A] Prelude
What do retirement plan sponsors and sustainable investors share? A long term focus. We will explore how different asset classes, particularly real assets, can be aligned with long-term climate-related objectives, such as reducing carbon footprints to net zero.
By extension, we suggest ways for retirement plan sponsors—whether in the guaranteed Defined Benefit (DB) or investment based Defined Contribution (DC) space—to align their investments with increasingly common sustainable climate goals.
B] Key takeaways
Climate-related risks and opportunities are present in virtually all asset classes. However, real assets—including infrastructure, real estate, timberland, and farmland—may offer relatively stronger profiles of climate resilience to investors. As the world transitions to a low-carbon future, exposures to and within specific asset classes can be optimized to maintain alignment with climate and other environmental goals.
As Defined Benefit (DB) plan sponsors consider assigning mandates and Defined Contribution (DC) plan sponsors build and monitor fund lineups, these fiduciaries can also be mindful of how retirement portfolios can align with key climate goal milestones. Taking the long-term view!
A commonality between a typical portfolio for retirement and a sustainable investor is that both share a long-term horizon, seeking to achieve defined objectives over the course of many years. Even multiple decades.
The World Economic Forum Global Risk Report 2023 states that 6 of the top 10 risks over the coming 10-year period are climate and environment related. And the time frames for making fundamental changes to avoid significant economic and social damage from climate change and nature collapse are closing.
Investment portfolios focused on long-term return objectives will be less likely to achieve them if climate change mitigation and nature and biodiversity regeneration aren’t also achieved on a global scale. We will now focus on how investment portfolios can be built to align with these important and financially material environmental themes.
C] Climate change risk and opportunity in retirement asset allocation
Unanimous scientific agreement tells us that humans have emitted enough greenhouse gasses (GHGs) over the last century, and mostly in the last 30 years, to warm the planet just over 1°C above preindustrial levels. If we carry on business as usual with this level of emissions, we’ll cause the planet to warm about 4.5°C on average by 2100.
Sophisticated modeling of climate change reveals that it’s virtually certain to lead to dramatic results. To avoid the worst of these physical risks, nearly every government around the world signed the Paris Agreement in 2015 in which signatories agreed to reduce their GHG emissions to a level that would hold global warming to 1.5˚C and well below 2˚C above preindustrial levels.
But to make this happen will require transformational changes to the way societies and economies work. Virtually every sector is currently dependent on fossil fuels in one way or another. Moreover, developed-market economies are commonly habituated to outsize levels of consumption relative to emerging markets and so replacing fossil fuels with renewables to support today’s baseload energy requirements will be no small task.
To achieve their GHG reduction targets, countries are setting net zero by 2050 goals and developing low-carbon policies and incentives to accelerate their progress. Companies’ products, services, and operations can be affected by these policies, and so companies, in turn, are setting their own net zero targets.
By focusing on these company-level objectives, investors—and their plan sponsor partners—have the opportunity to assess how their portfolios can align capital with net zero targets!
D] Defining net zero
Put simply, net zero refers to negating the amount of GHG caused by human activity. First by reducing emissions and then by focusing on strategies for absorbing carbon dioxide from the atmosphere. The net result is a 0% increase in net emissions.
GHG emissions come from different places relative to a given company, some of which the company management can control and some of which it cannot—or can at best influence. These direct and indirect emissions are categorized into scope 1 (direct emissions), scope 2 (indirect), and scope 3 (indirect, upstream, or downstream in the company’s value chain):
• Scope 1 emissions are produced by the company directly—For example, for an automotive manufacturer, while running its machinery to build cars in its factories;
• Scope 2 emissions are generated by the company indirectly—For example, by purchasing electricity to power factories and heat or cool buildings;
• Scope 3 emissions are generated up and down the value chain of the company—For example, by customers who drive the automobiles produced by the company.
In order to set a net zero emissions target, companies must first measure their scope 1, scope 2, and scope 3 emissions and then identify how they can reduce emissions as a primary strategy and absorb any emissions that can’t be abated as a secondary strategy.
Often, scope 1 and scope 2 emissions are simpler to measure and reduce by switching to renewable power or innovating industrial processes. Scope 3 emissions are typically larger than scope 1 and scope 2 combined for companies in a variety of industries.
They’re also more complex to measure and reduce and may require systemic changes, such as a wholesale shift from the production of combustion engines to electric vehicles powered by a clean energy grid.
E] Measuring preparedness and resilience of different asset classes
Next, we take a look at how different asset classes are generally positioned relative to net zero by 2050 targets, as well as options for decarbonizing broader portfolios. When investing through the lens of climate risk, the first step is to understand the impact that climate change has had or is likely to have on an asset or an issuer’s business, as well as the impact that the asset or issuer may have on the climate.
