The challenge of Paris Aligning an investment fund

What is the Paris Agreement?

The Paris Agreement is an international treaty on climate change, which was signed in December 2015. The treaty was the first public acknowledgment that the temperature increases witnessed over the past decades are a result of accumulated carbon emissions, stemming from human activity.

All signatories of the Paris Agreement commit to:

• Keeping the increase in global average temperature to well below 2°C above pre-industrial levels
• Aiming to limit the increase to 1.5°C, as this would reduce the risks and impacts of climate change
• Ensuring global emissions peak as soon as possible
• Reducing emissions thereafter in accordance with the best available science

Signatories must also submit national climate action plans, explaining how they will reduce emissions and contribute towards the goals of the agreement. Every five years, progress is reviewed and these plans are updated.

What does it mean for a fund to be Paris Aligned?

Climate issues can have a material effect on company financials. For example, from physical risks, increased regulation or public backlash. This is why investors are increasingly considering climate issues in their investment decisions. Certain investment funds have taken this one step further by attempting to align their portfolios with the goals of the Paris Agreement. 

There are several ways to do this. One option is to adopt a portfolio-level framework. Fund managers must measure portfolio-wide emissions and track their progress over time, usually adhering to predetermined annual reductions. For example, the EU Paris Aligned Benchmarks require a 7% annual reduction in emissions intensity. 

Alternatively, fund managers can take a company-specific approach. This involves choosing individual companies for the contributions they make towards the Paris Agreement. For example, they may provide solutions for reducing emissions through their products and services, or they may have implemented strict targets for decarbonising their operations.

The challenges with portfolio-level approaches to Paris Alignment

Portfolio-level frameworks can pose a number of challenges for investors, which may ultimately thwart progress towards the goals of the Paris Agreement. In particular, the strict requirements for annual emissions reductions could lead to investors focusing more on the criteria than on the real-world impact from investee companies. After all, simply reducing portfolio emissions doesn’t necessarily help to lower emissions in the wider world.

For example, most companies looking to cut emissions will not experience a consistent, linear reduction year in and year out. Instead, there will be jumps as the company makes changes, such as switching to renewable energy or rolling out a new, more efficient process. If the timing is wrong, the company could be cut from the portfolio before its good work comes into effect.

Furthermore, a small number of companies may generate the majority of portfolio emissions, especially if they operate in an emissions-intensive industry such as manufacturing. The fund manager may be tempted to simply reduce their stake in these companies, improving the portfolio emissions data but making no real-world impact. Similarly, they could simply swap these holdings for low-emitting companies, such as software firms.

Our approach

We believe taking a company-specific approach to portfolio construction is the most effective way to contribute towards the goals of the Paris Agreement. When choosing companies, we consider their emissions, the steps they are taking to reduce these, and the solutions they may offer to help others reduce emissions. This information helps us to determine how a company is contributing towards the goals of the Paris Agreement, how to best engage with them, and also how they might benefit from the decarbonisation trend that we expect to persist for decades.

As active investors, we engage with companies to drive progress. For example, we encourage all companies to adopt Science Based Targets (SBTs) for emission reductions. These are targets which align with what the latest science deems necessary to meet the goals of the Paris Agreement. In other words, they show that a company is committed to the Paris Agreement. 

We may also encourage companies to improve disclosure of their environmental impact, or align their executive remuneration with climate metrics. And we will review their progress over time to check that they are on track, or to address any issues.

By taking this approach, we believe that investors can help in the global effort to reduce emissions and limit global warming, ultimately contributing towards the goals of the Paris Agreement.