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Taking a Portfolio’s Temperature

Paris-alignment scores are useful indicators of net-zero progress, but data shortages raise questions around accuracy.

As asset owners and managers commit to aligning their investment strategies to the goals of the Paris Agreement, there is an increasing need to access climate-related data from investee corporates.

For asset owners, it’s also pivotal to track whether asset managers are managing their portfolios in line with net zero targets and offering fund solutions that are truly Paris-aligned.

Increasingly, temperature scores are proving a popular way of simplifying and summarising a portfolio’s exposure to climate risks, and can give the asset owner visibility of their progress towards net zero portfolio emissions.

“Temperature alignment scores are easy to understand from a presentational perspective, as they indicate a portfolio’s degree of alignment with the Paris Agreement’s less than 2°C or 1.5°C temperature scenarios,” says Kate Brett, Head of Sustainable Investment for the UK and Europe at investment consultancy firm Mercer.

To calculate this, investors typically use third-party data vendors, online emissions-tracking tools and Paris-alignment guidance provided by investor bodies.

“A temperature score is a useful starting point to then make capital allocation decisions that will ensure the portfolio is moving towards net-zero emissions,” adds Daniel Klier, President of Arabesque.

For example, if a portfolio has a temperature score of 2.3°C, then the investor knows they need to cut 0.8°C of emissions from their portfolio well before 2050, either by divesting from the most carbon-intensive laggards or engaging with investee companies to ensure they decarbonise at an accelerated rate.

Regulators are increasingly asking institutional investors to demonstrate their degree of Paris-alignment. The UK Department for Work and Pensions recently issued proposals which would require occupational pension schemes to calculate and report their portfolio’s alignment with the goal of limiting global warming to 1.5°C above pre-industrial levels. This aligns with prior guidance issued to UK asset managers, insurers and pension providers by the Financial Conduct Authority. The latter included recommended temperature metrics for investment products and managed portfolios, such as Implied Temperature Rise (ITR), which also featured in the Task Force for Climate-related Financial Disclosure’s (TCFD) recently updated implementation guidance.

But it is challenging to produce an accurate temperature score when an asset manager or asset owner does not have all the information they need. All temperature scores are underpinned by estimations, which calls into question their accuracy. Scores need to be supported by transparent methodologies and be carefully scrutinised, experts say.

“There is a conflict between the desire for simple communication of a portfolio’s temperature alignment and the complexity of the underlying steering when it comes to climate-related issues. A score is far easier to communicate to regulators, disclosure frameworks and the general public, but it requires compromises in both data quality and data processing,” says Jakob Thomä, Managing Director of the 2° Investing Initiative (2DII).

Tools at the investor’s disposal

A lack of in-house resources and expertise on climate science often means asset managers “rely on third-party data providers” and toolkits to calculate portfolio emissions, generate temperature scores and complement their own data, according to Kate Elliot, Head of Ethical, Sustainable and Impact Research at Rathbone Greenbank Investments.

Rathbone Greenbank Investments uses data providers such as MSCI to translate climate-related data from corporates into individual temperature alignment scores, which can then be used to calculate overall portfolio exposure.

Arabesque and SaaS-based carbon accounting and management platform Persefoni both produce raw data sets for companies globally and generate baseline temperature scores that asset managers can use to then model alternative temperature outcomes for their managed portfolios and funds. Persefoni’s data is “auditable and compliant” with the Greenhouse Gas Protocol and the Partnership for Carbon Accounting Financials (PCAF), according to Tim Mohin, Chief Sustainability Officer at Persefoni.

PCAF’s Global GHG Accounting and Reporting Standard provides guidance for measuring emissions and ensuring Paris-alignment across asset classes, giving asset managers and asset owners a foundation to set more tailored science-based targets.

2DII’s Paris Agreement Capital Transition Assessment (PACTA) has been used by more than 3,000 institutions worldwide. PACTA measures portfolio alignments across different climate scenarios, using available global physical asset-level data. More than 600 portfolios are tested on their Paris-alignment every month, says 2DII’s Thomä. Investors are also able to measure how different climate scenarios will influence asset prices.

The Paris Aligned Investment Initiative (PAII) is a forum helping asset managers and owners align with the goals of the Paris Agreement. Established by the Institutional Investors Group on Climate Change (IIGCC) in 2015, the initiative is now supported by three other regional investor networks: Ceres, the Asia Investor Group of Climate Change (AIGCC) and the Investor Group on Climate Change (IGCC).

PCAF and 118 investors representing US$34 trillion in assets engaged in the development of PAII’s Net Zero Investment Framework. It models the behaviour of current and aligned portfolios for each investor under four climate scenarios: 3.7°C by 2100; below 1.5°C by 2050 (1.3°C by 2100); below 2°C (1.6°C by 2100); and 1.9°C by 2100.

Last year, PAII published case studies for ten asset owners who have used the framework, including the Second Swedish National Pension Fund (AP2), the Ontario Teachers’ Pension Plan, PGGM Investment Management and the Brunel Pension Partnership.

AP2 has used the framework effectively, the report noted, having sufficiently “adopted investment beliefs, policies and processes aimed at aligning its portfolio with the goals of the Paris Agreement”. This includes halving its equities portfolio emissions since 2015, increasing its allocation to green bonds in the strategic portfolio from 1% to 3% in 2019, and investigating how different climate scenarios can influence strategic asset allocation.

