Get Beyond ‘Net Zero’

Queen Elizabeth, caught on camera discussing the COP26, the 2021 United Nations Climate Conference, said it was “irritating” when “they talk, but they don’t do.” She was referencing political leaders, but her comment also applies to the corporate sector. Across the globe, it has become popular for companies to commit to net-zero carbon emissions as a means of combating climate change. The world’s two largest public companies, Microsoft and Apple, have both committed to carbon neutrality by 2030. AstraZeneca, the British pharma giant, says it will “ensure its entire value chain is carbon negative” by the same date. Japan Airlines, like many in its industry, is targeting net zero by 2050. So too are energy majors, including Total, BP, and Shell. Climate-focused investors should not take these pledges at face value. Long-duration goals and an emphasis on the “net” side of the equation can give a company a public relations boost while avoiding the difficult work of serious emissions reduction. Consider:

• An Accenture study recently found that just 9% of European companies are on track to meet 2050 emissions-reductions targets.

• A court in the Netherlands told Royal Dutch Shell in May 2021 that its net-zero commitment, undertaken under shareholder pressure, was inadequate.

• Santos, the Australian gas supplier, is being challenged legally over whether it has a “clear and credible plan” to achieve net-zero emissions by 2040, as it has pledged.

As detailed in a new white paper, Beyond Net Zero: Supporting the Transition to a Climate-Resilient Planet, investors today face a difficult task. They must separate the companies paying lip service from those taking measurable steps to cut emissions and adapt to a low-carbon economy. That’s certainly the mandate of the EU Sustainable Finance Action Plan, which targets 55% emissions reduction by 2030. New Morningstar equity indexes leverage Sustainalytics’ climate research to achieve EU requirements while providing broad market exposure. The indexes can guide investors looking to align their portfolios to a 1.5-degrees Celsius warming scenario, channel capital to companies taking real action on climate change, and get beyond empty net-zero pledges.

A Deepening Crisis Clouded by Imperfect Data

It’s hard to keep up with all the dire climate reports by the global community:

• The U.N. Intergovernmental Panel on Climate Change issued a “Code Red to Humanity” in an August 2021 report warning that limiting the global temperature rise to the 1.5- to 2-degrees Celsius range “will be beyond reach” without “strong and sustained” emissions reductions.

• The World Meteorological Organization estimates that weather disasters, such as floods, wildfires, and heat waves, have become 4 to 5 times more common and are causing 7 times more damage over the past 50 years.

• The Network for Greening the Financial System, a consortium of 90 central banks, warns global gross domestic product could fall 5% below its expected 2050 level if greenhouse-gas emissions are not reduced.

The EU Sustainable Finance Action Plan lays out a detailed road map for investors. Among many mandates, covering companies and their investors, are provisions for index providers. Strategies carrying an objective of reducing carbon emissions must reference a climate benchmark badged in one of two ways:

• EU Climate Transition Benchmarks (CTB)

• EU Paris-Aligned Benchmarks (PAB)

While the PAB is more demanding than the CTB, both standards require significantly reduced portfolio-level carbon intensity, avoidance of high-carbon activities, and emissions reductions over time. EU climate indexes are mandated against simply underweighting high-emitting sectors. They must employ more sophisticated, company-specific analysis to achieve regulatory objectives.

The Morningstar EU Climate Indexes rely on a number of Sustainalytics’ climate capabilities:

• Scope 1, 2, and 3 emissions data--reported when available, estimated when not (more than one third of companies in sectors where climate change is a material issue do not disclose emissions).

• Carbon Risk Ratings, a forward-looking measure that evaluates how well companies are transitioning to a low-carbon economy.

• Controversial Product Involvement Data and ESG Controversies Research.

Morningstar also cross-references the Science-Based Targets initiative, which helps companies gauge the extent and the timing of greenhouse-gas-emissions reduction programs. While a company is more likely to decarbonize its operations, supply chains, and products and services if it makes public commitments, pledges must be scrutinized. Some net-zero commitments invoke the promise of uncertain carbon-removal technologies. The very concept of carbon neutrality can involve shifting emissions around through divestments and offsets that may reduce an individual company’s footprint but does nothing to combat climate change. “Net zero” obviates the difficult work of real emissions reduction, like a weight-loss plan without exercise, healthy diet, and portion-size control.

