Historically, climate investing was considered a by-product of ESG investing. In recent years, the environmental pillar, alongside the social and governance pillars, has gained a lot of traction and the emergence of the net zero topic has definitively established climate investing as one of the greatest challenges faced by asset owners and managers.

What does net zero mean?

Climate risk is the biggest challenge humanity has to face in the 21st century, affecting both the biosphere and the economic paradigm that currently under-pins 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 decade 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.

In order to reach net zero emissions by 2050, we need a 40 per cent reduction of carbon emissions by 2030 and a 62 per cent reduction by 2035. Therefore, net zero investing policies imply a first dimension, which is the decarbonization dimension. To reach this goal, asset owners and managers must decarbonize their portfolios with a reduction rate that follows a given pathway. However, net zero investing cannot only be reduced to this dimension. Net zero investment portfolios require a second dimension, which is even more important than the decarbonization pathway.

According to a recent report published by Queen’s University, Canada must invest $128 billion every year if it would like to maintain the temperature increase under two degrees. The study concludes that Canadian investments into green solutions must represent 6.4 per cent of the Canadian GDP per year. This is really a huge amount.

The previous figure only concerns Canada. If we consider the world, McKinsey estimated that we must invest an extra $3.5 trillion per year in order to achieve net zero by 20502. This represents 4.1 per cent of world GDP. The gap between current investments and what is expected is then huge because we cannot close the gap as soon as possible and we must invest massively today to find new green solutions in the future.

What is the implication in terms of climate investing?

The previous figures are very challenging because asset owners and managers mainly focus on portfolio decarbonization when they speak about net zero investing. However, we cannot reduce net zero investing to an exercise of portfolio decarbonization. Portfolio decarbonization is only one part of the solution. What is key is the second part of net-zero investing, which is the transition dimension: how to finance and promote the transition to a low-carbon economy.

In this context, net zero investing is multi-faceted. For example, impact investing aims to generate a positive and measurable environmental impact by calculating avoided emissions, producing clean water, or better managing the land. Engagement, voting policy, and shareholder activism is another part of net zero investing. The underlying idea is to transform companies to be sure that they are on a good pathway. The objective of asset owners and managers is then to maintain their exposure on the issuers that present transition ambitions. Finally, a third consideration of net zero investing is the relevant portfolio construction.

Decarbonization versus transition

It is not always easy to reconcile the decarbonization dimension with the transition dimension. The decarbonization process consists in reducing the carbon footprint of the portfolio with respect to a benchmark. For instance, if the carbon footprint of the benchmark is equal to 200 tCO2/$million and if we target a 20 per cent reduction rate, this implies to build a portfolio, whose carbon footprint is less than 160 tCO2/$million.

Portfolio decarbonization is relatively an easy task because we observe very large differences between the issuer’s carbon foot- print. Some issuers have very low carbon footprint (less than 10 tCO2/$million) while other issuers may have very large carbon footprint (greater than 1000 tCO2/$million). Therefore, portfolio decarbonization consists in replacing the issuers of the portfolio with high carbon footprint by the issuers with low carbon footprint. This process generally   leads to a portfolio, which underweights the energy, utilities, and materials sectors and overweights the financials sector.

The transition process consists of selecting the issuers with the highest greenness properties. There is no unique definition of the greenness intensity. It is generally measured with the green revenue share or the green capex share.

The green revenue share gives the current picture of the green business for each issuer, while the green capex share is more a forward-looking measure of the issuer’ greenness in the future. Generally, the greenness intensity of a portfolio is low because the universe of green assets is relatively small. Indeed, green activities and business concern only a part of the economy such as alternative energy, green building, or sustainable agriculture.

Sometimes, the decarbonization of a portfolio may lead to a lower greenness. The reason is that green activities are not necessarily located in the issuers with low carbon footprint. For example, some issuers of the energy or utilities sectors can have a high carbon footprint while they have developed solutions based on wind, hydro, or solar energy. They can then have a mixed business with renewable energy and fossil fuel activities. This is why we can observe a negative correlation between the decarbonization dimension and the transition dimension. The real issue of net-zero investing is not to exclude from portfolios issuers with a current high carbon footprint and a high potential for the transition to a low-carbon economy because the worst case would be to stop financing those issuers, that could find green solutions.

How to build a net-zero portfolio?

There are two approaches asset owners and managers can take when it comes to building a net zero portfolio. A first solution to build net zero portfolios is to consider an integrated approach with the dual objectives of both reducing the carbon footprint and improving greenness. The underlying idea is adding to the decarbonization process several constraints related to the transition dimension. For instance, a typical constraint is to increase the green revenue share of the portfolio with respect to the benchmark. Another typical constraint is to verify that the carbon trend of the portfolio is negative in order to impose a self- decarbonization of the portfolio. While the integrated net zero approach remains a top-down method, it encompasses some bottom-up features by selecting the best- in-class issuers for each sector according to the transition dimension.

The core-satellite approach

A second solution to building a net zero allocation is to consider a core-satellite approach, where the core is a decarbonized portfolio and the satellite is a transition portfolio. This approach is particularly relevant for strategic asset allocation, real assets, or fixed income portfolios. The objective of the satellite is then to promote climate and green solutions in the perspective of net zero emissions. Contrary to the decarbonization pillar, which is based on asset exclusion, bottom-up asset selection is the backbone of the transition portfolio. Moreover, the core-satellite approach implies that the allocation in the transition portfolio must increase over the time since the universe of green assets is expected to grow.

Either investment approach – integrated or core-satellite – can support the transition to a low-carbon economy. With the urgent need for climate action, a focus on portfolio construction can help narrow the gap between current investments and what is needed to find new green solutions in the future.

Thierry Roncalli is Head of Quantitative Research at the Amundi Institute.