A Top-Down Approach to Net Zero Portfolios

By Ariel Babcock, CFA & Devin Weiss

Future-oriented businesses and investors are recognizing the need to confront the issue of climate change in their respective industries, leading to a rapid increase in net zero emissions commitments.¹ Approximately one quarter of S&P 500 companies and around 10% of MSCI All Country World Index (ACWI) constituents have made net zero commitments to improve their environmental impact.^{2 3 4}

This trend is gaining a following in the investment community as well. 33 of the world’s largest asset owners representing $5.1 trillion in AUM, through the UN-backed Net Zero Asset Owner Alliance, have made long-term commitments to achieve net zero portfolio emissions by 2050.⁵ And while asset managers have been encouraging portfolio companies to take decisive climate action, those managers are now beginning to make the same commitment themselves. The recent launch of the Net Zero Asset Managers initiative, with investor signatories controlling $9 trillion in AUM, represents a new commitment on the part of the asset management industry to change the way capital is deployed.^{6 7}

The stakes are high. Efficient capital markets reward businesses and investors that solve big problems—and climate change presents one of the biggest problems facing the world today, giving institutional investors a tremendous opportunity to unlock the upside of climate conscious investment. But these portfolio commitments to net zero emissions are often decades into the future. And many investors have yet to develop practical ways to incorporate climate change into their portfolios or implement climate-based investment strategies in a uniform way.⁸ Rather than focusing solely on the companies in a bottom-up fashion, investors can take a top-down approach to drive net zero investment portfolio construction.

Why a top-down approach?

Portfolios can be built top-down by focusing on themes, sectors, or macroeconomic trends and then selecting particular companies or securities accordingly. Or portfolios can be built bottom-up, selecting companies and then seeing how themes, sectors, or economic factors come together.

The same is true for climate-aware portfolios. A bottom-up approach focuses on evaluating the companies or individual securities in the portfolio to determine an overall climate footprint. But this leaves asset owners with a painstaking level of detail and a lack of clear levers to pull to shift things in their targeted direction. For leaders of asset owners in particular, there is a top-down alternative. By deciding at the highest level which portions of a portfolio will be silent on climate, which will invest according to the owners’ principles, which will incorporate future carbon expectations, and which will be used to catalyze change, an asset owner has clear levers to pull to track progress along a glidepath toward meeting longer-term climate commitments.

Rather than simply looking to the companies to deliver a net zero future, asset owners can categorize their portfolios – based on their own actions and mandates – as a useful means to evaluate their own achievement of net zero goals.

Focusing capital on long-term climate solutions

The global community set out vital climate goals for 2050, and to achieve them means cutting carbon and carbon-equivalent greenhouse gas (GHG) emissions in half by 2030.¹⁰ By some estimates, funding this “decisive decade” will require at least $1.6 trillion per annum in supply-side energy investments alone.¹¹ The institutional investment community has a significant return opportunity: the businesses that create solutions to climate change – and the investors that back them – will be rewarded handsomely.

Despite some promising financial innovations (e.g., green bonds, sustainability bonds, green microfinance, new ESG investing products), there is still a relatively small amount of capital deployed against climate solutions. Given the potentially lucrative upside of early action, the lack of capital deployed by investors is surprising. A few explanations include short-term biases, concerns about violating fiduciary duties, data challenges, complex interrelationships, lack of scale and liquidity, new or untested technologies or finance vehicles, and risk evaluations that are not climate-conscious.¹² As an increasing proportion of the institutional investment community makes net zero emissions commitments, the time is right to rethink portfolio construction to overcome these biases and take advantage of the significant investment opportunity.

How to get to net zero?

Today’s typical approach to climate-aware investing concentrates on divestment and impact. Investors choose to divest from direct holdings in fossil fuels, for example, or they choose to invest in impact funds that have objectives around both return and climate. In these cases, the investor drives some part of the portfolio to be invested in line with their principles but is silent on the remainder.

We see four distinct approaches to climate-aware investing:

A silent approach, where asset owner mandates are silent on climate.
A principles-based approach, where asset owners have applied their climate values to investing in a rules-based way.
An analytical approach, where investors incorporate future climate scenarios into their investment decision-making.
A proactive, catalyst-based approach, where investors actively try to change the climate through their investments.

A top-down approach to constructing net zero portfolios

Investment Approach	Examples
Silent Approach	Extrapolation: assumes the future will mirror the past	Discount: Discounts the potential for future investment losses from climate change
Principles Approach	Impact: combination of investing and philanthropy	Divestment: exclusion of specified companies or industries, may be combined with carbon offsets
Analytical Approach	Reweighting: overweight underpriced assets/underweight overpriced assets based on different views of future carbon pricing or value of stranded assets	Innovation: options pricing or venture capital mindset for investing in long-shot technologies that could have a significant return and effect on the climate
Catalyst Approach	Solutions: invest in known solutions to drive scale, e.g., green infrastructure, agriculture, or electrification of transportation	Engagement: influence companies to transition from high- to low-carbon intensity through active ownership

A silent approach

The silent or “discount” approach implicitly assumes that the future will mirror the past and sees no need to adjust to a changing climate or to proactively invest behind climate themes. This approach sets aside the likely impact of climate change and the potential opportunity presented by climate-aware investment. By discounting the potential for future climate-related losses or by assuming these risks are so far in the future as to be irrelevant for current investment decisions, utilizing a silent approach to climate change over-weights near-term outcomes at the expense of longer-term trends. The “tragedy of the horizons” – as coined by former Governor of Bank of England Mark Carney – is a critical issue for long-term investors.¹³ While a silent approach may be appropriate for truly short-term investors, it misses the opportunities inherent in investing in longer-term climate solutions.

