The pathway to net zero

David Russell, Chair, Transition Pathway Initiative

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The pathway to net zero

David Russell, Chair, Transition Pathway Initiative

Over the years an increasing number of funds have made commitments or established ambitions to achieve either Paris alignment or net zero, terms that are frequently used interchangeably, by 2050. Both the UN‘s Net Zero Asset Owner Alliance, and the IIGCC‘s Paris Aligned Investor Initiative support and encourage asset owners and investment managers to set such ambitions.

Processes are implemented to meet these goals. The first step usually taken is to measure a fund’s carbon footprint to establish a baseline, the start point for that net zero journey. Funds then establish processes to track their carbon footprint and implement policies to reduce it.

A focus on reducing a fund’s carbon footprint as the key target is the approach that most funds have initially taken. At its simplest, a line can then be drawn between where a fund’s carbon footprint is now to net zero by 2050. For most this means roughly an annual 7% reduction over the next 25 years, with interim targets typically set for 2025 and 2030.

As we come to that first interim target point, we are already seeing that funds are achieving their targets and are reducing their carbon footprint in line with or even exceeding the targets they have set.

However, the fact is that it is relatively easy to reduce a carbon footprint: You just sell carbon heavy assets. The carbon footprinting process helps you identify which companies have the most impact on your footprint, and there are also numerous benchmarks and products available which follow the 7% per annum trajectories. So yes, portfolios can be decarbonised.

This is great for those portfolios or funds. However, this has limited real world effect. Why? Because if you are selling a carbon heavy asset in the equity (or credit) market, or even in private markets, another investor is on the other side of the deal buying it. The asset and its associated emissions don’t change, all that changes is a fund’s holding of the asset and its carbon footprint.

Another issue is that carbon footprints are a backward-looking metric. They tell you what the emissions were at some point in the past, when the carbon emissions data were collected or published by a company. This means that the footprint data can be one, two or even more years out of date.

In addition, recent apparent reductions in carbon footprints have also been assisted by the denominator effect: carbon footprints are calculated by dividing emissions by asset values, and markets are at an all-time high. This has led to lower carbon footprints even if emissions don’t change at all.

So the upshot of this is we are seeing fund carbon footprint reduction, but the real-world impact of portfolio decarbonisation is difficult to see. How is this helping address climate change risk?

A different approach
Asset owners and other investors are beginning to question if a simple focus on decarbonisation is the best way for them to be achieving their end goal of reducing the risk that a changing climate poses to their portfolios. As a result, there is now more focus on forwarding metrics, assessing where companies are going to be in the future rather than where were they in the past.

There are a number of tools or approaches available for investors to focus on where and how companies are transitioning. These include:

• • Climate Value at Risk (CVaR) which quantifies the potential financial impact of climate-related risks on the portfolio, considering both physical and transition risks.
• • Implied Temperature Rise (ITR), which estimates the potential increase in global temperature based on the current constituents of a portfolio.
• • The proportion of a portfolio which has targets in line with the Science Based Targets Initiative (SBTi) which helps companies set greenhouse gas emissions reduction targets that align with climate science.
• • The Transition Pathway Initiative (TPI) which assesses companies’ preparedness for the transition to a low-carbon economy, focusing on their management quality (the governance of the transition) and carbon performance.

Some of these metrics or data sources are more useful than others: I would argue that its critical for investors to understand which companies in their portfolio are or are planning to transition, where they are going, rather than static “this is my portfolio now” type metrics. Such forward looking data can be built into investment process, such as integrated into investment decision making, built into stewardship programmes, or used to establish benchmarks or indices.

From an investment perspective, identifying and supporting those companies that want or are planning to transition seems a sensible way for investors to behave to support the transition. And understanding which companies are transitioning supports investment managers in deciding where to invest rather than being told only where they can’t.

So whilst there will always be a place for carbon footprints in measuring where funds are in their net zero journey, forward-looking climate transition metrics and data are essential for investors to assess and manage climate-related risks. It is a much stronger approach to addressing climate change than simply reducing a portfolio carbon footprint and I am sure we will see more funds adopt this approach in the future. After all, the aim is to address climate change and reduce its predicted impact on investment returns rather than simply decarbonise portfolios.

Members can view David’s keynote at UKSIF Ownership Day 2025 here.