Achieving net zero: It starts in the mind

The CFA Institute mission to help the investment industry understand and fully implement net-zero investing is ramping up.

Following the launch of its groundbreaking paper: Net Zero in the Balance: A Guide to Transformative Industry Thinking, the global association of investment professionals continues to highlight the financial risks of climate change and the potential returns to investors in addressing this challenge.

Leading the charge is the report’s author, Roger Urwin, FSIP, global head of investment content, Towers Watson. This article recaps recent interviews with Urwin and other key report contributors including Margaret Franklin, chief executive officer, CFA Institute; Sonja Laud, chief investment officer, Legal & General Investment Management; and Linda-Eling Lee, head of the MSCI Sustainability Institute.

Urwin says net-zero investing requires a nuanced and holistic approach that considers the real economy impact of investing in different sectors and companies.

It is much more than simply reducing portfolio emissions by selling high-emitting assets and buying low emitting assets.

“In today’s financial landscape, there are practical challenges including complex supply chains, transition risk, greenwashing, policy uncertainty, lack of standardisation, short-termism, and concerns about financial performance and fiduciary duty,” he says.

But perhaps the “trickiest” part is the mindset shift that’s required, hence the paper’s provocative title.

“The investment industry continues to make heavy use of narrower theoretical investment theory, including modern portfolio theory and associated theories in which climate-related considerations and systemic risks are not included,” Urwin says.

“Transformative change can be difficult, and even painful, because it often means tackling longstanding and embedded practices, such as measuring and rewarding performance against market benchmarks over short-term time horizons. It is crucial to recognise these barriers and formulate new ideas to ensure best results are achieved for all stakeholders.”

The paper from CFA Institute focuses on “systems thinking” to build a framework for net-zero investing. Systems thinking effectively means two things: thinking about the whole ecosystem and its interconnections with the past; and a pattern that is changing all the time.

Urwin has an acronym to explain the complexity, SURPINE, which stands for systemic, uncertain, pervasive, interconnected, non-linear and endogenous.

Among the paper’s key takeaways are:

• Frameworks are essential for putting net-zero investing into practice. Frameworks recognize net-zero investing as part of sustainable finance, with asset owners making commitments within their fiduciary responsibility and asset managers implementing these commitments.
• Innovations are necessary for wider adoption of net-zero investing, including balanced scorecards, total portfolio thinking, and an expanded version of stewardship.
• Investment strategies for net-zero investing must balance net-zero goals with risk and return goals. Essential components of such strategies include consideration of government and regulatory policies, engagement with other stakeholders, and enhancement of organizational capabilities.

Big and fast action

Franklins agrees that the task ahead requires transformational change on a massive scale and at a swift pace.

“The financial ecosystem requires new thinking and tools to meet the unprecedented complexity and scale of the problem,” she says, adding that there’s no getting around that the size and level of commitment required will place a burden on organisational resourcing and leadership.

“All investors should be keeping a close eye on developments in net-zero investing because progress is unlikely to be smooth and organisational resilience will be tested but, ultimately, those that follow a well-designed strategy can build their resilience to adverse climate outcomes, meet their fiduciary duty to maximise risk-adjusted returns, and contribute positively to a transition to net zero in the real economy.”

The report’s top five recommendations for investment organisations are:

1. Build deeper organizational beliefs about climate using systems thinking to explore the likely future scenarios.
2. Grow your understanding of net-zero investing. Develop your strategy to complement your vision.
3. Pay attention to the changing regulatory environment and the governments’ commitment to net zero.
4. Develop your collaborative network to support faster learning and more coordinated efforts.
5. Attract talent from diverse fields to build climate investing capability. Develop T-shaped capabilities.

On the path to net-zero, Legal & General Investment Management’s (LGIM) Sonja Laud is encouraged by the investment industry’s increasing focus on company engagement, which demonstrates significant progress from the early days of value statements articulated through exclusions.

LGIM has made a commitment to reduce emissions by 70 per cent by 2030 and be net zero by 2050, across the group’s $1.42 trillion in assets under management.

“More investors are willing to deal with the dirty stuff and more actively engage with those companies. This is massive leap forward because that’s the missing part of the jigsaw,” Laud says.

“It can be a really powerful message if you are successfully engaging with them. If you can articulate a benefit statement to companies – a clear engagement goal, clear path towards it, and it will enhance your financials – there will be mutual understanding, so companies and investors push in the same direction. This can be very open, constructive and clear.”

However, more open, frank and honest debate is needed on what is realistically possible, given the experience of different countries, Laud says.

For example, energy poverty is a real issue in countries like India, and investing in emerging markets requires a realisation that a responsible investment proposition will look very different to developed countries.

“You can’t approach emerging markets companies as if they are on the same path as developed [markets],” she says. “Sitting on your moral high horse and telling companies what to do doesn’t work. It will not solve the overall issue of a just transition if investors do more in emerging markets.”

The industry also has to be realistic about the level of global collaboration that is possible, according to Laud, particularly between governments and policy makers in the current global political environment.

Globally, Europe is a key leader, with European companies decarbonising quicker than those in other jurisdictions.

MSCI data shows that 14 per cent of EU-domiciled companies are aligned to a net-zero pathway, compared with just 3 per cent outside the EU.

Furthermore, investment in net zero benchmarks increased from $10 billion to $100 billion in the five years to April 2023, driven in large part by the European Commission.

The European Commission, which promotes the general interest of the European Union by proposing and enforcing legislation, set out the criteria for an official EU Paris-aligned benchmark focusing on emissions reductions.

However, Europe is just a small sub-set of the global conversation and in order to achieve a future state where greenhouse gas emissions and removals are balanced, investors also need to focus on where the decarbonisation needs to happen, says MSCI Institute’s Lee.

For example, more than three quarters of the global coal-power generation capacity is in Asia Pacific, a region that also has less disclosure of transition plans by listed companies.

More than 90 per cent of large, listed companies in developed markets have disclosed their Scope 1 and 2 emissions, compared with 65 per cent in emerging markets.

Lee says that both policy and capital needs to be focused on decarbonising the most impactful assets, and this will require an open mind and thinking beyond the norm – something that the CFA Institute guide says systems thinking can provide.

With any large, complex problem, it helps to break the problem up and look at it in chunks, acknowledging that issues overlap and have a hierarchy, which is all part of systems thinking, Urwin says.

“Looking at net-zero investing across all factors, all at once, runs the risk of creating confusion. There are too many moving parts to do this satisfactorily,” he says.

As presented in the paper from CFA Institute, separating investment organisations and their net-zero ambitions into sub-systems or models, such as, the business model, investment model, operating model and people model, enables issues to be studied at the highest level.

“We can concentrate our attention on understandable and useable chunks, and focus on best practice principles,” Urwin says.