Putting Net Zero investing into practice: lessons from the field

The transition to a net zero future will simply not be possible if institutional investors, such as pensions and hedge funds, don’t transition their investing practices to focus on clean, climate-friendly businesses. These firms manage nearly one-third of total global financial assets, but shifting the allocation of resources is a huge and risk-filled task.

For this reason, the UN Principles for Responsible Investment Initiative (UNPRI) established the Net-Zero Asset Owners Alliance (NZAOA), supporting a group of 71 institutional investors with over $10 trillion in assets committed to developing net-zero emissions portfolios by 2050. Part of their challenge was gaining foresight into how the global economy is likely to transition, according to advanced energy and industry decarbonization models.

To help in the effort, UNPRI commissioned a research group at the University of Technology Sydney’s Institute for Sustainable Futures to develop version 2 of the One Earth Climate Model (OECM), which was published in the book Achieving the Paris Climate Agreement Goals: Part 2 (Springer, 2022). The model presents detailed decarbonization pathways broken down by industry sub-sector.

A new report by UNPRI shares insights from asset owners implementing net-zero commitments in listed equity portfolios utilizing the OECM and other models. As these types of commitments become the norm, this early insight will be crucial in guiding further action toward net zero. The report highlights over 30 case studies from equity investors who are putting net zero principles into action, with actionable steps that asset owners can put into practice.

The first step is to measure current total emissions of their portfolio holdings. Investors need a baseline to measure progress, and they need to identify the largest sources of emissions. It is also necessary to know which direction those emissions are trending for each company. These projections can be compared to benchmarks set by the NZAOA or compared against the OECM’s sectoral pathways. Once asset owners know where they stand, they can begin to set targets.

To properly evaluate individual companies, the report suggests the following questions be asked to each company to help determine if the company is on the right path toward decarbonization:

1. Does the company disclose emissions?
2. What is the company’s emissions trend?
3. Has the company set and disclosed targets?
4. Are the targets credible?
5. Are Scope 1, 2, and 3 emission-reduction targets aligned with a science-based trajectory?
6. Has the company achieved previous targets?
7. Has the company established decarbonization pathways? Does management understand relevant trajectories and technologies?
8. Does the company have transition and implementation action plans in place? Do the plans cover financial impacts and governance? What are the capex projections? Do they fit with targets; are they realistic; what assumptions are they based on?
9. Are there incentives for management to meet targets and to engage with customers and suppliers?
10. How does the company’s track record compare to that of peers?

There are several resources available when setting targets, including the Paris Aligned Investment Initiative’s Net Zero Investment Framework (NZIF), Science Based Targets Initiative for Financial Institutions (SBTi), and the Net-Zero Asset Owner Alliance Target Setting Protocol(TSP). These guidelines will help investors decide whether they need to invest in new companies or introduce net-zero targets to existing companies they own stakes of.

When seeking to take action toward net zero targets, asset managers have a few key levers: divestment, changing the size of portfolio holdings, investment in lower-carbon issuers, and engagement. In general, this translates to getting rid of high emitters, reducing the percent of your portfolio with high-emitters by downsizing your investment, upsizing your investment in low-emitters, or, lastly, helping high-emitters decarbonize through guided engagement.

Since it is relatively quick and easy to identify companies in a portfolio that contribute the most to greenhouse gas emissions, divesting and, thus, decarbonizing funds can be relatively straightforward. However, most asset managers are opting to engage companies they’re invested in that have high emissions, with the aim of influencing them to adopt net zero targets more quickly. Engagement with a company on net zero goals includes:

1. Calling on the company to commit to decarbonization and to disclose emissions and emissions reduction plans.
2. Making clear expectations that issuers follow the decarbonization paths they commit to.
3. Suggesting to companies that they promote their low-carbon products in regions where they can offset higher-emitting alternatives.

If a company fails to improve over time, fails to disclose their emissions, or reach their decarbonization goals, asset managers should try to exert further pressure on company management. If that doesn’t work, asset owners should exclude that specific company and put it on a publicly shared exclusions list. This will create large incentives for companies across all sectors to comply with decarbonization goals.

Danica Pension, one of the largest pension funds in Denmark with holdings around $66 billion, used the OECM to outline their sectoral targets. They show how science-based targets for sectoral decarbonization can be used in a pragmatic way to inform portfolio measurement. Their portfolio holdings were evaluated against sector targets, which they used as guides to engage with laggards and support those companies in their decarbonization efforts.