Rethinking net-zero alignment
Bloomberg Professional Services
This article was written by Lingjuan Ma, Quant Index Researcher at Bloomberg.
Climate change is transforming the global investment landscape, creating new risks and opportunities. Deep, rapid, and sustained emissions reductions are required to achieve the Paris Agreement, resulting in a significant transformation across economic sectors. This leads to shifts in company valuation for those that do not adapt in step. Net-zero aligned benchmark indices can be instructive tools to help investors achieve their investment objectives, while simultaneously supporting the transition to a net-zero economy.
Despite its importance, the concept of “net zero” remains poorly understood. Furthermore, countries are not on track to meet their net-zero targets. In this blog, we delve into the misconceptions surrounding net zero and provide examples to illustrate our perspective on net-zero alignment. We also offer a thorough discussion of our solutions.
What is net zero?
Net zero means net-zero anthropogenic greenhouse gas (GHG) emissions, a state in which emissions produced through human activity are balanced by emission removed. The Intergovernmental Panel on Climate Change (IPCC) collects and assesses modelled emission pathways as part of its reports synthesizing the latest scientific knowledge on climate change. Figure 1 shows when emissions need to become net zero. Generally, scientists prefer to focus on pathways with “no or limited overshoot.” An overshoot means that global emissions must become net negative to remain aligned with the Paris Agreement; the technological and political feasibility of net negative emissions is questionable.
Under the Paris Agreement, countries are required to submit their own Nationally Determined Contributions (NDCs) outlining climate commitments and mitigation actions. The green/dashed line in Figure 1 shows the median emission pathways implied by NDCs as announced prior to the 2021 United Nations Climate Change Conference in Glasgow (COP 26), which runs until 2030. These climate policies support a continued build-up of fossil fuel infrastructure, which is evidenced by the higher emissions up to 2030. Indeed, there is an expectation that countries will update and enhance their commitments over time.
It is recognized that achieving net zero requires significant transformations across economic sectors. Investors need tools to assess risks and opportunities such transformations bring. This is where benchmark indices come in. Appropriate benchmark indices can be used as effective tools by investors to support the transition to net zero.
Broad market index as an alignment tool
Pension funds and endowments are indexed to broad market indices such as Bloomberg Global Aggregate index. Desirable investment characteristics such as high investment capacity and low turnover lead to the wide adoption of passive indexing by institutional investors. This, in turn, raises the question of whether investors should rely on these market indices to effectively mitigate transition risks.
A broad market index would be net-zero aligned if all its constituents’ transition timely to a net-zero economy. Despite the recent decoupling of emissions and economic growth, the International Energy Agency (IEA) has reported that global CO2 emissions have continued to grow by about 1% annually.
Current emission trends, coupled with uncertainties around the adequate pricing of climate risks and policy actions to address them, suggest the broad market indices may not be useful tools for sufficiently assessing and responding to transition risks.
Low-carbon indices can lead to unintended outcomes
One popular and obvious alternative has been low-carbon indices. These indices aim to achieve lower carbon intensity than the broader market indices. The low-carbon criteria are typically implemented through either a fixed decarbonization percentage relative to the overall emission intensity of the parent index or the selection of the best-performing companies within each market segment.
This approach often achieves decarbonization at the expense of the more carbon-intensive segments. To illustrate this, we create a low-carbon fixed income index from the Bloomberg Global Aggregate Corporate Index (BGLCTRUU) and a low-carbon equity index from the Bloomberg World Large & Mid Index (WORLD Index). To control for tracking error risk, we impose sector neutrality. The results are strikingly similar across asset classes: both indices consistently overweight the least carbon-intensive region (Europe) and underweight more carbon-intensive regions like Emerging Markets (EM) and the United States (US).
The Paris Agreement acknowledges a delayed peaking of developing countries emissions. Redirecting capital away from carbon-intensive segments could hinder mitigation and adaptation efforts, exacerbating exposure to physical climate hazards. This exposure negatively impacts creditworthiness, leading to higher (sovereign) bond yields and spreads.
Granularity matters
The speed and shape of decarbonization differ by sector and region. For the hard-to-abate sectors, cost-competitive decarbonization technologies are yet to become commercially available. In contrast, the power sector is spearheading the energy transition, with new onshore wind or solar emerging as the most cost-effective sources of power in many markets.
Developed countries have primarily focused on how to make the transition. Emerging countries, on the other hand, have prioritized socio-economic requirements. The real-economy aligned decarbonization, therefore, is a process where considerations are given to technological advances and differentiated regional climate policy, maximizing the social and economic opportunities of climate action.
Net-zero alignment: Transition leaders and real-economy decarbonization
The emphasis of net-zero alignment has recently come full circle, returning to the net-zero objective outlined in the Paris Agreement and its connection to real-world decarbonization through finance. Within this framework, the role of finance is to encourage flows towards the transition, prioritizing tangible contributions over paper portfolio decarbonization achieved through underweighting more carbon-intensive segments of the market.
Several key initiatives have discussed frameworks of meaningfully aligning with net zero, for example the Net-Zero Asset Owner Alliance (NZAOA) and the Institutional Investors Group on Climate Change (IIGCC). At the heart of these principles is the prioritization of real-economy decarbonization, which is achieved through rewarding transition leaders, such as companies that are either actively transitioning or well-prepared for the transition. This entails adopting a sectoral and regional science-based approach to assess transition readiness. Our paper examines the manifold advantages of integrating regional and sectoral variations into index construction by dynamically adjusting weights across regions and sectors. We demonstrate that the resulting index efficiently mitigates transition risks and makes a better use of investors’ tracking error budget. In each sector, the index prioritizes green assets, resulting in an overweighting that fosters a diversified “green bet” strategy. The real-economy decarbonization also involves considerations around a just energy transition and forward-looking metrics such as company climate ambition and green capital expenditures.
The role of net-zero alignment extends beyond adjusting weights to target lower emission intensity in financial portfolios. Its primary objective is to incentivize finance flowing toward the transition. Benchmark indices leveraging science-based sectoral and regional pathways offer a more effective approach to assessing the net-zero transition.
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