Our key conclusions
We found that a number of challenges and trade-offs can crop up when pursuing climate goals (e.g., alignment with a specific temperature-based target like ITR) using a purely top-down approach. For example, a desired asset allocation may not be viable at a certain level of ITR, given that a majority of companies in the investable universe are not yet aligned with established temperature targets (although we expect ITRs to come down over time as more companies set targets, resulting in a larger investable universe). In addition, a top-down approach can result in significant changes in a portfolio’s underlying assets — changes that may amount to a poor trade-off for the resulting ITR reduction. Finally, asset owners should beware of sector and regional concentration risks that can result from optimization exercises.
Based on our analysis, we think it will generally be critical to pair a top-down optimization process (e.g., using ITRs) with building-block implementation in order to minimize portfolio changes and pursue specific climate-change objectives (e.g., targeting groups of companies that have credible transition plans or offer climate solutions). We would highlight a number of top-down and bottom-up ideas for asset owners to consider:
Top-down ideas:
- Establish what climate alignment means. In our research, we incorporated climate in two complementary ways: 1) using climate-related assumptions to improve the accuracy of our CMAs, and 2) taking a forward-looking view of climate goals the asset owner might want to achieve, such as the integration of a Paris-aligned transition scenario with specific temperature alignment goals.
- Benchmark selection can blend traditional indices and sustainable, green, or Paris-aligned indices, although the latter may come with sector or style skews, as noted above.
- Climate-aware investing is not simply a risk-avoidance exercise. To pursue alpha potential from the effects of a warming world, asset owners may want to lean into climate-exposed regions, sectors, or industries with a tilt toward climate solutions or adaptation. We think this is an area ripe for thematic investing approaches.
Bottom-up ideas:
- We think asset owners should consider implementing a preference for companies that have set so-called “science-based targets” and/or other net-zero approaches, as this may provide maximum flexibility in reaching climate goals. However, asset owners should be aware of trade-offs, including very different sector exposures than in broad benchmarks.
- Exclusions are an option, but we would advocate for engagement with companies instead. Exclusions are based on backward-looking data and often target companies that are critical to the low-carbon transition and in the process of implementing targets to improve their business models’ alignment.
- While we have focused mainly on transition risk and climate-change mitigation in our SAA approach, we think underinvestment in climate-change adaptation constitutes a major market inefficiency. We believe adaptation solutions will be a significant opportunity with quite a different footprint than mitigation solutions.
Finally, whatever the approach to implementation, key performance indicators should be monitored over time. Not only can this help to create a clear connection between the asset owner’s investments and broader climate initiatives, but it will also provide reporting transparency that can ensure accountability and foster dialogue about trade-offs. For more on our research, read our paper, Designing a climate-aware strategic asset allocation.