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Research paper - Investment frameworks for a net zero pathway

Alex Bernhardt+3
7 Authors - Portfolio perspectives
28/11/2023 · 8 Min

Our paper, Aligning investments with the Paris Agreement – Frameworks  for a net zero pathway, explores various strategies for institutional investors to align their equity portfolios with pathways targeting net zero greenhouse gas emissions by 2050.1

We describe and assess four frameworks: 

  • BNP Paribas Asset Management’s ‘Net Zero Achieving Aligned Aligning’ (NZ:AAA) approach which classifies companies based on their efforts towards aligning with net zero by 2050
  • The European Union’s ‘Paris Aligned Benchmark’ (PAB) framework
  • Excluding fossil fuel companies from portfolios
  • A dark green approach investing only in clean energy companies. 

For each framework, we have considered minimum tracking error portfolios to assess the impact of the chosen approach on the expected risk, returns and sustainability of an investment strategy replicating the performance of the underlying market capitalisation index.

While minimum tracking error portfolios do not consider a possible net zero risk premium, if such a premium exists, these portfolios should more easily outperform the market cap index in the medium to longer term.

Minimum tracking error portfolios could be useful as an investment solution for many investors, in particular institutional investors, i.e., large investors who tend to set limits on the amount of tracking error risk they can accept relative to the market cap portfolio. In the absence of a reliable estimation of the net zero risk premium, they are a pragmatic solution allowing investors to better size the risk budget allocation to that premium.

Below we summarise the main features of these frameworks including their diversification, risk and sustainability components. We report on how each framework aligns with the recommendations of organisations seeking to decarbonise the economy and achieve net zero by 2050 and beyond.

NZ:AAA: achieving, aligned, aligning screens

Our NZ:AAA approach is based on ranking companies as ‘Achieving’, ‘Aligned’ and ‘Aligning’ with science-based decarbonisation pathways or contributing towards the energy transition and decarbonisation of the real economy. 

  • The Achievingscreen identifies companies already achieving net zero emissions and/or selling products and services significantly associated with climate mitigation as part of the Sustainable Development Goals (SDGs) or products and services aligned with the EU Taxonomy.
  • The Alignedscreen identifies companies on a pathway that contributes to capping global warming at 1.5°C and/or are selling products and services sufficiently aligned with this goal.
  • The Aligningscreen identifies companies on a pathway that contributes to capping global warming at 2.0°C that may be good candidates for engagement and stewardship encouraging them to take further steps towards decarbonisation and sustainability. 

At present, only a few companies pass the Achieving screen, mostly from the utilities, real estate, information technology, industrials and consumer discretionary sectors. If we group Achieving and Aligned stocks, only the energy sector is excluded. If we add Aligning stocks, all sectors are represented at a global level, in Europe or the US.

The number of companies passing the three screens ranges from 37% for the MSCI ACWI index, representing 61% of its market capitalisation, to 71% for the MSCI Europe, representing 79% in market cap.

If we look for companies passing only the Achieving or Aligned screens (i.e., that are more consistent with a net zero approach), we find 23% and 53% of companies in the MSCI ACWI and MSCI Europe, respectively, with market caps of 42% and 61%, respectively. Only 5% of companies pass the Achieving criteria.

Currently, replicating market cap indexes using the Achieving and Aligned screens leaves us with a tracking error of about 1.3% for the MSCI ACWI, MSCI World and MSCI Europe and 2% for the S&P500. If we also accept Aligning stocks, the tracking errors fall to 0.8% and 1.2%, respectively.

If we limit ourselves to Achieving companies, the exposure to EU Taxonomy criteria is strong. It remains high if we extend investments to Aligned and even Aligning stocks. Similarly, we find significant tilts toward SFDR Sustainable Investments in particular in portfolios invested only in Achieving companies; it is still high when applying Achieving and Aligned screens.

