact where it is most needed, he said.

The conversation touched on the importance of investor engagement and how it should stretch beyond just corporate engagement to reach new parts of the financial system. For example, it is important to support different parts of the data ecosystem to improve data to feed into decision making. Bridgewater uses data from between five and 10 providers, picked from an initial pool of around 40 based on their ability to answer key questions around measuring impact. Panellists concluded that data on modern slavery is particularly poor.