Autheurs
A large and growing number of institutional investors have committed to decarbonisation goals, mirroring the spread of national climate targets. At an industry level, this is an evolving area, and there is currently no consensus on how to achieve these objectives. One consequence is that decisions may not be made with alpha in mind, and many investors are choosing a passive index as their initial route to implementation. However, as we show in this paper, Paris-aligned benchmarks (PABs) face portfolio construction limitations and trade-offs.
- PABs can create significant active risk which comes with a systematic style bias: By using PABs as a proxy for the passive implementation option, investors are making an active investment decision.
- Lower quality Scope 3 emissions will dominate the construction of a PAB: The phase in of Scope 3 emissions to the PAB regulations1,2, may pose challenges to portfolio construction.
- PABs may inadvertently hinder the transition to a low-carbon economy: PABs exclude some of the firms that are likely to be most critical for decarbonising the energy sector, especially in emerging markets.
Investors may wish to take implementation further, going beyond narrowly optimising their portfolio to meet a constraint, to optimise their capital allocation to both drive system-wide decarbonisation and achieve their desired financial outcomes. In line with this thinking, and the motivations for institutional investors, we highlight alternative carbon metrics and decarbonisation approaches. We believe that active management and careful carbon metric selection can provide a more dynamic and effective way to balance the financial objectives of the portfolio while delivering progressive reductions in emissions.
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