THE RACE TO THE PARIS AGREEMENT: REDUCE OR AVOID?

November 22, 2021

There is a rising involvement of the financial industry to provide investors with investment solutions that mitigate carbon emissions of portfolios. The financial flows from these investments can drive the climate transition by influencing the cost and access to capital for companies. Investment solutions can be divided in two distinct approaches.

1. Carbon reduction strategy

It consists in constructing investment portfolios that have a lower CO2 intensity (1) than traditional portfolios. Two distinct measures of CO2 have been used to build carbon reduction portfolios.

The first approach is based on the current CO2 emissions of the companies. The second approach is based on the carbon trajectory of the companies. The carbon trajectory is the path of reduction that a company’s future CO2 emissions have to follow in order to be in line with the Paris Agreement objective (<1.5° C) by 2050. In that case, the goal is to achieve a global portfolio temperature that is aligned with the 1.5°C objective. Exhibit 1 below compares the properties of the two approaches.

Given its forward-looking nature, we prefer the carbon trajectory approach. Companies in high emitting sectors such as utilities, energy and materials will have a significant role to play in achieving the ongoing climate transition. They are the most important players in the renewable energy space and some of them have very ambitious CO2 emission reduction targets even if their current emissions are high.

A carbon reduction strategy can be implemented without taking significant tracking-error risk with respect to the benchmark. However, the amount of renewable (green) energy generated by such a portfolio remains sub-optimal and insufficient to reach the objective of the Paris Agreement.

2. Carbon avoidance strategy
It consists in investing in companies whose products and services will contribute to accelerate the transition to a greener economy. The strategy selects companies that have developed products and technologies, which contribute to avoid CO2 emissions (solar panels, wind turbines, carbon capture solutions, etc.).

Using a robust and systematic portfolio construction, carbon avoidance portfolios can be aligned with the Paris Agreement objective as well. Investors can thus get the best of both worlds.
The investment universe of such portfolios being smaller than for carbon reduction strategies, there is a higher tracking-error risk with respect to the benchmark. Having said that, it can be controlled and maintained at reasonable level.

Exhibit 2 compares the impact of carbon reduction and carbon avoidance portfolios that have been calibrated to have the same tracking-error. What does it tell?
- Carbon avoidance generates 2.5x more renewable energy than carbon reduction.
- Carbon avoidance portfolios generate higher (scope 1 and 2) carbon emissions (upper right chart). This is the direct consequence of the higher allocation to utility and energy sectors that groups most of the renewable energy producers but can be high carbon emitters.
- Carbon avoidance strategies avoid 2.4 x more CO2 emissions than carbon reduction ones.
- Both carbon reduction and avoidance have a temperature trajectory, which is below 1.5° C and are thus aligned with the Paris Agreement.

Exhibit 2: Comparing the impact of carbon emission and carbon avoidance portfolios

Conclusion

Overall, both carbon reduction and carbon avoidance strategies are aligned with the objective of the Paris Agreement. However, reducing carbon emissions will not be enough to decrease CO2 emissions of the whole economy by 7% each year until 2050. Investments in innovations that enable to increase renewable energy production and avoid carbon emissions will be required. This is the role of impact investing, which invests in companies whose products and technologies avoid future carbon emissions.

1 Carbon intensity measures emissions relative to the revenues of a company. It considers a company’s polluting efficiency or inefficiency relative to the total level of its output. It is expressed as the amount of CO2 emissions in tonnes per USD 1 million of sales.

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