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Executive Summary
“Reconciling Portfolio Diversification with a Shrinking Carbon Footprint” presents a comprehensive analysis of net-zero-aligned portfolios (NZPs) and their implications for institutional investors aiming to mitigate carbon transition risk while maintaining effective diversification. This paper emphasizes the need for balancing environmental objectives with portfolio stability, focusing on a methodology that ensures alignment with market benchmarks.
What Are Net-Zero-Aligned Portfolios?
NZPs are investment portfolios that aim to reduce their carbon footprint over time, in line with the prescribed, science-based Intergovernmental Panel on Climate Change (IPCC) decarbonization pathway for the global economy. This alignment serves as a hedge against potential regulatory shifts targeting emission reductions.
The authors argue that NZPs are increasingly attractive to institutional investors because they can offer diversification benefits comparable to traditional portfolios while mitigating exposure to high-carbon assets. Constructing an NZP, however, presents the challenge of maintaining diversification and achieving a low tracking error relative to market indexes.
Decarbonization and Diversification Strategies
Creating an NZP involves gradually decarbonizing a portfolio along a science-backed trajectory while minimizing deviations from sector norms. The authors highlight that a market-wide transition toward net-zero emissions would enable investors to diversify without sacrificing returns or facing unexpected regulatory shocks. The gradual rebalancing method within NZPs helps achieve sector neutrality, maintaining a balance between carbon transition risk and diversification.
A well-balanced NZP also protects investors from asset stranding. This is particularly relevant for such sectors as the automobile industry, where future policy interventions may disrupt asset values even if they do not strand assets immediately. By limiting high-carbon asset exposure, NZPs allow investors to align with the global transition toward decarbonization.
Methodology for Constructing NZPs
The authors outline the core methodology for NZP construction: choosing both a dynamic carbon budget and a selection process based on firm-level emissions. This strategy relies on emission data, including both direct and indirect emissions (Scope 1, 2, and 3), ensuring an accurate reflection of carbon exposure. The portfolio is rebalanced periodically to adhere to a decarbonization pathway compatible with IPCC targets.
The NZP approach only gradually reduces the weight of brown companies over time to be on a net-zero trajectory and includes low-carbon emitters in each sector. This allows for a portfolio construction that can be close to sector neutral relative to the market benchmark by shifting portfolio weights over time toward the companies in the sector with lower emissions. This limits tracking error and could, in effect, create competition among corporations in each sector to reduce carbon emissions, so they do not lose their position in decarbonizing portfolios.
The authors applied the IPCC’s 2021 pathway to achieve a 1.5°C scenario by 2050, reducing carbon emissions by 30% annually. This maps into a 30% annual reduction rate for the portfolio carbon footprint, or an initial 70% haircut in 2024 followed by a 7% annual rate of decline until 2050. The authors point out that if decarbonization were to be postponed by one year, then this 30% per year rate would increase to 50% per year the following year.
Case Study: PenSam’s Net-Zero Approach
PenSam, a Danish pension fund, serves as a case study to demonstrate the NZP model’s practical application at scale. A robust way of keeping diversification risk low is to have sector weights that are close to those in the real economy. PenSam committed to the Paris Aligned Investment Initiative with a target of a 55% emissions reduction by 2025 relative to 2019.
From 2020 to the beginning of 2024, PenSam had used the MSCI ACWI Climate Change benchmark. The benchmark’s reweighting scheme resulted in significant sector concentration, especially toward the highly volatile information technology sector, as well as too much concentration in individual companies in that sector. The sector overweighting and the resulting tracking error relative to the broad market index (MSCI ACWI) had increased significantly since implementation in 2020.
To mitigate these issues, PenSam shifted to the S&P Global Carbon Budget Climate Index, which offers balanced sectoral exposures and adheres to carbon budget targets. The S&P index incorporates strict sectoral weight restrictions that align with PenSam’s desire to avoid significant deviations from the market index.
Global Context and Implications for Investors
The NZP model aligns with the growing momentum behind global net-zero commitments, with more than 130 countries pledging carbon neutrality by midcentury. Despite these commitments, greenhouse gas emissions have yet to decline. The authors emphasize the implications for investors—particularly passive investors holding diversified market indexes—who face increased regulatory and technological risks from brown assets.
NZPs offer a strategic advantage by allowing investors to hedge against these risks, aligning their portfolios with anticipated policy changes. The authors emphasize that delayed decarbonization increases transition risks, making proactive NZP adoption essential for risk-averse investors.
Key Takeaways
NZPs present a viable approach for institutional investors to decarbonize without compromising diversification. NZPs enable investors to mitigate carbon transition risks effectively by following science-based decarbonization pathways while preserving sectoral exposure. By actively excluding high-carbon assets and rewarding companies that commit to decarbonization, NZPs contribute to the broader transition toward a low-carbon economy.
The authors emphasize that NZPs are not a standalone solution to the climate crisis. Real impact requires substantive changes in company operations and widespread decarbonization of the economy. However, NZPs reduce barriers for investors to support the green transition, providing a pragmatic model for future investment strategies.
Authors
Patrick Bolton
Professor of Finance, Columbia University, New York City, and Imperial College, London
Marcin Kacperczyk
Professor of Finance, Imperial College, London
Henrik Lorin Rasmussen
Chief Portfolio Manager, PenSam, Farum, Denmark
Frédéric Samama
Adjunct Professor of International and Public Affairs, Sciences Po, Paris, and Columbia University, New York City