Looking beyond portfolio decarbonisation

We are obliged to set portfolio decarbonisation targets by the regulator. Some have made longer-term promises to be net zero ahead of 2050. Others have set ambitious interim decarbonisation targets – for Cushon, we are targeting an 80% reduction in scope 1 and 2 carbon emissions financed in the growth phase of our default fund by September 2030.

Driven by a realistic transition plan, this interim target is part of Cushon’s mission to shift the Overton window – to change the discourse about what is possible.

Real-world decarbonisation is the priority for many of us – not just the decarbonisation of portfolios. We know that delivering portfolio decarbonisation in a vacuum can be counterproductive.

If all we do is sell our high carbon intensity assets (or persuade investee companies to divest themselves of them), the new owners may well care less about climate change than we do. While our portfolios will be cleaner, the balance of carbon emissions in the atmosphere remains the same.

As such, we strive to deliver real-world decarbonisation alongside portfolio decarbonisation, through effective engagement. We may also see value in investing in transition assets like wind, solar and battery technology.

Climate and financial models are misaligned

As asset owners and managers, managing risks should be at the forefront of our minds. This begs the question: shouldn’t we be focused on building portfolios that are resilient under the different climate scenarios we might face?

When I asked this question at a recent conference, not a single owner or manager in the audience agreed with me. Why? Surely as fiduciaries our principal role is to secure robust risk-adjusted returns for our members?

Perhaps we are comfortable focusing on portfolio or real-world decarbonisation because we think the risks are modest. The financial models are certainly telling us so. But climate models suggest our portfolios are exposed to very significant risks that are mispriced by the market. Do we really believe that climate models are wrong?

Maybe it’s because we think that portfolio or real-world decarbonisation are good proxies for portfolio resilience. This is dangerous, because they aren’t.

Re-thinking risk

Portfolio decarbonisation is an inadequate proxy for transition risk mitigation.

Cushon works with SparkChange – a specialist provider of carbon data, analytics and insight – to measure the negative impact on our portfolio of increases in the price of carbon (a carbon price increase is one of the main policy tools of government in delivering a successful transition). This analysis demonstrates that a low-carbon portfolio still leaves material downside risk exposure as the carbon price rises.

What’s more, portfolio decarbonisation is no proxy at all for physical risk mitigation. A low carbon factory is no more or less exposed to hurricane risk than a high carbon one.

Real-world decarbonisation is better but still not enough. It may be an adequate proxy for transition risk mitigation, providing we are confident of a successful transition.

In the event of a partial or delayed transition, many transition assets may prove to have been overvalued. There is a real risk that fiduciaries supporting a transition may find that the benefits, such as they are, have been socialised while the costs have been internalised.

Real-world decarbonisation is at best a partial mitigant of physical risks. These are already with us and will get worse for the next decade or so, however successful we are at reigning in future carbon emissions.

Building portfolio resilience

The risks are material and neither portfolio nor real-world decarbonisation on their own deliver portfolio resilience against them.

Building portfolio resilience requires analysis of different likely climate scenarios, careful thought about how they might impact asset values, and the development of mitigation and hedging strategies. It’s complex and we can’t rely on modelling alone to tell us what to do.

The good news is that it’s possible to create portfolio resilience alongside portfolio decarbonisation and with a contribution to real-world decarbonisation, but only if building that resilience is the primary focus.

Julius Pursaill is a strategic adviser to the Cushon Master Trust