Climate risk is the biggest challenge humanity has to face in the 21st century, affecting both the biosphere and the economic paradigm that currently underpins it. The latest reports released by the Intergovernmental Panel on Climate Change (IPCC) and the International Energy Agency (IEA) emphasize the urgency to act quickly. The former provides new estimates of the chances of crossing the global warming level of 1.5°C in the next decades, and finds that unless there are immediate and large-scale reductions in greenhouse gas emissions, limiting warming to close to 1.5°C or even 2°C will be out of reach. IEA’s report underlines that to achieve Net Zero Emissions, the annual clean energy investment will need to reach $4 trillion by 2030, with a 40% reduction of carbon emissions by 2030 and 62% by 2035.
Since the 2015 Paris Agreement and the emergence of net zero emission policies, climate change is now the top priority on the agenda of financial institutions, supervisors and policymakers. Consequently, the asset management industry also has a key role to play. Terms such as “portfolio decarbonization”, “temperature alignment”, “net zero carbon investment” and “Paris-aligned benchmark (PAB)1” have become the everyday reality of asset owners and managers. These will significantly alter portfolio allocation and investment frameworks.
Institutional investors are regrouping into the UN-convened Net Zero Asset Owner Alliance with the objective to “transition their portfolios to net zero GHG emissions by 2050”. Additionally, asset managers have formed the Net Zero Asset Managers initiative, which currently boasts 220 international asset managers and $57 trillion of assets under management. Governments have also implemented additional regulations to promote the efforts of companies and financial market participants around the disclosure and the transparency of carbon emissions data, such as the Sustainable Finance Disclosure Regulation (SFDR) and the EU Taxonomy.
The key challenge of these regulations is therefore the supply of relevant data in terms of frequency, quality and coverage. If these metrics are not self-reported by companies, data providers usually estimate their carbon emissions. However, the quality of these estimates is usually poor: academics find no evidence that these scores predict future changes in emissions. As we are at an early stage for the race to Net Zero, climate risk assessment methodologies have not yet reached maturity2. Numerous initiatives have put forward new climate risk measures that differ from traditional scope 1 + scope 2 carbon emissions3,4.
We recently published two working papers that study climate risk measures:
- Portfolio Construction with climate risk measures, conducting a survey of the current climate risk measures in the asset management industry and how portfolio construction practices use these “traditional” metrics;