Ahead of Climate Summit, Fund Managers Struggle With Portfolio Decarbonization

One day soon, your fund management company may tell you it has signed a "net zero" pledge. That means your fund manager is vowing to cut its net greenhouse gas emissions--which are widely agreed to cause global warming--to zero by a specific date, and to insist that the companies you invest in, or the bond issuers your fund lends money to, are doing the same.

In fact, your fund manager may have already made such a promise, as have scores of other companies, investors, nations, municipalities, and other institutions. This year, the United States vowed to cut greenhouse gas emissions by 50% to 52% by 2030, compared with 2005 levels.

Don't mistake it for an altruistic exercise. Increasingly, the investment community regards climate change as a material financial risk, one marked by physical risks owing to more extreme weather and longer-term changes in weather patterns, and by transition risk, because the switch from carbon-intensive fossil fuels will irrevocably alter many business models.

Net Zero and the Role of Asset Managers

Today, institutional investors overseeing more than $60 trillion in assets support a net-zero plan of action for the funds they oversee, according to the Climate Action 100+ initiative. That's more than half the amount of managed assets globally. Indeed, many of the funds covered by the range of approaches known as sustainable investing are actively involved in net-zero planning. Your fund may be among them. At Morningstar, we've identified six distinct approaches to sustainable investing, all of which are grappling with net zero: applying exclusions, limiting environmental, social, and governance risk, seeking ESG opportunities, practicing active ownership, targeting sustainability themes, and assessing impact.

Getting to net zero is a thorny ambition. Many challenges lie in the way. They include patchy disclosures, carbon-removing technologies that are far from perfect, and insufficient government action, according to a pair of new studies from Morningstar.

More net-zero commitments are likely to materialize after COP26 takes place this week in Glasgow, Scotland. COP26 is expected to be the most consequential climate summit since the Paris Agreement was adopted in 2015. The Paris Agreement is a legally binding international treaty that aims to limit global warming to well below 2 degrees Celsius (and preferably 1.5 degrees), compared with preindustrial levels, in order to avert the most dangerous, irreversible effects of climate change. Getting global carbon emissions down to net zero by 2050 is part of that. But since then, global warming has accelerated.

You and your fund have a critical role to play in bringing the world to net zero--once your fund manager figures it out.

"How [net zero] translates into an investment strategy for asset managers and how an asset manager's net-zero investment strategy translates into real-world, measurable emissions reduction is not yet clear," writes Jackie Cook, director of investment stewardship research for Morningstar, in a report assessing the challenges for asset managers that signed on to the influential 2020 Net Zero Asset Managers Initiative. (So far, that initiative has been signed by 128 asset managers that oversee $43 trillion in assets internationally.) The report was co-authored by Martin Vezér and Hortense Bioy.

Within 12 months of signing that initiative, asset managers must set interim targets to achieve greenhouse gas emissions reductions in line with the 50% cuts required by 2030, on the way to net zero by 2050. They must publish interim targets and action plans to achieve them. In addition, they must agree to work with clients, such as pension funds, to set decarbonization goals so that ever greater chunks of assets they oversee are managed with net zero in mind.

The Challenges and Leap of Faith That Come With Net-Zero Commitments

Cook, Vezér, and Bioy surveyed 12 prominent asset managers about the challenges of achieving net zero. So, what's the biggest problem? According to the asset managers, achieving interim targets makes them uncomfortably reliant on the actions of other players. These include clients, some of whom may be uncomfortable with shifting to net zero; companies in the portfolio who are reluctant to act; sovereign bond issuers, who are sometimes difficult to engage with; and governments whose policies and enforcement decisions often conflict.

Institutional investors who publicly commit to a net-zero investment strategy "are taking a leap of faith that the stakeholders on whose cooperation their success depends, including governments, will also rise to the challenge," Cook writes.

Other complaints? Measurement is often complicated by data quality issues, while most metrics are backward-looking. Asset managers are quick to point out that historical greenhouse gas emissions are a poor indicator of how ready an issuer is for the low-carbon transition.

Add to those the challenge of achieving real-world impact. Portfolio decarbonization doesn't necessarily result in decarbonization of the real economy.

Some Bright Spots in Net-Zero Efforts for Institutional Investors

Still, there are reasons to be optimistic. The tools to assess how much an investment portfolio is aligned with a neutral or negative carbon emissions pathway are evolving quickly. Guidance about reporting from the Task Force on Climate-Related Financial Disclosures as well as strategies for collaborative engagement and stewardship are already widely used by asset managers.

Asset managers emphasized the need to balance divestment, or selling an issuer, with engagement, or continuing to hold a company in order to prod it to change its ways. Both are strategies for linking investment decisions with real world impact. For example, some New York City pension funds recently announced they would divest $4 billion from securities related to fossil-fuel companies. Such moves are useful. "Divestment highlights the need to move away from fossil fuels and may raise the cost of capital for exploration and development," Cook writes. On the other hand, engaging with large carbon emitters--say through meetings, investor roundtables, making statements at annual meetings, writing public letters to a company, or voting to remove directors who have failed to address the company's climate risks--gives investors a voice in how a company evolves.

One catalyst for action: Regulators seeking greater transparency about investments. For example, the European Union's Action Plan for Financing Sustainable Growth targets net zero by 2050 and aims to make Europe the first climate-neutral continent. The EU plan entails cutting greenhouse gas emissions by at least 55% by 2030 and refocusing capital flows toward sustainable investment, as well as requiring greater transparency about investments that aim to reduce emissions.

New tools, such as improved benchmarks for fund managers, will help. Investors use benchmarks to help decide how they'll allocate assets and help them measure how they're doing. More climate-focused benchmarks will help set a standard for climate-related strategies and steer capital toward combating climate change, according to Dan Lefkovitz, strategist for Morningstar Indexes.

By way of example, Morningstar's EU climate indexes provide trajectories to decarbonization, while minimizing tracking error. They are significantly less carbon intensive than their broad market equivalents and aim to reflect a 7% reduction in carbon emissions per year. A recent study by Lefkovitz found that the climate indexes have delivered marketlike risk and returns over their back-tested period.

How the Race to Net Zero Is Shaping the Financial Landscape

Overall, net zero is changing finance. One ironic result: Your fund manager is calling for more government action. "Asset managers want governments to act on the climate crisis … to make stronger national commitments, backed by transition planning and … they want developed-country governments to fund their portion of the $100 billion-a-year climate transition," Cook writes. Among other things, they want governments to provide clarity on the markets for carbon offsets, on carbon pricing, and to mandate standardized climate risk disclosures. (You can find many of these points in the 2021 Global Investor Statement to Governments on the Climate Crisis, which has been signed by 587 investors representing over $46 trillion, or 40% of managed assets globally.)

Another outcome? It's refocusing investors on the long term. With target dates of 2030 and 2050, short-term thinking receives fewer rewards. One asset manager describes the advantage of early action as building "muscle memory" that hones the expertise to operate in a net-zero world. For example, ambitious climate targets force issuers to invest in new technologies.

One asset manager expressed the hope that COP 26 "... will add further momentum to recognition of the fact, by investors, that the climate transition is now inevitable and carries significant implications that, as asset owners and managers, we have a fiduciary duty to address."

"Considering how swiftly other sectors of the economy are joining the race, early movers stand to pull ahead of their peers," Cook says.