The BNPP AM NZ:AAA framework can be used to follow the recommendations of the Paris Aligned Investment Initiative (PAII) for portfolio construction and identifying companies for engagement and stewardship.

It provides a means of classifying companies in terms of how aligned they are with the recommendations of the UN High Level Expert Group (HLEG) on the Net-Zero Emissions Commitments of Non-State Entities. This applies particularly to the group’s recommendations on pledges, setting targets, transitioning away from fossil fuels, creating a transition plan and disclosing actionable plans.

We believe that members of the Net Zero Asset Owners Alliance (NZAOA) should also be able to implement net zero strategies aligned with these principles while using the NZ:AAA framework, or at least provided they add decarbonisation constraints.

Paris-aligned benchmarks (PAB)

The PAB framework sets standards for low-carbon benchmarks in the EU using the 1.5 °C scenario with no or limited overshoot. It focuses on reducing the carbon intensity of portfolios relative to their respective market cap index by at least 50% and establishing a trajectory to continue reducing the intensity every year by at least 7% a year until 2050.

The PAB rules require that 

  • the weight of high carbon emission sectors in the PAB should be at least equivalent to the aggregated exposure of those sectors in the underlying universe
  • companies active in controversial weapons, tobacco, hard coal and lignite, oil fuels and gaseous fuels are excluded. This rules out exposure to the energy sector. 

PAB exclusions currently concern 7-14% of the stocks in market cap indices such as the MSCI ACWI, World, Europe or the S&P 500.

PAB portfolios minimising their tracking error and applying only the minimum required regulatory standards invest in 64% of MSCI ACWI stocks and 85% of MSCI Europe stocks. Such portfolios have a beta of 1 and a tracking error of 0.40% relative to the MSCI ACWI and 0.80% for MSCI Europe.

Our analysis shows that applying only the minimum standards, PAB exposures to EU Taxonomy criteria and SFDR Sustainable Investments are in line with the exposures of their market cap indices.

Relative to approaches such as our NZ:AAA, PAB portfolios have a much lower carbon intensity. The PAB rulebook’s strict requirements for decarbonisation and an emissions trajectory reduce the room for successful engagement and stewardship with the bigger emitters.

The rulebook has been criticised for not encouraging companies in high-impact industries to transition to greener operations. Neither is there enough room to invest in high-emissions companies that may be contributing towards the energy transition.

The IIGCC suggests that investors cannot be expected to meet PAB requirements. It finds these too aggressive in terms of initial decarbonisation.

Interestingly, the NZAOA worries more about the voluntary constraints used by index vendors in their PAB offering. It believes PAB indices should be customised because investors may have different investment horizons, risk and returns expectations, and decarbonisation targets. They may expect to earn returns aligned with market cap indices, so the tracking error of commercial PAB indices could be too large and even rise in the future.

NZAOA members may find themselves at odds with the PAB’s rapid decarbonisation approach if they want to be aligned with the organisation’s principle of implementing a framework allowing for different speeds of decarbonisation across sectors and geographies.

Fossil fuel exclusions

The third approach centres on excluding fossil fuel investments. It involves divesting from companies that extract, produce or distribute fuels such as unconventional oil and gas, and other fossil fuels.

Investors may use exclusion strategies to both manage the risk of stranded assets associated with the energy transition and address climate change by putting pressure on fossil fuel companies to shift their focus. 

Empirical research has shown that fossil fuel divestment can lower the stock prices of companies with a higher carbon intensity, and that those same companies subsequently reduced their carbon emission intensity after divestment.2

Excluding fossil fuels leads to the exclusion of most energy stocks, many utility stocks, and stocks from sectors such as industrials, materials and financials. Fewer stocks are excluded in this approach than the number of stock exclusions under the PAB framework.

Much like the PAB approach, minimising the tracking error still results in well-diversified portfolios with an even lower tracking error than fully invested market cap indices. The tracking error is driven almost entirely by the absence of energy stocks in the portfolio.

