This paper outlines a comprehensive approach to integrating sustainability into portfolio optimization, with a particular focus on achieving net-zero emissions by 2050. The authors compare various methods for integrating sustainability goals in investor portfolios and highlight the implications of such approaches for investor outcomes to help investors navigate the tradeoffs between sustainability, risk, and return. By balancing their financial returns with their sustainability goals, investors can play a crucial role in the global effort to combat climate change, while maintaining their portfolios’ performance.

Coauthored by Robeco’s Clint Howard and Mike Chen, “3D Investing: Implications for Net Zero” emphasizes the value of innovative frameworks such as 3D investing in addressing the challenges of net-zero portfolio construction. By incorporating forward-looking climate metrics and emission pathways into a multi-objective portfolio optimization framework, 3D investing delivers to investors greater efficacy in integrating their sustainability goals in their portfolios.

Investors must weigh the urgency of decarbonizing their portfolios against the need to maintain their portfolios’ performance and risk profile. This requires a multi-faceted approach to optimization, where financial and nonfinancial goals are considered side by side, incorporating a forward-looking net-zero metric into the portfolio’s expected returns and stock risks along with their contribution to future emissions reductions.

The paper highlights the need to evolve traditional portfolio optimization models to incorporate nonfinancial objectives, such as sustainability. Metrics such as carbon footprints; environmental, social, and governance factors; and sustainable development goals are also growing in importance in investment decision making. The challenge is to align these goals through an appropriate multi-objective optimization framework that balances decarbonization efforts with returns and risk management.

Among the paper’s key findings is that the most effective way to integrate sustainability into portfolio management is by using an objective function—incorporating a forward-looking net-zero metric into the objective function and encouraging the portfolio optimizer to take exposure to stocks based on expected returns, risk, and forward-looking net-zero expectations. For portfolios with ambitious sustainability goals, using an objective function in portfolio construction, rather than simple constraints, yields superior results because the flexibility provided by the objective function allows for a dynamic tradeoff between a stock's expected return and its contribution to sustainability goals. This enables better alignment of the portfolio with net-zero targets.

The frameworks for aligning portfolios with the Paris Agreement’s 1.5°C carbon budget demonstrate the importance of tracking a portfolio’s carbon budget over time while maintaining minimal tracking error relative to the market index. This paper emphasizes the distinction between decarbonizing portfolios and aligning them with Paris Aligned Benchmarks and net-zero objectives.

How to balance the long-term objective of reaching net-zero emissions by 2050 with the short- and medium-term goals of balancing financial risk and return is a core issue the authors tackle. Compliance with the Paris Aligned Benchmarks requires a 50% reduction in carbon intensity relative to the market benchmark, a 7% year-on-year decarbonization, and adherence to several exclusions and constraints. Meeting such targets can be achieved through a combination of portfolio constraints and objective function terms.

Satisfying Investor Demand

The integration of environmental objectives into investment decisions has been a subject of extensive study, with much research showing that investors are increasingly deriving nonfinancial utility from investments in impact funds, demonstrating a willingness to sacrifice financial returns in pursuit of sustainability goals. Various methods have been proposed to incorporate sustainability into portfolios, such as excluding undesirable stocks, constraining portfolio exposures, or incorporating sustainability targets into the return/alpha component of the objective function.

One of the key tensions in net-zero portfolio construction is the balance between the urgency of decarbonizing and the need to meet financial risk and return objectives. Each portfolio construction method has its advantages and disadvantages in addressing this tension. For instance, divesting from companies with high carbon emissions may improve a portfolio’s carbon profile, but it could also lead to missed opportunities in companies that are instrumental in developing transition technologies. Similarly, excluding too many stocks could introduce additional risk to the portfolio, making it harder to maintain within a given risk budget. Therefore, investors must carefully balance these different dimensions to optimize their portfolios effectively.

In summation, innovative frameworks such as 3D investing offer investors the flexibility to adjust to evolving climate goals while maintaining financial performance, allowing for dynamic exposure to climate leaders and laggards based on their return expectations and sustainability profiles.

As investors face increasing pressure to align their portfolios with the net-zero transition, frameworks such as 3D investing will become essential tools for meeting both financial and climate-related objectives.

The Paper’s Authors

Clint Howard, Quantitative Researcher, Robeco, Rotterdam, the Netherlands

Mike Chen, Head of Next Gen Research, Robeco, Rotterdam, the Netherlands