The Good, the Bad, and the Ugly

Morningstar EU climate indexes employ a few exclusions but rely principally on a tilt methodology to assign companies above- and below-market weight based on carbon intensity, carbon risk, and whether they offer green solutions. So which constituents receive above- and below-market weight? Kone, the Finnish elevator manufacturer, is aligned with the 1.5-degrees Celsius scenario and receives maximum index weight:

• Kone’s emissions intensity is much lower than the industry median, and it demonstrates a steady year-on-year reduction trend.

• Kone receives a Carbon Risk Rating of Low from Sustainalytics. Kone uses renewable energy for part of its operations, in line with good practice (5%-10%), reports Scope 3 emissions, and considers environmental impact at each stage of development.

• Kone is involved in the Green Buildings theme, thanks to its efforts regarding energy efficiency and safety.

• Kone has set science-based targets for a 50% cut in emissions from its own operations and carbon neutrality by 2030.

Whirlpool, a U.S.-based home appliance maker, receives above-market index weight:

• Whirlpool participates in more than 45 programs in different states, provinces, and countries to recycle or reuse appliances.

• Whirlpool’s operations are quite carbon-intensive; however, the company remains at Negligible Carbon Risk because of its management strategies. Whirlpool has reduced energy intensity by roughly 12% since 2015 and achieved a 20% reduction in its absolute emissions.

• Whirlpool is committed to the Science Based Targets initiative and has formulated a goal to reduce greenhouse-gas emissions from its plants (Scope 1 and 2) by 50% by 2030 from a 2016 baseline.

Volkswagen, the German automaker, receives below-market index weight:

• Volkswagen is attempting to come back from its 2015 Dieselgate scandal, but a continued reliance on diesel models and its relatively late entry to the electric-vehicle race threaten its ability to meet the EU emissions targets.

• VW has a Carbon Risk Rating of High from Sustainalytics, with revenues from electric vehicles lower than competitors, fleet intensity above average, with no reasonable decrease in line with industry trends/requirements.

• VW said it would face at least $120 million in fines for missing its 2020 EU emissions reduction target, while the company’s Porsche unit has been investigated by German authorities for allegedly falsified fuel-consumption figures.

Royal Dutch Shell, one of the world’s largest energy companies, receives well below-market index weight.

• Shell carries a Carbon Risk Rating of High. Although it has begun diversifying into hydrogen, energy storage, and renewables, none of these represent significant revenue streams.

• Shell’s business strategy remains focused on the production of hydrocarbons, with over $10 billion in anticipated near-term spending on integrated gas and upstream projects relative to $2 billion to $3 billion of spending on renewables.

• While Shell has committed to reducing the carbon intensity of its business (including emissions from the use of its products) by 100% by 2050, based on 2016 emissions levels, and has an interim reduction goal of 45% by 2035, this trajectory is not aligned with a net-zero target.

• Shell relies on “future technologies” to reduce emissions. A Dutch court ordered further reductions, exposing Shell to more climate litigation and climate governance incidents.

Climate Indexes to What End?

COP26 takes place against the backdrop of a world wrestling with the catastrophic consequences of climate change but struggling to take necessary action. For investors, climate benchmarks are important tools. They can guide a climate-sensitive strategic asset allocation, provide measuring sticks for active strategies, and underly passive investments. Some investors want to be at the forefront of the transition to a 1.5-degrees Celsius scenario and direct capital toward climate solutions. Others are looking to mitigate climate-related risk or meet regulatory requirements. The Morningstar EU Climate Indexes significantly lower portfolio-level carbon intensity. The Global Markets Paris-Aligned Benchmark displays carbon intensity more than 50% lower than its parent index, while the Climate Transition Benchmark is 30% less carbon intensive. Meanwhile, the climate indexes have delivered marketlike risk and returns over their back-test period. They provide broadly diversified equities exposure and do not deviate substantially from market weights from a sector or regional perspective. As climate risk is increasingly accepted as financial risk, the goals of lowering carbon intensity and delivering a successful investment experience will likely converge. Investors need to go beyond empty net-zero commitments and identify companies that are combatting climate change and positioning themselves for a world less dependent on fossil fuels.

Dan Lefkovitz is a strategist for Morningstar's Indexes group.

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