Getting started on decarbonizing your total portfolio
Getting started on decarbonizing your total portfolio
The key tools for decarbonization
To recap our net zero paper, there are several key tools available to improve the overall carbon score or reduce the implied temperature rise (ITR) of a multi-asset portfolio. The tools we identified were disinvesting from assets with the very worst carbon scores, engaging with issuers, investing in positive climate solutions and using carbon offsets.
However, we recognize this is not just a technical challenge of how to improve your portfolio’s carbon score but also how the investments we make can result in actual decarbonization.
Steps to get started
In this paper we share how Schroders is decarbonizing our multi-asset portfolios and provide real-life examples. We believe there are three practical steps to improving the portfolio from a climate perspective (taken in the following order):
- Adjust long-term assumptions for climate change.
- Improve the temperature alignment of the active components.
- Improve the temperature alignment of the passive components.
Perhaps somewhat unusually, we believe it is preferable to adjust active components before passive components. First, as you will see later, improving the active components can have a more significant impact on the ITR than passive components. Second, specialized passive components can be more costly than standard passive components whereas active ones are typically not. Finally, some passive implementation can be more difficult if derivatives are used extensively. In addition, active managers engage more actively with the companies that they hold/plan to hold in order to improve their decarbonization approach.
- Adjust long-term assumptions
Most asset owners and fiduciaries start with a strategic asset allocation based on historical asset returns, risk and correlations. As we have outlined in our 30-year climate-adjusted capital market assumptions, we believe it is important to consider the changes that transitioning to a low-carbon economy may have on the outlook for asset classes.
When thinking about the impacts of climate change on our long-term asset return assumptions, we take into consideration three scenarios and a “no climate change" scenario. This latter scenario does not allow for physical and transition risks. The No Action scenario is one in which temperatures are set to rise more than 3°C above pre-industrial levels by the end of the century. Our base case is the Partial Mitigation scenario, where temperature increases are more limited due to the introduction of carbon emission mitigation policies starting from 2025. Finally, we have recently added a Net Zero scenario, in which, thanks to more aggressive mitigation policies, temperature projections are in line with the Paris Agreement.
Overall, accounting for climate change, equities are still expected to outperform other asset classes over the next 30 years. On a regional basis, emerging market equities are expected to outperform most developed equity (DM) markets (seen in Figure 1) when using a partial mitigation scenario. However, allowing for climate change tends to have a larger impact on emerging markets on average than for developed markets. Meanwhile, our forecasts suggest that credit and property will still deliver better returns than sovereign bonds.
The efficient frontiers for a typical portfolio targeting over 5% p.a. are different when using the 30-year assumptions with and without climate change adjustment (see Figure 2). The efficient frontier considering the consequences of climate change cannot achieve the same level of returns because the returns of the riskiest assets are reduced when climate change is considered. In our 30-year assumptions, we do not adjust risk assumptions for assets when allowing for climate change.
We have shown two different climate change scenarios. Due to the uncertain path of decarbonization, we believe scenario analysis is imperative for asset owners in considering the appropriate impact of changing long-term asset assumptions. Similarly, the Task Force on Climate-Related Financial Disclosures (TCFD) requires trustees of UK pension funds to “consider how different investments and strategies could be impacted by transition and physical risks, at an asset class, sector and firm level where appropriate.” The Pensions Regulator in the UK suggests using scenario analysis as a helpful tool.
When we consider climate-adjusted returns, the asset allocation of the portfolio changes. Figure 3 shows that when we adjust returns for climate change without restricting the amount that can be allocated to emerging markets (EM), there is a reallocation of portfolio assets from emerging market equities to developed market equities. This is due to the fact that emerging markets suffer a greater decrease in productivity in higher temperatures.
- Improve the temperature alignment of active components
For our multi-asset portfolios that are required to have lower carbon scores than their index benchmarks, we have either changed underlying active managers or worked with existing managers to improve their scores. This is in addition to adjusting our long-term return forecasts.
