Adapting to the climate transition - 10 questions to ask your asset manager

The narrative surrounding sustainable investment continues to grow and evolve in its complexity, with ever more metrics and frameworks by which to measure firms' performance. For investors trusting in their asset managers to deliver returns on their behalf, ensuring their capital is being allocated in alignment with these principles is critical to sustainable, long-term performance.

But how can investors be sure their asset managers have a complete perspective over the breadth of climate transition requirements? In the below, Lombard Odier provides ten questions for trustees to ask their investment manager to find out…

1. How do you balance the need to decarbonise all sectors of the economy, including harder-to-abate industries, with the need to manage carbon risks?

If we want the world to stay below 1.5°C warming, we need all sectors of the economy to rapidly decarbonise. This includes hard-to-abate sectors like steel, chemicals and cement. These industries will still be needed in 2050, even in a successful decarbonisation scenario.

Seeking to identify the leaders and laggards within each sector is a good first step. Assessing this requires an understanding of what pathways to net zero are feasible for different activities, and therefore what alignment means at a sector and sub-industry level.

Transition leaders in hard-to-abate sectors may well unlock competitive advantages relative to their peers, insulating themselves from carbon risks, and benefiting from shifts in demand towards lower-carbon products.

2. Does your investment approach actually lead to emissions reductions in the real economy?

If an asset manager claims the carbon intensity of their fund is lower than the benchmark, ask them how they achieved this. If it is by divesting out of highly emitting industries, you need to know whether their approach is greening the economy, or just avoiding the issue.

A well-aligned investment approach must actively seek out transition leaders in high-emitting sectors that bring the greatest potential for emissions reduction. In comparison, good performers in sectors like education and professional services are probably low carbon already, and can at best make a marginal contribution to the decarbonisation of the economy.

To assess real-world impact, an asset manager should be able to not only assess the carbon footprint of a portfolio over time, but also the extent to which reductions were the result of real-world reductions, rather than sectoral re-allocations.

3. What forward-looking metrics do you rely on to assess alignment to the transition?

The Task Force on Climate-Related Financial Disclosures (TCFD) has highlighted the importance of forward-looking metrics. In its latest guidance, the task force calls for financial institutions to describe the extent to which their activities are aligned with a well-below 2°C scenario. One way of doing this is using the implied temperature rise metric, which helps you to answer the question: ‘if the whole economy acted in the same way as the company, what would the resulting level of global warming be?' It looks at a company's entire decarbonisation trajectory, not just how green the company is today.

Not all asset managers will choose to use this metric, but all should have the capabilities to assess firm's alignment to the transition. At the minimum, they should understand the metrics that other asset managers are likely to be looking at.

4. What indicators do you use to assess the credibility of a company's targets?

Not all net-zero pledges are created equal. For any target to be truly credible it should be accompanied by a clear decarbonisation strategy, which should outline in detail the interventions that the company will make, and quantify the associated reductions in carbon emissions. Targets should be science-based and independently verified, backed up by interim targets, and have sufficient incentives for the firm's management to deliver on commitments.

The last test of credibility is whether the firm can transition while remaining profitable. Is there a market for firm's new climate solution technology? Will customers be willing to pay a premium for a greener product? These assessments will be sector and region specific.

5. Do you conduct an assessment of a company's net-zero alignment in-house or outsource judgments to third parties?

Any forward-looking assessment is judgmental. Views of investors may differ on the likely roadmap the economy may take, on the viability of different technologies, or on the credibility of one company versus that of another.

Outsourcing such forward-looking assessments, using off-the-shelf metrics from third-party data providers, can therefore be problematic. How do you ensure the assumptions these providers use are aligned to the investment convictions of the asset owner or the asset manager, and consistent with a fund's investment philosophy?

6. How do you approach the issue of Scope 3 emissions?

Any assessment of company alignment to the transition that ignores indirect emissions from the value chain is incomplete. For many industries, these emissions comprise the bulk of the total footprints. For instance, analysis suggests that 98% of the total carbon footprint of the automobiles industry is Scope 3, in particular from vehicle usage[1]. Similarly, the food industry often has significant upstream Scope 3 emissions relating to land use and biogenic emissions, which are hidden if only looking at operational scope 1 and 2 emissions.[2] Ignoring these sources of carbon paints a misleading picture of which sectors are actually green.

Waiting for better data to become available is dangerous, as it could expose portfolios to unseen transition and liability risks, and lead to sharp re-allocations when it does become available.

Already today, scope 3 emission figures can often be approximated using readily available data. Although a degree of estimation will be involved, it is preferable to be approximately right than precisely wrong.

7. What other carbon risks have you identified that may not be apparent from Scope 1, 2 or 3 emissions?

One of the key sources of hidden climate risks are enabled emissions. A company drilling oil wells may be low carbon itself, but through its activities it is enabling future emissions relating to fossil fuel extraction. These are not typically reported as part of Scope 3 emissions, and are often ignored.

To take account of such risks, we need additional analysis. Consider assessing the exposure of different economic activities to enabled emissions, rolling out specific deforestation metrics to identify these supply chain risks and integrating financed emissions as part of the carbon footprint of companies. In doing so, we attain a more comprehensive assessment of company exposure to climate value impact.

8. How do you approach the need to scale up funding in green investments?

The transition to net zero requires us to decarbonise key sectors and portfolios, but to enable those transitions we must also ramp up investment in relevant technologies and solutions.

The International Energy Agency estimates that $4.5trn (£3.3trn) per year is required in energy related investment alone[3]. Taking into account wider investments in the food and land use system, nature-based solutions, infrastructure, and the circular economy, we believe the figure may be closer to $10trn per year.

The climate value impact assessment helps identify climate solutions that need to be scaled up to support the transition and increase our exposure to these.

9. What is your view of the EU taxonomy, SFDR and other climate regulations?

Many investors will soon need to disclose the alignment of their investments to the EU taxonomy and classify their investment strategy under the different buckets of the SFDR (Sustainable Finance Disclosure Regulation). These regulations can lead to the disclosure of useful climate metrics but are not the be-all and end-all of climate investing and can lead to perverse incentives.

By seeking to identify what is and isn't green, the EU taxonomy can drive investment to key segments of the economy. However, an asset manager targeting high alignment with the EU taxonomy may pull funding from a company that is not labelled as green today, even if that company has a clear and detailed transition plan in place, delaying the transition. Similarly, SFDR will require certain objective criteria to be met in support of a sustainability claim.

Standardised disclosures on so-called principal adverse indicators (such as energy, water, emissions or waste) may lead to poor scores for key sectors such as steel, or the food industry. The objective should not be to divert investment from these essential sectors, but rather to identify companies reducing those impacts in a meaningful way.

10. What percentage of companies do you currently consider to be well aligned to the Paris Agreement?

With a plethora of new metrics emerging in the market to help investors assess their alignment to the climate transition, there is a risk that asset managers will "shop around" to choose those approaches that cast their investments in a better light.

It is estimated that only 25% of large caps in the MSCI World Index are today aligned to limiting warming to below 2°C, and only 6% to <1.5C.[4] The index as a whole is thought to be aligned to 2.9°C, roughly in line with estimates for trends in current policies of ClimateActionTracker. This is a comparatively conservative outcome, assuming that a company setting a net-zero target is not automatically aligned unless it also has a credible implementation plan in place.

One straightforward remedy to this challenge is to ask asset managers for their view of the alignment of the economy as a whole, revealing which approaches may lead to excess optimism and exposure to greenwashing.

Thomas Hohne-Sparborth is head of sustainability research and Dominic Tighe is a senior sustainability analyst at Lombard Odier