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Is Your Portfolio's Carbon Constraint Paris-Aligned?: Intelligent Ri
Is Your Portfolio's Carbon Constraint Paris-Aligned?: Intelligent Ri
Analysis
I NTE LLI G E NT R I
The application of carbon constraints has become common practice in ESG portfolios.
Investors often ask us how much below benchmark should carbon emissions/intensity
be in their portfolios. In many ways, the industry has settled on some heuristics. For
example, we have seen most investors ask for 30-50% below benchmark using historical
carbon intensity data. But is that enough to achieve our goals for a cleaner, greener
world? In particular, what does it take for a portfolio to be aligned with the Paris Accord
and net zero?
For institutional investor, qualified investor and investment professional use only. Not for retail public distribution.
Authors
www.man.com/maninstitute
Introduction
The application of carbon constraints has become common practice in ESG portfolios.
Investors often ask us how much below benchmark should carbon emissions/
intensity be constrained in their portfolios. In many ways, the industry has settled on
simple heuristics. For example, we have seen most investors ask for 30-50% below
benchmark using historical carbon intensity data.
But is that enough to achieve our goals for a cleaner, greener world? In particular,
what does it take for a portfolio 1 to be aligned with net zero and the Paris Accord
1.5-degree goal?
Background
Today, carbon constraints are widely applied in practice using Carbon Disclosure
Project (‘CDP’) data that discloses historical emissions of companies. In a typical
low-carbon portfolio, stocks in carbon-intensive sectors (such as utilities, energy
and materials) are typically penalised. Having said that, the makeup of a low carbon
portfolio is typically not very different from one without the constraints as it is usually
easy to achieve a portfolio with up to 50% carbon intensity/emissions lower than a
typical index. In Carbon Budgeting in Quantitative Managed Portfolios 2 , we describe the
skewness of carbon data and how lower carbon portfolios can be achieved typically by
eliminating just a handful of high-emitting names in the tail exposures of the portfolio.
‘‘
To be ‘net zero’, a
portfolio should, in
Paris Alignment Versus Net Zero
The Science Based Target Initiative (‘SBTI’) – a joint initiative between key players such
as CDP, United Nations Global Compact, World Resources Institute (‘WRI’) and World
Wide Fund for Nature (‘WWF’) – established requirements for the net-zero standard.
theory, be relatively One key principle behind the standard is that there should be “no net-zero claims until
long-term targets are met”, which for most companies means long-term target emission
carbon free. This
reductions of at least 90-95% by 2050. Hence, to be ‘net zero’, a portfolio should,
implies that a portfolio in theory, be relatively carbon free. This implies that a portfolio with a carbon budget
30-50% below benchmark, a current industry common practice, is inadequate for a net
with a carbon budget
zero claim.
30-50% below
While a claim of ‘net zero’ is difficult to achieve in portfolios, we believe that investors
benchmark, a current can build portfolios that are on the path to net zero and show alignment to the Paris
1.5-degree goals, by customising portfolios beyond simple carbon budgeting.
industry common
practice, is inadequate So, is a carbon constraint that is 30-50% below benchmark in carbon intensity enough
to be on the path to net zero?
for a net zero claim. ’’ 2050 is almost 30 years away, and a company committed to net zero should “set
near- and long-term targets” to achieve that goal (another tenet of SBTI’s net zero
principle). There is currently data available that allows investors to explicitly express
that a portfolio is on the path to net zero. As companies commit to net zero, they
register forecast target future emissions by year with the SBTI 3 , alongside the
budgeted emissions allocated. While most companies do not have projections out
to 2050, investors can look at the over-/under-forecast of company emissions into
the near future as an indication of whether a company is on the explicit path to net
zero. The overall portfolio emissions can be further constrained to align the portfolio
to SBTI’s budgeted emissions by utilising quantitative tools. Figure 1 shows two
contrasting utility companies, comparing future expected emissions to budgeted
(aligned) emissions.
1. There are two types of net zero claims being made: 1) Net zero claims by corporations eliminating carbon emissions from their own operations; and 2) Net zero claims
made by investment managers to eliminate emissions from their portfolio holdings. The latter is often some weighted version (based on portfolio holdings) of the former.
2. Source: Furdak, Wee; 2020 CFA Institute. 3. The SBTI budgeting process utilises two key methodologies for budgeting: SDA (Sectoral Decarbonization Approach) and
GEVA (Greenhouse gas Emissions per unit of Value Added). The methodology recognises that some sectors have more available technologies for emissions reduction and
hence apply different transition pathways by sector. For more information, see https://sciencebasedtargets.org/
tCO2e (million)
tCO2e (million)
600
300
500
250
400
200
300
150
200
100
100 50
0 0
12
13
14
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16
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13
15
24
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25
12
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25
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20
20
20
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20
20
20
20
20
20
Paris-aligned emissions: Upper Paris-aligned emissions: Upper
Bound 2-degree, Lower Bound 1.5-degree Bound 2-degree, Lower Bound 1.5-degree
Utility 1 carbon emissions Utility 2 carbon emissions
‘‘
While carbon
constraints on
Historical Emissions Do Not Equal SBTI Alignment
While carbon constraints on historical emissions is a first step to achieving greener
portfolios, a lower emissions portfolio is not necessarily more ‘1.5-degree aligned’ than
a higher emissions portfolio (Figure 2). Indeed, as the figure shows, there is very little
historical emissions relationship between carbon intensity (historical) and 1.5-degree alignment (future).
is a first step to Typically, carbon intensity is measured based on a company’s previous year emissions
over sales (ton/USD million). It is a backward-looking measure and does not take into
achieving greener account a company’s future emissions.
portfolios, a lower
emissions portfolio Figure 2. Carbon Intensity Versus 1.5-Degree Alignment
3.0
more ‘1.5-degree 2.5
’’
1.5
emissions portfolio.