For example, in one of our multi-asset portfolios we shifted from an active broad global equity fund to an active global sustainable equity fund and sustainable thematic funds (invested in themes such as food, water and the energy transition). Figure 4 shows how the portfolio weights have shifted from “not sustainable” components to the majority of holdings being sustainable or ESG integrated over time. Although this article focuses specifically on decarbonization, the example portfolio we show in Figure 4 has a broader sustainability agenda.
For asset owners with significant numbers of active managers, governance resource will be required to evaluate each manager’s current approach to reducing carbon emissions and to judge whether their future approach may meet the asset owner’s objectives. This is clearly not a one-off process.
For asset owners with limited time for governance, picking off the managers that manage mandates that are likely to have the biggest impact first, either by type of mandate or percentage allocation in the portfolio, might make sense. We show how to make this decision later in this paper when we analyze a typical portfolio.
- Improve the temperature alignment of passive components
Asset owners typically hold their passive allocations through one or more of the following:
- ETFs or pooled funds
- Segregated mandates
To adjust the passive allocations to improve the climate scores in segregated mandates, asset owners will need to work with their passive managers in the same way as with active managers. This will require adjusting the weights of stocks in equity indices, for example, by reweighting towards those issuers that have a better climate alignment. This is, in effect, an active decision as someone will need to make a decision about the methodology required to do this.
Some markets/indices can be more significantly affected by moving to lower carbon versions. Figure 5 shows that by reweighting the FTSE 100 Index it is possible to reduce the implied temperature increase from 2.5˚ C to 2.2˚ C without increasing tracking error significantly. However, it is not always this easy to achieve such a reduction in temperature alignment. The large proportion of technology companies in the S&P 500 index make it difficult to reduce the ITR of a passive US equity portfolio without compromising tracking error. Figure 6 shows it is difficult to reduce the ITR of the S&P 500 from 2.4˚ C.
For asset owners without segregated passive managers who can design reweighted indices for them, there are exchange traded funds (ETFs) available that can be used to improve the temperature alignment of passive components. Low carbon ETFs exclude or underweight companies that have high emissions or will potentially generate high carbon emissions in the future, while minimizing tracking error relative to the original index. However, these “off-the-shelf” products might not have objectives that suit the asset owner’s overall portfolio objectives and are also typically more expensive than standard passive strategies.
For asset owners that use derivatives for their passive exposures, the ability to decarbonize will depend highly on the availability of liquid, climate-friendly versions of commonly used derivatives and there are relatively few available today (examples include MSCI global low carbon target and EuroStoxx 50 low carbon). Investing against these low carbon indices offers a potentially lower cost option than actively managed strategies but the temperature alignment of these derivatives is determined by the methodology underpinning the index construction, which may not align with an asset owner’s sustainable investment objectives. It is also worth remembering that often the reason for using derivatives is for efficient portfolio management; for example, implementing asset allocation decisions without having to buy and sell physical assets. Asset owners will have to decide to what extent temporarily held positions in the portfolio should be included in the measurement calculation.
Evaluating the climate impact on a portfolio of making changes
Figure 7 shows an illustrative 60/40 equity bond portfolio that has an implied temperature increase today of around 2.85˚ C. We estimate that it is possible to reduce the implied temperature increase of the portfolio as follows:
1. Adjust long-term assumptions – reducing ITR by 0.02 ºC.
a. This does not change the ITR of the portfolio components but leads to a re-weighting away from emerging market equities to developed markets in line with the optimizations in Section 1.
2. Improve active components – reduces ITR by 0.14 ºC
3. Improve passive components – reduces ITR by 0.05 ºC.
By taking these three steps, the reduction in implied temperature increase seems disappointing. But today the amount by which you can improve the climate alignment of a portfolio without compromising the investment characteristics of the portfolio is quite small. However, by taking these point-in-time actions, we can also set the portfolio up to benefit from a through-time decarbonization process. In Figure 7, we only decarbonize the equity and credit components. The sovereign component is left unchanged as this cannot currently be measured.