A principles-based approach

What we define as a principles-based approach acknowledges the reality of climate change and is most concerned with limiting investment in carbon-intensive or “dirty” industries or with putting money into investments that have a positive impact on the climate but may not yet be commercially viable.

Many stakeholders advocate for activities like divestment or exclusion. The goal of divestment is twofold: to raise the cost of capital to “dirty” companies and to ensure the investor feels comfortable with the source of their gains. There are three primary limitations to a divestment-based approach.

First, by excluding assets from the investment universe, principles-based investors cannot invest in companies or industries that are transitioning to a more sustainable business model, missing out on potential returns.
Second, it leaves investors with no seat at the table and little means of influencing change.
Third, while it may raise a company’s cost of capital, a divestment approach may also simply transfer “dirty” assets from one owner to another. The higher cost of capital to the company may mean a higher return to the remaining investors, rewarding those who are happy to hold “dirty” assets, while having little impact on the overall climate itself.

Many asset owners following a divestment approach limit their policy to direct holdings. To ensure a consistent application of principles, care must be taken to apply the same exclusion criteria to indirect investment. Otherwise, if asset owners are silent on private or pooled investments, they could both divest from listed energy companies and invest in oil & gas through private partnerships or index funds.

Impact investing is the inclusionary side of a principles-based approach. Impact investing – investing with the intent to generate positive, measurable social and/or environmental impact alongside a financial return – is often considered to have a double bottom line.¹⁴ While impact investors may achieve similar or better returns than financial-only investors, the term impact generally implies a willingness to accept concessionary returns in order to achieve a social or environmental goal. This impact/return trade-off mindset creates a fiduciary duty conflict in some jurisdictions, limiting the ability of many institutional investors to adopt this approach, leading to impact investing historically being more common among philanthropic-minded investors. Nonetheless, impact investing can play a critical role in getting things off the ground, often providing the first-loss or seed capital for new initiatives, but has been challenging to scale.

An analytical approach

An analytical approach maintains broad industry exposure but reweights its portfolio holdings and invests in future technologies based on its climate outlook. This investor over-weights adaptable companies or assets that are transitioning faster while underweighting those transitioning more slowly. Or it develops relative asset weightings based on different views of future carbon pricing or the perceived value of stranded assets.¹⁵ The analytical approach assumes there will be changes in policy, technology, and relative asset pricing that create investment opportunities, and constructs a portfolio that aims to capitalize on them. This approach is consistent with the UN Net Zero Asset Owner Alliance’s capital allocation approach, “The primary focus of capital allocation strategies is to re-allocate capital between companies, sectors and asset classes based on certain restrictions and parameters linked to investment goals aligned with climate targets.”¹⁶

Investors in climate innovation adopt a non-linear option-pricing or venture capital mindset to evaluate attractive long-shot climate technologies by using scenario analysis to better evaluate the potential future value of the opportunity. When climate risk is fully incorporated into a portfolio’s strategy, over longer horizons those technologies start to look less risky and more appropriate for inclusion in a portfolio. Unlike a divestment or exclusionary approach, an analytical approach considers the trajectory of change as well as the current state of play.

A catalyst-based approach

Finally, a catalyst-based approach takes a proactive role in deploying capital to climate solutions and engaging with companies as they execute their long-term climate strategy. By investing in known climate solutions, asset owners can drive scale and broad adoption of technologies that make a real difference such as green infrastructure, renewable energy, sustainable agriculture, and climate-friendly mobility. By catalyzing the growth of new green asset classes and scaling technologies, this approach recognizes climate change as an attractive investment opportunity and participates on the leading edge of climate innovation.

Furthermore, engagement between investors and companies can be a catalyst for change. Long-term, climate-aware investors can combat the “tragedy of the horizon” by influencing companies to transition from high- to low-carbon intensity through active ownership. And, of course, many of the companies best placed to make significant investments required for a sustainable or circular economy are current industry players with existing facilities and expertise. At its core, a catalyst-based approach focuses on developing the green assets and funding the green companies of the future while actively advocating for and investing behind change at transitioning companies.