The AIGCC recently published a compendium to help Asian investors navigate the wide variety of climate-risk assessment tools and analytics. It assessed 18 providers, including MSCI and Moody’s ESG Solutions, across a range of climate-related data requirements, such as scenario analysis, time horizons and physical risks.

A guessing game? 

Not every company is disclosing the climate-related information that asset managers need to work out portfolio temperature alignment. If the data is not there, then data providers, frameworks and investors are forced to estimate, which undermines the accuracy of resulting scores.

“The state of the art right now is estimation and it’s terrible. Current portfolio temperature scores are based on this house of cards of estimated data,” Persefoni’s Mohin says. But as asset managers put pressure on investee companies to disclose their emissions through existing audited frameworks and platforms, these estimates will inevitably become more accurate, he notes.

“Investors are driving the need to have better data down into the portfolio companies,” Mohin says.

Eternal providers use statistical models to cover data gaps, says Elliot. If companies are not covered by the provider, Rathbone Greenbank Investments creates its own estimates, disclosing its methodology for clients.

When companies do not disclose climate-related data, asset managers need to “be careful not to overestimate their progress”, warns Klier. Oftentimes, companies are more likely to disclose their decarbonisation progress if they are putting in the work, he explains. At Arabesque, companies that do not disclose their emissions are awarded temperature scores that are warmer than the sector average.

One of the main issues causing gaps in the data is identifying and tracking Scope 3 emissions. Even when companies are providing disclosures of Scopes 1 and 2, this does not necessarily mean that they are disclosing their total emissions, which has a knock-on effect for investors.

Voluntary frameworks such as TCFD are now asking for companies and financial institutions to disclose Scope 3 emissions where they are deemed material, but progress remains slow, says 2DII’s Thomä.

Further, with 15 different subcategories within Scope 3, existing disclosures remain “incredibly varied”, leaving “a lot of space for data gaps which estimation models simply cannot fill accurately”, he notes. According to the Greenhouse Gas Protocol, the 15 subcategories include upstream leased assets, processing of sold products, investments and waste generated in operations.

Modelled data has to rely on certain assumptions, agrees Conor Hartnett, ESG Client Strategies Manager, EMEA, at Invesco. “Aggregating these up to a portfolio level and translating that into an ITR or temperature score therefore means you are building assumption upon assumption,” he says. Where applicable, Invesco reports the percentage of data coverage in a portfolio.

Some investors prefer to only use validated data from companies, rather than estimated temperature projections for companies that have not disclosed. Allianz Global Investors (GI) told ESG Investor that its current model does not use modelled emissions data, as it can “lead to some underestimation of the temperature in some sections of the portfolio – we prefer to avoid adding further assumptions in already complex prospective models”.

Scope of focus

It all gets more complicated when factoring in different asset classes.

For equity-only portfolios, calculating emissions is simpler: the asset manager can aggregate carbon data that is available at the individual security level to work out the portfolio’s overall exposure. If the portfolio holds around 1% of a company, then the asset manager knows it holds 1% of the company’s total emissions.

This does not work across other asset classes, such as sovereign bonds. These are financial instruments providing capital to governments, but opinions currently vary on the “appropriate scope” of emissions that it emits, according to S&P Global. Emissions could be measured per capita of the domestic population or per US$1 million of economic output, for example.

The Net Zero Asset Managers initiative (NZAMI) this week disclosed its interim targets, saying that an average of 35% of signatories’ assets are managed in line with net zero, the equivalent of US$4.2 trillion out of a possible US$11.9 trillion.

NZAMI signatories highlighted issues with measuring emissions across asset classes, noting that “in some asset classes or for some investment strategies, agreed net zero methodologies do not yet exist”. Several managers said they could not measure alignment to net zero across the following asset classes: derivatives, cash, private equity, green bonds, sovereign bonds, covered bonds and structured products.

NGO Reclaim Finance further points out that NZAMI’s guidelines do not explicitly prevent assets from driving the expansion of fossil fuel or coal.

Asset owners want to see increased transparency from asset managers on how they are tracking and managing portfolio emissions across assets, says Mercer’s Brett. “Part of our role is helping an asset owner select an asset manager with a strong approach to decarbonisation,” she says.

“We need to see more explicit guidance from governments and disclosure platforms on measuring emissions for different asset classes beyond equity, such as corporate credit, sovereign bonds and private markets,” she adds. This will make it easier for NZAMI signatories to manage the remaining 65% of assets in line with net zero.

Both the PAII and PCAF cover asset classes beyond equities.

PAII provides guidance across sovereign debt, corporate fixed income, and real estate, with plans to expand the framework into infrastructure and private equity, as well as developing guidance for tracking Scope 3 emissions. PCAF covers corporate bonds, business loans and unlisted equity, project finance, mortgages, commercial real estate, and motor vehicle loans.

Further, PCAF is collaborating with the PAII to advance the development of PCAF’s GHG accounting methodology, which will then underpin the PAII’s Net Zero Investment Framework, thus ensuring alignment between the two organisations.

Progress not perfection

Temperature scores ultimately need to be taken with a pinch of salt.

But they are nonetheless a useful starting point towards Paris-alignment and should “form part of an asset manager’s toolbox that can act as a guide to further analysis and engagement as necessary”, says Invesco’s Hartnett.

“We need to make progress rather than aim for perfection,” says Klier. “Using the data already publicly available, all investors have enough ammunition to work out their initial baseline of temperature alignment.”

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