Aligning Investments with the Paris Agreement

Institutional investors are increasingly focused on aligning their portfolios with net-zero emission targets to address climate change. This study, coauthored by researchers from BNP Paribas Asset Management, compares two primary strategies for aligning investment portfolios with net-zero pathways: the Net Zero Achieving, Aligned, Aligning (NZ:AAA) screens and the Paris Aligned Benchmark (PAB) rules framework. It offers practical guidance for investors and practitioners on building equity portfolios that adhere to the NZ:AAA and PAB requirements, examining their effect on portfolio diversification, expected risk, and success in driving down companies’ carbon emissions.

Key Frameworks: PAB vs. NZ:AAA

The NZ:AAA and PAB frameworks approach net-zero investing differently. Each approach has distinct characteristics, benefits, and drawbacks. The study highlights the strengths and limitations of both frameworks and presents an analysis to help investors understand which strategy best suits their objectives for achieving net-zero commitments.

The NZ:AAA framework is based on the forward-looking approach recommended by the Institutional Investors Group on Climate Change in its proposed Paris Aligned Investment Initiative. It prioritizes investing in companies already achieving net zero, companies with credible net-zero commitments based on forward-looking assessments, or companies contributing to climate solutions even if they are high emitters today. It also prioritizes engaging with high-emitting companies rather than immediately excluding them, allowing investors to encourage these companies to reduce their emissions over time. This approach supports companies in their transition, making it a more flexible option for those willing to work with high emitters to achieve net-zero goals.

The PAB framework, in comparison, is a European Commission–regulated approach that emphasizes reducing carbon intensity by excluding carbon-intensive companies. It is used in passive investment strategies or for benchmarks in active management. In contrast to the NZ:AAA framework, the PAB framework’s focus is on immediate carbon reduction rather than a forward-looking assessment of a company’s decarbonization plans. It offers a straightforward, rule-based approach to reducing carbon exposure but lacks an efficient mechanism for engaging with companies that are still on their decarbonization journey and fails to consider that some companies will require more effort to achieve net zero than others.

Both frameworks can support well-diversified portfolios with low tracking error compared to market-cap-weighted indexes, demonstrating that investors can align their portfolios with net-zero targets without compromising their fiduciary responsibilities. The choice between these approaches should be guided by an investor’s specific objectives, risk tolerance, and commitment to driving long-term climate impact.

Strategic Actions for Net-Zero Investing

Investors have three main strategies for aligning their portfolios with net-zero goals:

• Reallocation of capital: Investors can lower their carbon exposure by shifting investments from carbon-intensive companies to those with lower emissions or leaders in decarbonization.
• Engagement and stewardship: Investors can directly engage with companies, using their voting rights and influence to encourage companies that are behind on decarbonization to improve.
• Investing in climate solutions: Investors can focus on companies that provide products and services that support the energy transition, contributing to the decarbonization of the wider economy.

The Frameworks’ Practical Applications

Using the NZ:AAA framework, investors

• focus on companies with credible net-zero targets,
• invest in companies contributing to climate solutions,
• prioritize companies with potential for successful engagement, and
• support a balanced transition and drive systemic corporate behavior change.

Using the PAB framework, investors

• focus on shifting capital away from the most carbon-intensive companies,
• have a straightforward method for both immediate and future carbon reduction,
• have access to a broader range of investment opportunities, and
• rely on historical carbon intensities lacking forward-looking dimensions.

Key Takeaways

Both strategies have merits, but they serve different investor needs. The PAB rules provide a clear pathway for reducing carbon intensity within portfolios, but their backward-looking nature and exclusionary approach may limit their effectiveness in contributing to broader decarbonization efforts. The NZ:AAA framework, with its focus on forward-looking commitments, engagement, and climate solutions, offers a more holistic and impactful route to achieving net-zero alignment. This approach is better suited for investors seeking to prioritize reducing the carbon emissions of companies and align with climate goals. Investors must choose a framework that aligns with their specific objectives, risk tolerance, and commitment to climate stewardship. Understanding the nuances of each strategy will enable institutional investors to make informed decisions as they navigate the complex landscape of net-zero investing.

The Study’s Authors

Raul Leote de Carvalho, Deputy Head of the Quant Research Group, BNP Paribas Asset Management, Nanterre, France

Jane Ambachtsheer, Honorary Research Associate, Smith School of Enterprise and the Environment, University of Oxford, and Global Head of Sustainability, BNP Paribas Asset Management, Toronto

Alexander Bernhardt, Global Head of Sustainability Research, BNP Paribas Asset Management, Boston

Thibaud Clisson, Climate Change Lead, Sustainability Centre, BNP Paribas Asset Management, Nanterre, France

Henry Morgan, ESG Quant Analyst, Sustainability Centre, BNP Paribas Asset Management, Nanterre, France

Guillaume Kovarcik, Quant Analyst, Quant Research Group, BNP Paribas Asset Management, Nanterre, France

Francois Soupe, Co-Head of the Quant Research Group, BNP Paribas Asset Management, Nanterre, France