Following on from the strategic goals of COP26, the route to decarbonisation for the real economy involves engagement to define the details. James Sparshott and Catherine Ogden offer some insights. Sponsored comment from LGIM.
The COP26 conference in Glasgow attracted worldwide attention as leaders from across the globe made more and further-reaching commitments than ever before to try to halt the rate of global warming. For the Local Government Pension Scheme the need to decarbonise portfolios has become increasingly clear and many funds are on the path to net zero. However, many decisions still need to be made, monitored and actioned.
James Sparshott and Catherine Ogden
At LGIM, our overarching ambition is to help decarbonise the real economy. We are trying to lead by example and have committed to work in partnership with our clients to reach net-zero greenhouse gas emissions by 2050 or sooner across all assets under management. Drawing on industry best practice, and to help our clients understand what we mean, we have set out below our key requirements for a fund or investment portfolio to be considered ‘net zero aligned’. We have also committed to strengthening our standards as progress made by companies and governments worldwide accelerates.
What does this mean in practice for a portfolio?
1) Set targets
• Net zero greenhouse gas emissions by 2050
• Either a reduction of at least 50% in carbon intensity by 2030 relative to 2019 baseline or portfolio temperature alignment of 1.5°C by 2030.
These are two key milestones informed by the recommendations of the Intergovernmental Panel on Climate Change.
2) Adopt a decarbonisation pathway
• The investment process will incorporate a mechanism to make progress over time towards the targets set
• Multiple approaches could be pursued (potentially in conjunction) based on carbon emissions or temperature alignment for the entire portfolio and/or for key sectors (such as utilities)
• LGIM will continue to develop the capability for the portfolios we manage to allocate to low-carbon investments across asset classes and, where possible under the portfolio mandate, increase the ‘green’ proportion allocated to low-carbon investments, while reducing the proportion invested in companies we believe fall short of our climate standards, as set out in our Climate Impact Pledge.
3) Engage for change
• Engagement with investee companies to achieve real emissions reductions starting today is critical; many companies and indeed countries have recently made commitments to reduce their emissions over the coming decades but, ultimately, it is engagement with companies, and holding them to account for the pledges they make and actions they take, that will make the real difference. LGIM has a long history of corporate engagement and the activities of our investment stewardship team, summarised in our regular active ownership reports, demonstrate the real impact of our actions on the economy
• As a firm we are recognised for using our scale and the weight of our votes in advocacy and engaging with policymakers, regulators and companies on climate change
• Our engagement activities span both private and public markets. Using our scale and experience in private market investment, we are able to engage directly with companies regarding the private market assets in which we invest, for example real estate and infrastructure. Our private market activities complement our longstanding Climate Impact Pledge, through which we target companies associated with about 60% of greenhouse gas emissions from listed businesses
• Through both direct and collaborative engagement, we will ensure that in net-zero funds we engage with issuers responsible for more than 50% of a portfolio’s associated emissions. We will increase this figure further over time, in line with best practice set out in key net-zero investment frameworks.
In devising the standards detailed above, we have sought to incorporate elements of best practice from three investment frameworks: the Net Zero Investment Framework from the Paris-Aligned Investment Initiative; the UN-convened Net-Zero Asset Owners Alliance; and the Science-Based Targets Initiative. We recognise that industry guidance is evolving fast; we will continue to build on our approach.
Fewer than 10% of companies today are on track for net zero , meaning that for most diversified investors such as the LGPS we believe the most significant question is not whether a portfolio is net zero today, but how to devise strategies that effect long-term change in the market. This has a number of important implications:
The real economy
Net zero means that, on average at the global level, carbon-emitting ‘assets’ must match carbon-absorbing ‘liabilities’. This does not mean every company, sector or country will move at the same speed, and some emissions will be inevitable.
We are developing the analytics – such as our [email protected] climate modelling toolkit – to understand better which companies and countries are making progress towards net zero, and to attempt to quantify their related financial risks. We are further evolving our product range aligned with net zero and will continue to monitor and review our funds in light of the progress made in the real economy. At the same time, we will ratchet up our engagement with corporates and governments to help accelerate this progress, through programmes such as our Climate Impact Pledge.
So far, many of the discussions around emissions have focused primarily on listed asset classes, whereas some of the most significant emissions come from sectors which tend to dominate private markets, for example the built environment. As set out in our December 2020 net zero carbon roadmap, every real estate asset we acquire has to have an asset sustainability plan, setting out how we can improve the sustainability credentials of that asset. And in private credit, we use a rigorous screening process to identify material environmental, social and governance factors.
LGIM will continue to collaborate with regulators and industry peers – in initiatives like the Glasgow financial alliance for net zero – to help create more consistent, harmonised standards for net-zero investing across asset classes.
The net-zero challenge is broader than merely excluding high-emitting sectors, as all companies generate some emissions – either directly through their operations (scope one and two) or through their value chain (scope three). Some high emitters, such as mining companies, will have an important role in developing and investing in solutions. Unilaterally divesting holdings is therefore not guaranteed to lead to the decarbonisation of the real economy and indeed could impede necessary investment in climate solutions.
Our choice of initial exclusions – new thermal coal and new oil sands – targets some of the highest-carbon sectors of the global economy, which are structurally misaligned to the direction of travel, and to which cleaner, cheaper alternatives are increasingly available. They are also designed pragmatically, so as not to immediately and substantially reduce diversification – and increase turnover and costs – for some of the existing portfolios that are committing to net zero.
For net-zero-aligned funds, we have not committed to large-scale purchases of carbon credits to offset the emissions associated with portfolios, as our aim is to prioritise real-world emissions reductions.
A net-zero world
In summary, at LGIM we are continually evolving our capability to meet these challenges, providing climate solutions across asset classes and investment strategies for our clients. These range from thematic funds focused on clean energy to climate-aligned credit and low-carbon index solutions.
LGIM will continue to debate and collaborate with regulators, stakeholders and industry peers to help create more consistent, harmonised standards for net-zero investing across asset classes. We will do this through our involvement in initiatives like the Glasgow Financial Alliance for Net Zero, as well as via the key role held by our CEO, Michelle Scrimgeour, as co-chair of the COP26 business leaders group.
LGIM, the LGPS and other asset owners and managers all have a role to play in tackling the systemic issues facing people and the planet, and will play a crucial part in reaching a net-zero world.
James Sparshott is head of local authorities at LGIM
Catherine Ogden is sustainability and responsible investing manager at LGIM
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