Unsurprisingly, a minimum tracking error strategy excluding fossil fuel stocks has a level of decarbonisation that is almost as high as the PAB approach.

Finally, simply excluding fossil fuel stocks from a portfolio is an inadequate strategy for investors following the net zero investment recommendations of the UN HLEG, the IIGCC or the NZAOA.

Dark green: clean energy thematic investing

The fourth and final approach in this analysis focuses on investing in companies engaged in the production or distribution of clean energy technologies such as wind, solar, and hydroelectric power, as well as in energy storage, energy efficiency, and electric vehicles.

Unlike the other frameworks, investing only in clean energy reduces the breadth of the investment universe because many sectors simply play little or no active role in the energy transition.

We found 1.2% of the companies in the MSCI ACWI index and S&P 500 qualify as clean energy. For the MSCI Europe, only 2.8% qualify. This approach is even more restrictive than selecting only ‘Achieving’ companies in the NZ:AAA framework.

Minimum tracking error portfolios invested only in selected clean energy stocks have large tracking errors, ranging from 7.7% for the MSCI ACWI index to 14.9% for the S&P 500. Moreover, such portfolios have a beta higher than 1, suggesting their excess returns have a positive correlation with the returns of their market cap indices.

However, from a sustainability point of view, these portfolios rank highly, with some of the lowest carbon intensities, the highest exposures to companies qualifying as SFDR sustainable investments and the highest exposure to companies passing the EU Taxonomy criteria.

Clean energy thematic investing can be one component of the net zero investment strategies of investors following the recommendations of the UN HLEG, the IIGCC or the NZAOA.

The future of net zero investing

Portfolios constructed on a set date relying on current and recent historical data are not necessarily representative of the future. In a scenario where net zero is achieved by mid- century, minimum tracking error portfolios investing in either NZ:AAA or PAB companies, or excluding fossil fuel companies, should converge towards the market cap portfolio as we get closer to 2050.

We believe institutional investors play a crucial role in driving the transition to net zero emissions. This paper should help clarify the strengths and weaknesses of various frameworks for investing in net zero and help investors understand the alignment of these frameworks with recommendations from organisations that seek to decarbonise the economy by 2050 and beyond.

In practice, investors are likely to combine a variety of approaches to align their portfolios with net zero, drawing on the frameworks discussed in this paper, coupled with stewardship (voting, company engagement and public policy advocacy).

As a signatory to the Net Zero Asset Manager initiative, BNP Paribas Asset Management is committed to partnering with clients to help them implement net zero alignment strategies in line with their investment objectives.

For more on net zero, download ‘Aligning investments with the Paris agreement: frameworks for a net zero pathway’ or our net zero roadmap.

[1] Written by Raul Leote de Carvalho, Jane Ambachtsheer, Alex Bernhardt, Thibaud Clisson, Henry Morgan, Guillaume Kovarcik, Francois Soupe  

[2] M. Rohleder, M. Wilkens, J. Zink. (2022). “The effects of mutual fund decarbonization on stock prices and carbon emissions” Journal of Banking & Finance, 134, 106352. doi: 10.1016/j.jbankfin.2021.106352 

Disclaimer

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
Environmental, social and governance (ESG) investment risk: The lack of common or harmonised definitions and labels integrating ESG and sustainability criteria at EU level may result in different approaches by managers when setting ESG objectives. This also means that it may be difficult to compare strategies integrating ESG and sustainability criteria to the extent that the selection and weightings applied to select investments may be based on metrics that may share the same name but have different underlying meanings. In evaluating a security based on the ESG and sustainability criteria, the Investment Manager may also use data sources provided by external ESG research providers. Given the evolving nature of ESG, these data sources may for the time being be incomplete, inaccurate or unavailable. Applying responsible business conduct standards in the investment process may lead to the exclusion of securities of certain issuers. Consequently, (the Sub-Fund's) performance may at times be better or worse than the performance of relatable funds that do not apply such standards.

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