Decarbonisation – a net zero blueprint for your whole portfolio

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Although decarbonising an investment portfolio is a multi-faceted, multi-stage exercise, it needn’t be complicated. Adding the dimension of sustainability – in this case, decarbonisation – to your portfolio construction process does not mean changing your approach entirely.

We don’t need to re-write the book on portfolio construction to add this chapter on sustainability. We share our method for decarbonising a portfolio which invests in multiple asset classes, building on our three-part decarbonisation guide for asset owners (available upon request), published last year. We use this approach in our own multi-asset decarbonisation strategy.

A portfolio cannot decarbonise in a vacuum

In any decarbonisation investment strategy, it is crucial to distinguish between the portfolio and the planet.

It is easy to simply decarbonise the portfolio; we can do that through divestment. But by doing so, we would a) significantly compromise the investment integrity of the portfolio, which is an unacceptable trade-off, and b) we would have very little – or probably no – impact on real world decarbonisation.

We believe it is necessary to articulate our approach to decarbonisation as a feedback loop between the portfolio and the planet. Figure 1 illustrates this feedback loop.


Figure 1 – Our ability to decarbonise our portfolio depends in large part on the decarbonisation of the investment universe

Source: Schroders Multi-Asset, January 2024


As we pursue decarbonisation of the portfolio, it is necessary to be aware of the universe within which we operate. Maintaining a balanced and effective feedback loop is important for maintaining investment integrity as we augment the portfolio with a decarbonisation objective. Different strategy types within our portfolio can help us achieve this balance in different ways.

Many strategy types, one decarbonisation goal

There are many ways to classify investment strategy types. As we introduced decarbonisation into our investment equation, we felt it helpful to frame a new classification of strategy types.

Our own particular investment philosophy is to be unbiased with respect to underlying strategy type; in our multi-asset decarbonisation strategy we use whichever underlying strategies we need, in whichever proportions we feel appropriate, to deliver on our objectives.

We try and choose the best tool for the right job at any given time. But even for asset owners that are inclined towards certain strategy types over others, the concepts we share below should be useful.


Figure 2 – Decision-makers with responsibility for the whole portfolio should use different strategy types for different purposes


While technically we can manage a portfolio’s emissions directly, doing so fails to recognise that the portfolio operates within an investable universe which is set for us by the world at large. The portfolio’s emission-reduction efforts must be consistent with what the investable universe affords us, or else we risk compromising the investment integrity of the portfolio. That critical threshold, where pursuing an additional unit of emissions reduction finally breaks the portfolio, is what we call the breaking point.

Ex post emissions can be managed directly in the portfolio, but only up to the breaking point. Beyond that, ex post (past events) emissions are not manageable directly, and we must focus on managing ex ante (future events that are based on forecasts or predictions rather than concrete results) inputs to the portfolio, as we have always done.

The chart below (figure 3) shows that emissions can be managed (reduced) directly for a global equity portfolio and global corporate bond portfolio, but only up to a certain breaking point. We need not point out where the breaking points are on this chart!


Figure 3 – Breaking point for the global equity and corporate bond universes


Our Y-axis is a humble measure of point-in-time active risk: the degree to which the portfolio’s weights differ from the emissions-agnostic starting point.

We have done the same exercise with other measures of risk, including conventional tracking error volatility, concentration at security, country and sector level, and factor exposures. The important point is that risk is felt differently by different asset owners, investable universes differ, and so the breaking point is specific to the investor.

Figure 3 shows the scope for ex post management of the portfolio emissions output using ‘lower carbon’ strategies is only possible up to a breaking point. It is also true that a focus on ex post management of emissions does not contribute in any way to a reduction in broader universe (or planet) emissions.

‘Climate action’ strategies, therefore, play a key role in managing the feedback loop between portfolio and planet. Finally, as we recognise that transition can bring attractive investment opportunities, asset owners should consider allocating to ‘climate solutions’ strategies too, including private assets.

