Aligning portfolios with climate goals: a new approach for financial institutions
To achieve the goals of the Paris Climate Agreement and limit the increase in global average temperatures to well below 2 Â° C, human society must achieve zero net long-lived greenhouse gas emissions by the middle of the century. To prevent average global temperatures from rising more than 2 Â° C by then, we will need to limit cumulative carbon emissions on the net zero path to less than 1,000 gigatonnes; to avoid a rise of more than 1.5 Â° C, no more than 400 gigatons can be emitted. Both goals require substantial short-term reductions in emission levels, which are around 40 gigatonnes per year. To meet the 1.5 Â° C target, the world must reduce current emission levels by two-thirds over the next decade.
This great transformation will only be possible if we replace, on a large scale, the productive asset base of the global economy with non-emissive technologies. Financial institutions understand that the capital requirements for this historic business are enormous. The success of the transition to a zero net society depends on the ability to maintain capital flows to emissive industries engaged in decarbonization activities while redirecting funding to activities that do not support the ambition of 1.5. Â° C.
The financial sector therefore needs the appropriate tools and indicators to set climate targets and measure progress against them. In cooperation with leading financial institutions, McKinsey joined the portfolio alignment team, set up by Mark Carney in his capacity as UN Special Envoy for Climate and Finance. Our collective objective has been to make it possible to measure the relative alignment of the portfolios of investors and lenders with the objectives of the Paris Agreement. We emphasize that these technical supports are designed in such a way as to interact with the counterparties and to facilitate their transition. It is only through engagement, rather than divestment, that we can transition to a 1.5 Â° C future.
The approach to financed programs and its challenges
Today, the most widely used tool for measuring climate impact across the global financial sector is the calculation of financed emissions. The concept of funded shows is pretty straightforward. It begins when a financial institution invests, lends or insures a business. This company continues to produce programs. The financial institution then counts a proportional fraction of that company’s emissions in its own carbon footprint. The climate impact of a financial institution can be measured as the sum of the issues it finances in all the companies in its loan portfolio, investment portfolio or insurance portfolio.
Calculations of funded emissions are an important and useful tool. Most of the climate commitments made by financial institutions, now representing nearly $ 100,000 billion in assets under management, are made in terms of financed emissions. Most climate data management and analysis infrastructures produce these measurements.
The use of financed emissions, however, creates three challenges related to the development of effective climate strategies. First, by calculating funded emissions, institutions can tell where they are now but not where they need to go. Physical science clearly shows that reaching a warming limit of 1.5 Â° C or 2 Â° C depends on both achieving zero net emissions and limiting the cumulative amount of greenhouse gases. greenhouse that we emit on the way to the objective. To align with the ambition of the Paris Agreement, the world needs a climate strategy built around a total carbon budget, and not just a net zero target at one point in time.
The second challenge is the complexity of determining carbon at the portfolio level. To achieve an effective net zero transition, we must recognize that different geographic areas and sectors will have to decarbonise at different rates, according to their different capacities and needs. Industries in developed economies need to reduce their emissions faster than the world average; emissions financed in portfolios focused on these savings can and should reflect the faster rate of decarbonization. For emerging economies and portfolios focused on them, the rate is bound to be slower. Failure to take these crucial differences into account can lead to unworkable or inadequate climate strategies to slow global warming.
The third challenge for the financed emissions approach is that this measure would discourage financial institutions from financing the decarbonization and responsible retirement of existing emitting assets. By simply measuring emissions, institutions would be encouraged to avoid large emitters in favor of small emitters, disregarding low-carbon versus non-low-carbon companies. Institutions providing funding to a rapidly decarbonizing emitter would increase their levels of funded emissions, negatively affecting their measured climate impact. Thus, the approach would limit the strategic space available, forcing to focus only on green growth while deprioritizing the greening of âbrownâ assets. Yet turning brown assets into green assets is at least as big and important a problem (and an opportunity) as the promotion of new green growth today.
The Refined Approach: Portfolio Alignment Tools
In response to these challenges, the portfolio alignment team worked with leading institutions, method providers and financial sector thinkers to codify a new approach to measuring climate impact: the use of ‘portfolio alignment tools. Portfolio alignment tools are computer models that use forward-looking climate scenarios to estimate the division of the global carbon balance by sector and geography. This allows users to measure the performance of emissions along a trajectory rather than at specific times; it also allows measurement down to the level of each counterparty in the portfolio.
Portfolio alignment tools can solve all three challenges of the financed emissions approach. First, financed emissions are assessed in the context of a carbon budget or an emissions trajectory. This helps institutions to chart their course towards the goals of the Paris Agreement. Second, the carbon budget or trajectory is constructed as a composite of the trajectories of the companies making up the portfolio. The overall trajectory thus reflects the unique sector and geographic composition of a portfolio. This helps reveal whether an institution’s climate strategy is both achievable and sufficient for the collective goal. Third, trajectory analysis allows financial institutions to differentiate between low-carbon and non-low-carbon businesses. This allows them to extend decarbonization financing to large emitters, provided they make the necessary climate progress by renovating, replacing or removing existing assets. To achieve an effective net zero transition, we must recognize that different geographies and sectors will need to decarbonise at different rates.
To achieve an effective net zero transition, we must recognize that different geographies and sectors will need to decarbonise at different rates.
The portfolio alignment tools thus provide an essential context for the measurements of financed emissions. In doing so, they can guide financial institutions in developing science-based climate strategies, informed by economic and technological realities, and open to meeting the financing needs of decarbonising companies.
The portfolio alignment team was mandated by the Climate Related Financial Reporting Working Group to produce a survey and synthesis of existing best practices in the creation and use of portfolio alignment tools.
What the new approach means for financial institutions
The leaders of financial institutions know that this decade is crucial for climate action. Portfolio alignment tools can help facilitate needed changes to existing climate strategy approaches and decision-making processes. It is therefore important to start thinking about these changes now, even if the tools are still very recent.
Commitments to cease funding in specific industries could, for example, be reconsidered. Portfolio alignment tools give financial institutions the freedom to extend funding to large issuers, provided that the funding goes towards responsible retirement or the decarbonisation of emitting assets and that the decarbonization or retirement is successful. It’s also worth starting to think about how to tell the story of portfolio alignment to shareholders, clients and regulators. The story is complicated but essential because it reveals a clearer picture of the path we must take to achieve the goals of the Paris Agreement. Executives can also start investing in improving the data environment and technical fidelity needed to support large-scale portfolio alignment tools.