The fifth step in Redington’s 7-point climate action plan is default client advice: aligning our model portfolios with the goals of the Paris Agreement and changing the way we advise our clients to set strategic asset allocations. Here’s how we plan to do this:
Going forward, our base case advice is that clients should have a 2050, or sooner, net-zero target for CO2-equivalent portfolio emissions. The good news for most investors is that moving to a net-zero portfolio is fairly straightforward.
But what do we actually mean by a net-zero portfolio?
We define a net-zero portfolio as one which is run with the aim of reducing CO2 (or equivalent) emissions to zero by 2050 (or sooner), and where emissions have been reduced by at least 33% today, relative to the current asset allocation.
The rationale for targeting a 33% emissions reduction today rather than a straight-line reduction to 2050 is:
- We expect a strategic asset allocation to be in place for around ten years, therefore the emissions-reduction pathway should work throughout the lifecycle of the allocation, not just in today’s position;
- Risk is only reduced if you do something – planning to do something does not reduce risk; and
- It’s relatively easy to implement.
From a financial perspective, the transition to net zero could be priced in well before 2050. So, in order to reduce climate risk in their portfolio, investors need to consider making changes today, rather than making gradual changes over a prolonged period. If investors wish to continue taking more climate risk than necessary, they should, at the very least, ensure they’re getting rewarded for it – in the same way they would approach other risks.
Aligning your portfolio with net zero might be less work than you think
In current market conditions, the change in asset allocation required to achieve net zero by 2050 is relatively easy to implement, and well within the risk and return constraints of many investors. How is this so?
- Emissions are concentrated to within a few sectors and companies;
- These sectors tend to be prevalent in credit rather than equity indices;
- Lower credit spreads make credit relatively less attractive than non-credit assets for meeting expected return targets;
- Some styles of investing (quality, momentum) give both low carbon emissions and a historically-rewarded risk premium; and
- Even within credit indices, a small number of issuers/sectors account for most of the emissions.
This concentration of emissions within a few key sectors means that investors can reduce the emissions of their portfolios by changing their strategic asset allocation and re-weighting existing allocations. Coupling the adoption of a 2050 net-zero target with existing investment objectives will, in a large number of cases, push investors towards the changes that should be made anyway given the current market environment of low credit spreads.
Given that most existing portfolios will likely have been built around a series of both investment and non-investment constraints (which could be as simple as being anchored to legacy allocations), the starting point for most investors is not a theoretically perfect ‘efficient portfolio’. And, indeed, the potential error involved in estimating what that portfolio should be is already rather large. Hence, while a net-zero portfolio may not be the theoretical ‘max Sharpe ratio’ portfolio, this is typically the case for existing portfolios anyway – and the max Sharpe portfolio may not deliver the highest realised Sharpe ratio in any case.
It’s important to note here that reducing portfolio emissions is different to increasing climate impact; the latter involves reducing the sources – or enhancing the sinks – of greenhouse gases. Some climate-impact strategies will have low emissions, while others will have relatively high emissions. Hence, it’s important to set an emissions target at the portfolio level rather than the individual asset level.
So, what does a net-zero portfolio with a target date of 2050 and a 33% reduction in emissions today look like?
Such portfolios will look broadly similar to existing portfolios, but with a tilt towards equities and away from credit, and a tilt towards quality and momentum and away from value. The equity/credit shift is as much driven by expected return constraints as climate constraints. A move away from direct market exposure and towards alpha-based strategies could further reduce emissions, however, this remains relatively expensive and is a different decision.
To find out how our team at Redington can help you align your portfolio with your net-zero target, please get in touch: info@redington.co.uk
Unless indicated, these are the views of the author’s and may differ from those of the firm.