Figure 4 illustrates how climate action strategies dominate the capital allocation, but climate solutions strategies contribute the higher proportion of portfolio footprint, especially for the equity portion of the portfolio. This mismatch between the amount of capital allocated to a strategy type vs the share of portfolio emissions that it generates is to be expected, given the types of assets in these strategies.

For example, climate solutions strategies are often invested heavily in infrastructure and energy transition assets which have high current emissions in the portfolio but the potential to reduce emissions in the real-world.


Figure 4 – Climate solutions have a high footprint share, relative to capital deployed


Climate action and climate solutions strategies manage ex ante decarbonisation inputs that are under their control.

For equities, that means prioritising engagement efforts, while for bonds, managers will look to assess and manage use of proceeds, in addition to engaging with issuers. For impact strategies, decarbonisation solutions, and alternative assets, decarbonisation impact can be more direct.

We think these three ‘levers for change’ can be represented in a Venn diagram, shown in Figure 5, with circle sizes representing the proportionate exposure to that part of the Venn diagram. Asset owners should seek to map their holdings to the Venn diagram, and then evaluate those holdings in the context of the Venn diagram.


Figure 5 – Different asset classes have different decarbonisation levers for change associated with them

Source: Schroders Multi-Asset, January 2024


The key takeaway from this is that investors can take different decarbonisation-related actions with different asset classes.

Perhaps more importantly, the use of different strategy types within asset classes can allow the whole portfolio to achieve different things with respect to decarbonisation, and with vastly different potency. No asset class or strategy type is unequivocally better than any of the others; they are just different, and asset owners should use them to the extent that they contribute to the portfolio’s objectives.

Bringing it all together

When decision-makers with responsibility for the whole portfolio look at their portfolio from the top down, they should have access to clear, transparent, and flexible views of the portfolio’s emissions profile.

For example, we have heatmaps which show us our emissions profile across asset classes, broken down by region and sector, which we can drill into for greater levels of granularity. We’ve argued that investors can, should, and will pull many different levers to decarbonise their respective portfolios, but in the end, the asset owner will need to summarise progress into one or two primary variables.

For our own strategy, we have chosen carbon footprint (emissions normalised by enterprise value) for our ultimate ex post decarbonisation metric, but on our daily dashboards we monitor both carbon footprint and carbon intensity (emissions normalised by revenues).

Our decarbonisation tracker in Figure 6 is the chart that holds us accountable for everything that has taken place in our portfolio, at all investment levels. The breaking point – discussed earlier – acts as a floor for the blue and green lines at any given point in time but employing our levers for change will help to lower that floor.

We certainly don’t commit to a consistent rate of change in our footprint or intensity. The recent tick-up reflects an asset allocation decision to increase credit exposure at the end of 2023, which is something we retain the power to do regardless of the short-term decarbonisation impact. We might also decide, if we exhaust the footprint-reduction that our lower carbon strategies can deliver, to increase our allocation to climate action strategies. This may increase our footprint temporarily.

We might decide to pursue, on investment grounds, a climate solutions opportunity, which will almost certainly increase our footprint temporarily. The key point is that we are accountable to a downward trend in our key decarbonisation metric or metrics.


Figure 6 – The portfolio is accountable to a long-term downward trend in footprint

Source: Schroders Multi-Asset Decarbonisation Strategy, January 2024. The chart reflects, for now, only the corporate (equity and corporate bond) portion of our portfolio, which at time of writing amounts to around two-thirds of our assets


In conclusion

Augmenting our multi-asset strategy with an explicit decarbonisation objective did not mean re-inventing it entirely.

We believe asset owners can incorporate their decarbonisation objectives across the whole portfolio by using this pragmatic approach:

  • Recognise that the portfolio cannot decarbonise in a vacuum; rather, it operates in a feedback loop.
  • There are different decarbonisation levers for change across asset classes, and decision-makers should employ different strategy types to do different things.
  • The monitoring framework should be kept simple; only one metric, or maybe two, will matter in the end.
Lesley-Ann Morgan | Global Head | Pensions & Retirement | Schroders | mail me | Ben Popatlal | Strategist | Multi-Asset | Schroders | mail me |

 



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