Sustainable Investing
Paris-aligned investing: Active or passive?
7 min read 5 Aug 24
The algorithmic nature of passive funds’ investment processes can create the risk of over-simplification and short-termism when tackling the long-term challenge of climate change. We think that an active approach is not only more effective, but essential for investors aiming to make real contributions towards achieving the goals of the Paris Agreement.
Passive vehicles tend to follow a portfolio-level approach to alignment to the Paris Agreement. This typically includes a pre-determined annual decrease to portfolio greenhouse gas (GHG) emission metrics, such as the 7% reduction called for by the EU’s Paris-aligned benchmarks1. This is achieved by making portfolio allocation decisions based on companies’ carbon intensity.
However, a sustainable fund running a portfolio-level carbon intensity framework could simply hold a selection of low-emitters, such as software companies. Similarly, GHG emission reductions could be achieved by simply trimming positions in the highest emitters. While a passive approach managed in this way would meet its sustainability objectives on paper, its contribution towards the real-world GHG emission reductions needed to address climate change could be questioned.
It is worth noting that decarbonisation isn’t a linear process. Companies can experience volatility in GHG emissions over shorter time periods, caused by revenue mix shifts, supply chain issues, or unexpected external events. Furthermore, when companies invest capital to aid their decarbonisation efforts, the results are not usually instantaneous and may not be seen for several years. If GHG emissions rise from one year to the next, the company may be removed from a passive vehicle before its investment has come to fruition.
“Decarbonisation isn’t linear. Companies can experience volatility in GHG emissions over shorter time periods, caused by revenue mix shifts, supply chain issues, or unexpected external events.”
Carbon intensity and the risk of capital misallocation
A common method used by passive funds to assess alignment with the Paris Agreement is to compare a company’s emissions with its total value. This is typically calculated by dividing the company’s total emissions by its Enterprise Value Including Cash or EVIC (the sum of the company’s market capitalisation, total debt and cash/cash equivalents).
Measuring carbon intensity in this way can create issues for investors, as any share price fluctuations will affect the denominator, skewing the carbon intensity figure without any change in absolute GHG emissions. A company’s inclusion in the portfolio could therefore be influenced by its market value, rather than its decarbonisation efforts.
As an example, a large technology company’s value could increase significantly due to improved sentiment around artificial intelligence, despite no change in its carbon footprint. Using the EVIC method, this would cause a corresponding decrease in carbon intensity. The company would not necessarily have become a more sustainable business, but investors working to a carbon budget may increase their position size on the back of a more attractive carbon intensity, simply as a result of a rising market capitalisation. At a large scale, this arguably increases the risk of capital misallocation.
A missed opportunity to deliver additionality
We believe that an effective method for investors to encourage decarbonisation progress is to work closely with investees, on topics such as setting targets and developing a strategy. The managers of passive funds do not necessarily take advantage of their stewardship privileges in this way, effectively missing out on the opportunity to encourage positive change and deliver investor additionality.
In our view, these characteristics result in a short-term approach to portfolio management, contrary to the fact that alignment to the Paris Agreement is a long-term endeavour. According to the IPCC, global emissions must fall 43% by 2030 (versus a 2019 baseline year), and reach net zero by 20502. With this long time horizon, it is not enough to simply reduce GHG emissions in the short term. We believe that to be truly aligned with the goals of the Paris Agreement, companies – and investors – must be willing and able to put in the work over several decades.
Focus on real-world outcomes
We believe that a portfolio’s alignment to the Paris Agreement cannot be measured solely by carbon intensity or other pre-determined metrics. Instead, investors must consider their real-world contributions towards the absolute GHG emission reductions needed to limit climate change.
Typically, within M&G Investments’s Paris-aligned strategies, our holdings will contribute towards the Paris Agreement by decarbonising their own business, and in some cases, also providing climate solutions for their customers to do so. The latter, in some cases, would be excluded from passive portfolios due to high emissions, despite playing an important role in decarbonisation.
Case study: Weir Group
We can consider some of the drawbacks of passive Paris-aligned investing – and the requirements of an active approach – by considering Weir Group.
