Using portfolio alignment metrics in climate investing

When ESG related metrics were first being used in portfolio construction, they solely focused on how to improve financial outcomes with the potential for an additional moral benefit. Even when they became more climate focused, these still largely only looked at investments from a risk versus opportunities perspective. However, they have since evolved in both scope and nuance - we now have clear metrics for both financial objectives and for real-world environmental and social impact.

The introduction of a portfolio alignment metric into the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations and potential inclusion as a fourth metric for UK pension funds to report on is an example of this. Portfolio alignment measures how aligned a company or portfolio is to the goals of the Paris Agreement. It goes well beyond typical risk and return objectives - limiting the global temperature rise will undoubtably have positive environmental as well as social effects.

Alongside the positive impact outcomes, we also believe considering portfolio alignment is critical in creating resilient portfolios. This is therefore something which we focus on in our own approach to analyse and construct fixed income portfolios.

How do portfolio alignment metrics help?

To start, static carbon emissions data is backward-looking - often over a year old given the lag in reporting time. It gives little indication of the direction of travel, the risks associated with higher emissions or even the environmental impact of the company. It is also hugely biased by sector, with the utilities, oil and gas and basic materials sectors dwarfing the emissions of technology and financials by many multiples.

Excluding these high emitting sectors would undoubtedly reduce a portfolio's carbon emissions. However, it could also have significant unintended consequences - excluding a significant portion of the investible universe could increase volatility and reduce the potential returns of a portfolio while also limiting the ability to contribute to these sectors' transition to net zero.

Take the utilities sector as an example. For many pension schemes facing challenges such as cashflow negativity, utilities also provides a source of high quality and long duration issuance. To exclude it completely would also deny a vital opportunity to drive this industry towards net zero and create sustainable infrastructure for our economy.

Using portfolio alignment metrics can overcome many of these issues - they are forward-looking, take companies' net zero objectives into account, and, crucially, they are sector-neutral, meaning large swathes of the investible universe don't need to be excluded and we can compare not just within sectors, but between them.

More aligned portfolios could also be more financially sustainable as the underlying companies are likely to face less regulatory hurdles and could benefit from changing consumer habits.

And, on the face of it at least, portfolio alignment metrics can be relatively simple to grasp. A simple example is the % of a portfolio which has approved net zero targets from the Science-Based Targets initiative (SBTi) - easy to calculate, understand, compare and aggregate across portfolios.

Climate alignment metrics are also not without their complexities and challenges, though. For example, implied temperature rise - one of the alignment metrics considered in the TCFD recommendation, provides a simple output but the underlying methodology is complex, data quality and consistency is still improving, and it can provide some surprising and unexpected results. Further, they are unlikely to capture the physical risks associated with climate change - meaning it is not the panacea of climate metrics world.

How can investors use alignment metrics?

A conversation between asset owners and their asset managers to discuss the benefits and drawbacks of different climate metrics and how these can be applied is a first step.

Investors may then wish to set goals for issuers and portfolios to reach. For example, a portfolio could target 80% of their portfolio to have a net zero target by 2025 from a baseline of around 40% today. This could be achieved by encouraging more underlying companies to set net zero targets and by gradually tilting the portfolio away from non-aligned issuers.

However, having clear flags for engaging with companies whose progress may veer off this path is crucial.

This approach acknowledges that climate-aware portfolios will need the flexibility to realign themselves over time as the understanding and data around net zero matures and that company-level decarbonisation journeys will take time.

Metrics that guide the hand

Ultimately, portfolio alignment metrics are advantageous for portfolio analysis and construction and can help guide our investment process to achieve both financial and environmental goals. It is vital that these metrics are sophisticated and detailed enough to be constructive instead of restrictive, but also clear enough for investors to comprehend and rally around to create industry-wide impact.

Bruno Bamberger is solutions strategist at AXA Investment Managers