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000
Carbon intensity
For example, an SBTI-aligned portfolio can, in many cases, still be invested in energy
and utilities, unlike a low-carbon portfolio that likely avoids these carbon-intensive
sectors. Utility 2, an integrated electric company servicing multiple states, is in many
regards a leader in the sector when it comes to alternative energy. At a carbon
intensity of 450 CO2 ton/USD million (versus the MSCI World at 138 CO2 ton/USD
million), the company is likely to be excluded from many low carbon portfolios (Figure
Carbon Intensity
500
(CO2 Ton/USD million revenues)
450
400
350
300
250
200
150
100
50
0
Utility 2 MSCI World
We would also note that being ‘net zero’ is a much more stringent requirement than
being ‘carbon neutral’. A mega-cap tech firm, for example claims of being “carbon
neutral since 2007”. This is indeed a bold statement. Dig a little deeper, and the
company has achieved carbon neutrality by purchasing renewable energy offsets, while
it continues to emit (based on 2019 data) 5.3 million tons of CO 2 emissions (Scope 1
and 2). This would, of course, be insufficient based on the SBTI’s Net Zero Standard,
which explicitly requires companies to focus on “rapid, deep emission cuts” rather than
achieving net zero by purchasing offsets.
tCO2e (million)
60
4
3 50
40
1
0 30
2012 2013 2014 2015 2016 2017 2018 2019 2012 2013 2014 2015 2016 2017 2018 2019
50%
40%
30%
20%
10%
0%
1.5-1.75°C 2°C 2.7-3°C 4°C >5°C
4. As of 20 November 2021.
0
0
20
40
60
80
10
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30
40
0
100
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0
1
2
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5
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0
Sector
100
200
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400
Region
20 20 20 20 20 20
12 12 12 12 12 12
20 20 20 20 20 20
14 14 14 14 14 14
20 20 20 20 20 20
16 16 16 16 16 16
20 20 20 20 20 20
18 18 18 18 18 18
UK
20 20 20 20 20 20
20 20 20 20 20 20
Energy
Utilities
Financials
20 20 20 20 20 20
Asia ex Japan
22 22 22 22 22 22
20 20 20 20 20 20
24 24 24 24 24 24
Consumer Discretionary
tCO2e (Millions) tCO2e (Millions) tCO2e (Millions) tCO2e (Millions) tCO2e (Millions) tCO2e (Millions)
10
20
30
40
20
40
60
80
0
50
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0
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20
20 20 20 20 20 20
12 12 12 12 12 12
20 20 20 20 20 20
14 14 14 14 14 14
20 20 20 20 20 20
16 16 16 16 16 16
Figure 6. SBTI Emissions Trajectory by Sector/Region
20 20 20 20 20 20
18 18 18 18 18 18
20 20 20 20 20 20
Japan
20 20 20 20 20 20
Materials
Real Estate
20 20
Technology
20 20 20 20
22 22 22 22 22 22
Emerging Markets
Consumer Staples
20 20 20 20 20 20
24 24 24 24 24 24
tCO2e (Millions) tCO2e (Millions) tCO2e (Millions) tCO2e (Millions) tCO2e (Millions)
0
5
0
0
10
15
20
25
30
0
1
2
3
4
5
6
0
1
2
3
4
10
20
30
40
50
20
40
60
80
US
20 20 20 20 20
Emissions
Emissions
20 20 20 20 20
Europe
Industrials
20 20
Health Care
20 20 20
22 22 22 22 22
20 20 20 20 20
24 24 24 24 24
Communication Service
requirement. ’’ 2
-1
-2
-1
-2
-1
-2
-3
Indeed, while the weight of companies in benchmark that are 1.5-degree aligned is less
than 30% (Figure 8a), we can build a portfolio that has a meaningful different projected
emissions alignment (Figure 8b) compared with the benchmark. In our hypothetical
portfolio, the weighted average overall carbon emissions in a 1.5-degree warming
scenario is below zero (under budget), compared with the benchmark, which is more
65%
60%
55%
50%
45%
40%
35%
30%
25%
1.5°C_or_1.75°C_ 2°C_aligned 2.7°C_or_3°C_ 4°C_aligned 5°C_aligned
aligned aligned
Portfolio Benchmark
15
Millions
10
-5
-10
-15
-20
1.5°C_or_1.75°C 2°C 2.7°C_or_3°C 4°C 5°C
Portfolio Benchmark
Conclusion
Building a 1.5-degree aligned portfolio is very much like building a portfolio with a
carbon constraint, in our view. The skewness in the data allows for portfolios – that are
aligned with almost no noticeable industry and factor biases – to be built.
Valerie Xiang
Portfolio Analyst, Man Numeric
Valerie Xiang is a portfolio analyst at Man Numeric. Prior to joining
Man Numeric in 2019, Valerie worked at Panagora and Citigroup
Global Markets. Valerie received a bachelor’s degree in economics
from Fudan University and master’s degree in finance from
Massachusetts Institute of Technology.