As a producer of mining equipment, Weir Group is not an obvious sustainability business. The company is unlikely to be screened into a passive Paris-aligned portfolio, due to its significant GHG emissions. The company has a conservative approach to GHG emissions disclosure. Its reported Scope 3 GHG emissions (those arising from its value chain) include a comprehensive inventory of all its customers’ GHG emissions. However, the company demonstrates a strong commitment to decarbonisation, having set a science-based target for GHG emission reductions, and developed a sustainability strategy that covers both its own GHG emissions and those of its customers.
Indeed, Weir Group’s products help its customers to avoid a large amount of GHG emissions. Mining is a hugely energy-intensive process, and Weir focuses on developing efficient machinery to reduce energy usage (and the associated GHG emissions).
For example, Weir’s Enduron® High Pressure Grinding Rolls use up to 40% less energy than traditional grinding circuits, and do not require the use of grinding media. Together, this saves up to 200,000 tonnes of CO₂ each year across the company’s installed base. Weir’s Nemisys® N90 tooth system also delivers a 44% reduction of embodied CO₂ due to its improved wear life, meaning fewer replacement parts and more efficient performance.
We have engaged with Weir Group many times over the past few years. In 2020 and 2021 we held several meetings with Weir’s chair and head of sustainability, to understand how Weir can align itself to a net-zero carbon economy, and to promote technological innovation in its supply chain and the adoption of sustainable products by its customers. Given its significant Scope 3 footprint, we supported management’s thorough and careful approach to mapping out a structured pathway to net zero. We have also engaged with the board to ensure that Weir’s ambitious ESG targets are reflected in its remuneration framework, which is now the case.
Source: Weir Group Annual Report 2023, and M&G research.
Assessing alignment requires deep analysis
Assessing alignment to the Paris Agreement requires deep, holistic analysis in areas such as governance, strategy and target-setting, alongside ongoing monitoring of progress. While passive approaches can screen for criteria such as GHG emission disclosures and targets, they cannot comprehensively assess topics concerning company intentionality, such as decarbonisation strategy and the presence of sustainability links within executive remuneration. Considering the long-term nature of the decarbonisation challenge, we believe these are vital components of a company’s alignment.
Within M&G’s Global and European Paris-aligned strategies, our team of embedded analysts produces carbon reports for investee companies. These feature analysis in areas such as the company’s carbon footprint and handprint, GHG emission reduction targets, company intentionality and accountability, recent progress and areas for continued engagement.
Every year, we also conduct ‘traffic light’ analysis of investee companies, which is published in a fund annual emissions report. This involves rating companies’ progress (on a long-term and year-over-year basis) across a range of areas, such as:
- The breadth of GHG emissions disclosures
- Credibility of emission reduction targets
- Decarbonisation strategy and governance
- Any changes or improvements in climate solutions offered
- Whether the company is on track, versus a Paris-aligned decarbonisation pathway
Engagement is essential
We believe that regular company engagement must form an integral part of any investment process claiming to align with the Paris Agreement. This would be difficult to do meaningfully with a broad portfolio of hundreds of companies. However, with a more concentrated portfolio, engagements can be tailored to individual companies, targeting the greatest impact regardless of how far they are along their decarbonisation journeys.
Engagement is an essential part of our process within M&G’s Global and European Paris-aligned strategies, and goes hand-in-hand with our long-term approach. We aim for a holding period of around a decade, meaning that we can work closely with investees to encourage and support their climate efforts over time.
Topics for engagement may include encouraging investees to provide comprehensive GHG emissions disclosures, setting science-based targets for emission reductions, creating a decarbonisation strategy, linking executive remuneration to milestones within this strategy, and monitoring ongoing progress.
Growing investor interest in tackling climate change is undoubtedly a positive trend. However, we believe that the popularity of passive investment vehicles could create less than ideal outcomes, as they are arguably less effective at contributing toward the goals of the Paris Agreement, leading to an inability to address real-world change. Instead, we believe Paris alignment requires a holistic, company-specific approach that is rooted in deep research, focused on real-world outcomes and comprising regular investee engagement.
The information provided should not be considered a recommendation to purchase or sell any particular security.
1 European Commission, ‘Commission Delegated Regulation (EU) 2020/1818 of 17.7.2020’, July 2020.
2 Intergovernmental Panel on Climate Change, ‘The evidence is clear: the time for action is now. We can halve emissions by 2030.’, (ipcc.ch), April 2022.
Find out more about M&G's Sustain Paris Aligned strategies
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.