Juggling multiple objectives
The difficultly for asset owners and asset managers is that we all have multiple objectives – return, risk and climate – and these may not all be aligned over the same timeframe. We would hope that over the longer term, focusing on assets that are well positioned for decarbonization will also result in higher returns. However, as we have seen with recent geopolitical issues, oil and gas and associated investments that are less climate positive can provide portfolios with significant returns.
In our previous paper we highlighted some of the impacts on portfolio integrity (such as diversification and risk) when the carbon objective is pushed too far too quickly. An earlier, more aggressive decarbonization strategy is likely to incur higher transition costs to protect against physical costs. Given the limited number of underlying issuers that have a credible decarbonization target, an aggressively steep decarbonization curve will reduce the investment universe drastically, possibly compromising the investment integrity of the portfolio.
We believe it is important to understand the effects of positioning the portfolio on the trajectory today and plan on annual reviews of how to continue to improve the positioning to achieve the long-term target. Using the three steps we explained earlier, asset owners can set up their portfolio to benefit from a progressive decarbonization process as the sustainable investment universe grows. Through time, not only will existing assets decarbonize, but new assets will become suitable for the portfolio, allowing incremental improvements.
Figure 8 shows the point-in-time decarbonization that can be achieved by a typical portfolio today. However, this is just a small portion of the overall amount of decarbonization that asset owners will need to do over the coming decades.
To manage through-time decarbonization, we believe it is important to understand the systemwide decarbonization trajectory if investors are to decarbonize their portfolios in an effective and responsible way. We believe the best way to do this is through policy research. Understanding both fiscal and central bank policies on climate change will help investors assess the risks and opportunities that their portfolios face. Policymakers will play a significant role in defining the systemwide decarbonization trajectory. Understanding this “benchmark” trajectory will be crucial for investors in understanding how the supply of investable sustainable assets will evolve through time. We will expand further on this topic in a forthcoming paper.
It is also worth noting that inertia may cost returns. Lack of climate-friendly investments, at least in the short term, can result in high valuations and reduced long-term returns; for example, renewable energy in 2021. Chasing limited supply at any given point in time, rather than trying to understand what the trajectory of the supply of sustainable assets will look like in the future will expose investors to greater sustainability risks. Similarly, seemingly high valuations in the short term could lead investors to avoid certain assets, even if they are positive for the portfolio’s climate profile. That again could be sub-optimal for the portfolio’s ultimate dual objective: that of portfolio and systemwide decarbonization while maintaining robust investment characteristics.
Finally, the investment implications of decarbonization cannot be captured by the historical performance of asset classes. Therefore the decarbonization objective must be embedded in the construction and frequent review of the portfolio (understanding the limit to point-in-time decarbonization). Setting a strategy for reducing ITR both now and in the future will help with the management of the new risks and opportunities that will come with systemwide decarbonization.
We believe there are three steps asset owners should take to decarbonize their portfolio:
- Adjust long-term assumptions about climate change.
- Improve the temperature alignment of their active components.
- Improve the temperature alignment of their passive components.
Asset owners must consider whether these steps are consistent with their governance budget and the possible impacts they might have on other portfolio objectives and characteristics, such as risk and return.
These three steps will help asset owners to start their decarbonization journey, even if the change in temperature alignment of the portfolio today is small. More importantly, asset owners will need to plan for how to manage both the risks and opportunities that will come with systemwide decarbonization. The use of engagement and positive climate solutions will help asset owners to progressively improve their portfolio from a climate perspective until their net zero target is achieved.
 Implied temperature rise (ITR) of an investment portfolio is a forward-looking metric that captures long-term temperature rises, based on the ambitions of global policymakers and companies to tackle climate change.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.