By Alex White, Managing Director, Co-Head of ALM at Redington
Not investing in high emitters doesn’t stop them from existing, and in high-emitting sectors, some companies are tackling their emissions far better than others.
From October 1st, TCFD reports for large DB schemes will include an alignment metric. Three categories of alignment metrics are outlined below:
• Binary target measurements measure the percentage of investments with declared targets.
• Benchmark divergence models compare emissions against normative pathways.
• Implied Temperature Rise (ITR) models extend benchmark divergence models by translating an assessment of alignment into an implied global temperature rise.
The idea behind ITR is that emissions do not tell the whole story. Suppose Company A is a steel manufacturer producing half the average steel emissions per ton. While it is still a high-emitting company, if its practices became the norm, global emissions would decrease meaningfully. Equally, even if Company B, an accountancy firm, has twice the average emissions of its peers (scaled for size), it will not make much difference to global emissions either way.
Very broadly, it makes sense to think of companies as either better or worse than the norm. Comparing Company A's and Company B's emissions misses the point that, to reduce emissions, we should encourage Company A's practices and discourage Company B's.
This is the core of ITR metrics. For each company, there is an 'emissions budget' describing how much a company like it could emit in a global pathway that saw temperatures rise by no more than (say) 2 degrees. You can then compare the company's projected emissions against the budget to reach an alignment score.
This is not a trivial calculation, and it is not well suited to a regulatory environment as there is so much room for subjective judgment. In particular:
• How do you assign a carbon budget?
• How do you project emissions?
As the example of companies A and B above show, this is probably the minimum level of complexity needed to bridge the gap from portfolio emissions to global emissions. As an investor, an ITR metric is probably the best metric currently defined to measure how aligned your portfolio is to a given global climate target. However, different, viable approaches could lead to meaningfully different numbers. Any trustee board adopting this approach will inevitably take on more operational and regulatory risk than those using a simpler approach.
This is presumably one of the main reasons for allowing binary measures instead. These are much simpler to calculate and understand, but they don't factor in scale. The proportion of companies aligned is a potentially misleading metric if most of a portfolio's emissions come from a small subset of un-aligned companies. Emissions data is highly skewed, and most of a portfolio's emissions can easily come from around 5% of the holdings (and sometimes much less than that).
Emissions metrics are regularly evolving and improving. Perhaps some form of emissions-weighting will be introduced into binary metrics, or an entirely new approach will be proposed. For now though, these metrics add new information but also have their own weaknesses.
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