It has been said that climate change is not a black swan but a “grey rhino” running directly towards us.¹⁷ Climate change’s impact on investment returns is unclear in terms of both magnitude and timing but we can hear the footsteps and we know it is dangerous. The current common asset owner approach of staying silent on climate, divesting from limited assets or investing small amounts in impact investing is not sufficient and leaves investment portfolios vulnerable in terms of both risks left unaccounted for and missed return opportunities. But attempting to implement a bottom-up approach, tallying up the emissions of every asset in the portfolio, can seem like an insurmountable task given the data limitations and leaves many owners with unclear levers to pull when deciding how to make a change. By utilizing a top-down combination of analytical- and catalyst-based approaches to portfolio construction, institutional investors can facilitate the innovation and solutions needed to meet the global climate challenge while capitalizing on a significant opportunity in the process.

^{Article 2.1c in the Paris Agreement commits all signatories to: “Making financial flows consistent with a pathway towards low greenhouse gas emissions and climate resilient development.” Paris Agreement, United Nations Framework Convention on Climate Change, November 2015, https://unfccc.int/files/meetings/paris_nov_2015/application/pdf/paris_agreement_english_.pdf. For the purposes of this article, we will refer to a “net zero commitment” as one that focuses on achieving overall net zero emissions of greenhouse gases (GHGs). This includes carbon dioxide (CO2) but also other GHGs, recognizing the full set of pollutants that contribute to climate change. “Net zero” means that any GHG emissions (including CO2 and other GHGs) are balanced by absorbing or otherwise eliminating an equivalent amount of GHGs from the atmosphere.}
^{Murray, “Net Zero is the New Business Imperative,” Forbes, September, 2020. Available at: https://www.forbes.com/sites/edfenergyexchange/2020/09/23/net zero-is-the-new-business-imperative/?sh=396ffb624fd4}
^{“Deeds not Words: The Growth of Climate Action in The Corporate World,” Natural Capital Partners, September, 2019. Available at: https://assets.naturalcapitalpartners.com/downloads/Deeds_Not_Words_-_The_Growth_Of_Climate_Action_In_The_Corporate_World.pdf}
^{FCLTGlobal analysis of the MSCI ACWI constituents as of 30 December 2020.}
^{Makortoff, “Top Asset Owners Commit to Big Carbon Emissions Cuts,” The Guardian, October, 2020. Available at: https://www.theguardian.com/environment/2020/oct/13/top-asset-managers-commit-to-big-carbon-emissions-cuts}
^{“Leading Asset Managers Commit to Net Zero Emissions Goal with Launch of Global Initiative.” Ceres. 11 December 2020. https://www.ceres.org/news-center/press-releases/leading-asset-managers-commit-net-zero-emissions-goal-launch-global}
^{There are many asset manager organizations which advocate for better climate outcomes at companies, among them are Climate Action 100+, the Institutional Investor Group on Climate Change (IIGCC), and the UN Principles for Responsible Investment (PRI). Membership in these organizations carries no expectation of committing to net zero emissions on the part of the investor, however.}
^{Aldy and G. Gianfrate, “Future- Proof Your Climate Strategy,” Harvard Business Review, June 2019. Available at: https://hbr.org/2019/05/future-proof-your-climate-strategy}
^{Members of the U.N.-Convened Net zero Asset Owner Alliance. “Inaugural 2025 Target Setting Protocol.” January 2021. https://www.unepfi.org/wordpress/wp-content/uploads/2021/01/Alliance-Target-Setting-Protocol-2021.pdf.}
^{Guy, “Decisive Decade for Climate Starts Now Despite COP26 Delay,” NRDC, May, 2020. Available at: https://www.nrdc.org/experts/brendan-guy/decisive-decade-climate-starts-now-despite-cop26-delay}
^{Buchner, A. Clark, A. Falconer, R. Macquarie, C. Meattle, R. Tolentino, C. Wetherbee, “Global Landscape of Climate Finance 2019,” Climate Policy Initiative, November, 2019. Available at: https://www.climatepolicyinitiative.org/publication/global-landscape-of-climate-finance-2019/}
^{Ameli et al, “Climate finance and disclosure for institutional investors: why transparency is not enough,” Climate Change 160, October 2019. Available at: https://link.springer.com/article/10.1007/s10584-019-02542-2}
^{Slavin, “Tragedy of the Horizon Still Holding Back Action on Climate Change, Carney Says,” Reuters Events, November, 2018. Available at: https://www.reutersevents.com/sustainability/tragedy-horizon-still-holding-back-action-climate-change-carney-says}
^{See Impact Investing Institute: https://www.impactinvest.org.uk/modules/introduction-to-impact-investing/.}
^{We define ‘stranded assets’ as those which are rendered uneconomic by proper pricing of the carbon pollution externality, made obsolete by new technologies, or which face a dwindling consumer market.}
^{“Inaugural 2025 Target Setting Protocol,” United Nations Environment Program, N.D., Available at: https://www.unepfi.org/wordpress/wp-content/uploads/2021/01/Alliance-Target-Setting-Protocol-2021.pdf.}
^{Coined by Michele Wucker in 2012, a “gray rhino” is a highly probable, yet neglected threat, with an enormous impact but uncertain timing.}