Two high-level metrics that are useful for measuring these dual impacts are the presence of disclosures and targets, specifically, whether a company has: Measured and reported on its scope 1/2/3 emissions and set a net zero by 2050 target. Using these data points as proxies for preparedness and resilience in the face of both climate change and the transition to a lower-carbon economy, we can assemble asset class-based measures of the same using broader market indexes.
F] Prevalence of net zero targets among major asset classes
On this view, real assets, such as global infrastructure—which includes utilities, transportation infrastructure, and energy infrastructure—and global real estate investment trusts, are ahead of other asset classes when it comes to measuring their scope 1 and scope 2 emissions and infrastructure is leading the pack in terms of setting net zero targets.
This reflects several factors, including real assets’ generally higher exposure to both physical climate risk and low-carbon transition risk (and therefore more proactive risk management and reporting), government regulation regarding emissions reporting, investor and client demand for climate risk information and action, and the growth of opportunities in these industries, such as green buildings and renewable energy.
Both the global and Canadian equities asset classes follow closely behind. Large multinational companies are under scrutiny from customers, investors, and regulators on the climate front and are working to understand their climate risks and build the systems needed to manage these risks and report publicly on progress.
The high prevalence of sovereign issuers, sub sovereign issuers, and other government-owned corporate issuers in Canadian fixed-income strategies may explain the lower rates of scope 1 and scope 2 reporting and net zero strategy setting. Although the Canadian government itself has a net zero strategy that outlines the activities it’s undertaking, the debt-issuing entities themselves don’t report on their climate risks and opportunities as commonly as public issuers do.
G] Aligning equities/fixed-income investments with climate-related goals
There are a number of ways equity and fixed-income investment managers can align with a net zero by 2050 target or take advantage of risks and opportunities arising from the transition to a low-carbon economy. By extension, DB and DC plan administrators can assess different strategies’ alignment by considering whether they:
- 1. Invest in climate leaders—Investors can focus on companies deemed to be leading the low-carbon transition whether in their products and services or in the way they operate.
- 2. Invest in the low-carbon transition—Investors can seek out opportunities to help finance the low-carbon transition by finding higher emissions companies that have a credible low-carbon transition plan with short- and longer-term targets and that have made demonstrable progress.
- 3. Invest in the environmental, social, and governance-labeled bond market—Green, sustainable, and transition bonds make up a new and fast-growing market segment.
- 4. Engage with or avoid high emitters—Other options include engagement: working with high-emitting companies to help them set and begin acting on credible transition plans.
H] Exploring capabilities in sustainably managed real assets
Investments in real assets are valued for providing diversification benefits, inflation protection, preservation of capital, and stable yield potential. But they also present asset owners with an opportunity to play a role in climate change mitigation and adaptation.
Real assets such as agriculture, timberland, and real estate innately contribute to meeting basic human needs for food, materials, and shelter, while infrastructure contributes to essential water, energy, and transport services. When managed sustainably, we believe these asset classes can play a critical role in addressing climate change, nature loss, and rising inequality.
Investment in sustainable timberland and agriculture can provide low-cost, natural climate solutions that may also act as a first line of defense for protecting and enhancing biodiversity. Moreover, natural capital, including woodland and farmland, represents 37% of the opportunity to deliver the emissions reductions needed to limit global warming to 2˚C or below.
As carbon measurement practices continue to evolve and more investors and companies begin to assign explicit financial value to carbon sequestration and ecosystem services such as clean air and water, we believe that these attributes of natural capital will become more valuable.
There’s a host of sustainable investing opportunities across the real assets spectrum. Renewable energy, a necessary component of the low-carbon transition, is central to sustainable opportunities within the infrastructure asset class. Technological advances, such as the tools and techniques of precision agriculture, are key to achieving greater efficiency in the use of scarce inputs, lowering emissions, minimizing waste, and reducing the farming sector’s carbon footprint.
Meanwhile, real estate assets are vital to reducing the built environment’s carbon footprint and we believe investors will increasingly demand building efficiency improvements, fuel switching, and renewable technology that support carbon reduction goals.
For landlords, the benefits of having so-called healthy buildings include attracting quality tenants. In addition, such properties can potentially attract tenants who are willing to pay higher rents for sustainable spaces; however, the largest driver that may attract tenants could be regulatory change. Some recently passed regulations in California and New York City are cases in point.
I] Finally: Retirement plan managers and stewardship
According to the Thinking Ahead Institute’s 2022 Global Pension Assets Study, the number one missed opportunity for pension funds over the last 20 years is stewardship.
Retirement plan administrators have no small stake in understanding sustainability imperatives and related investment strategies. Without this capacity, we think asset owners and their beneficiaries could be subject to significant downside risks in their long-term portfolio outcomes.
But with it, DB and DC plan sponsors are better prepared as stewards of capital!