Climate-aware equity strategies are growing in number and in the approaches they employ. Sarita Gosrani, director of ESG at bfinance, talks about this evolution and some of the complexities for investors when evaluating one strategy against another.
As assets have flowed towards sustainable investment strategies, there has been a rapid increase in both the number and variety of products available to investors.
This greater diversity is extremely beneficial to asset owners, who can access a wider range of offerings—many of them very innovative—which have sustainability at their core. Yet investors must tread with caution: significant challenges remain.
Equities have sat on the front line for the early waves of ESG activity in the investment industry. With the recent increase in the availability of data and evolution of investor requirements, these strategies have transitioned from focussing only on carbon emission reductions to considering forward looking climate risk more holistically and even generating impact through measurable environmental and social outcomes.
Asset managers are innovating and evolving their own methodologies to assess and incorporate climate change and meet client needs. Yet there are number of crucial issues requiring close consideration from investors.
Unsurprisingly, a large proportion of climate aware strategies hinge on carbon emissions data. While coverage and quality have improved significantly during recent years, there are still significant shortcomings to address.
These include poor coverage of particular regions and the omission or unavailability of Scope 3 emissions, which account for more than three quarters of firm emissions.
Furthermore, the available data is not easily verifiable due to the current lack of standardisation in methodologies and the difficulties encountered by businesses with complex structures.
Another consideration is the lack of consistency between different data sources, particularly as there remains a disparity between methodologies used to calculate carbon metrics.
Arguably the biggest concern lies in the timeliness of emissions data: lagged and backward-looking, it provides no real insight into the forward-looking exposure of a company.
Given the above, investors relying solely on carbon emissions data must seek to understand the quality of data and how they are being used in the management of assets. Further, investors must understand that this approach may limit their influence over companies that will be more relevant to the transition, and (therefore) their potential to contribute to the transition to a low carbon economy.
A more complete approach to incorporating climate risk is to combine carbon emission data with forward looking metrics such as company’s net zero trajectory and commitment.
Global climate related commitments and targets are increasing. However, datasets for forward looking climate metrics are still nascent and largely dependent on underlying company disclosures. Increasingly the focus is shifting towards the action being taken to underpin the commitments.
Other challenges include short fund track records and an evolving regulatory and fund taxonomy that can make it difficult for investors to compare strategies.
It is important to note that these climate strategies may result in higher carbon footprints than the strategies that target emission reductions —especially in earlier years—since they can hold companies that may be high emitters but demonstrate a commitment to transitioning to a low carbon economy.
Whilst this can be explained, it can be problematic for investors reporting on their carbon footprint at a point in time.
Investors are increasingly looking to quantify and communicate climate risk, impact, and measure progress against their own net zero objectives. The inherent complexity of climate change makes measurement difficult, although the available methodologies and metrics to address different needs are evolving rapidly.
Investment managers are innovating to develop climate models that capture physical and transition climate risk through tools such as scenario analysis alongside temperature alignment metrics.
A drawback, however, is that these tools—like so many other modelling tools—rely on a range of assumptions which are ever-changing and incorporate a degree of uncertainty about the future.
Voting and engagement statistics can, arguably, provide a more readily available approach to measurement—and one that is perhaps under-utilised. Dialogues with companies to drive change and alignment with the transition are crucial in measuring impact and progress.
There remains a lack of transparency from investment managers on their work in this space. A new Engagement Reporting Guide being released in November 2021 by the Investment Consultants Sustainability Working Group may help to improve the quality and quantity of disclosure undertaken by asset managers.
Steps for investors
Investors’ growing focus on climate risk and the ongoing evolution of investment strategies in this space is an extremely positive shift—for risk management, for investment opportunity and for the planet at large.
Investors should expect significant refinement in methodologies as well as improving coverage. In the interim, however, it is important to understand the approaches being used by the investment managers.
To this extent, investors need to demand more from investment managers and seek to understand the key variables: the portfolio coverage of carbon data (both backward- and forward-looking), the ways in which available data are used in the investment and risk processes, and the quality of monitoring for climate impact and stewardship.
That being said, striving for perfection in these areas should not deter investors who are seeking to capture climate risks and support the energy transition.
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