Zero-Washing: The Risk of Net Zero Investment Portfolios

A key transition risk from climate change is a material global rise in the price of carbon. A carbon price shock at just $75 / ton of CO2e will impact over $20 trillion of Enterprise Value through a greater than 5% decline in their return on capital. [1] Implementing carbon budgets or creating net zero portfolios can help reduce this risk. However, managers need to ensure that they are not “zero-washing”.

Different Paths to Net Zero

Technically, a Net Zero business model means that the carbon emissions produced by any activity must be reduced to zero or offset by carbon absorbing activities. However, simply getting to net zero emissions for a company is not enough to ultimately achieve the emissions mitigation required to limit the global temperature rise to 1.5 degrees Celsius. It is the pathway and business model design that matters. For instance, purchasing offsets to cancel out the emissions that a company has produced will get you to net zero but that doesn’t necessarily reduce absolute emissions in the real economy. Companies must first reduce emissions. Offsets can then be used for hard-to-decarbonize sectors or activities.

The Pembina Institute [2] has published guiding principles to get to a net zero economy. Figure 2 illustrates how net zero pathways impact global emissions differently.

While offsets are a useful and necessary tool, they are not all created equal. The Oxford Offsetting Principles [3] identify 5 types ranging from avoided emissions at the lowest end to offsets that enable carbon removal with long-lived storage at the higher end. [4] Understanding the type of offset being used in a net zero strategy is key to determining if the approach is actually reducing emissions.

It is also important to understand the underlying carbon metrics from companies. Since there are significant financial incentives tied to making a net zero commitment and no industry standard as to what that actually means, “carbonwashing” [5] can be prevalent amongst companies.

Net Zero Investment Portfolios and the Risks of Zero-Washing

Calculating a weighted average carbon intensity (WACI) or carbon footprint of a portfolio and managing this within set limits may mitigate carbon risk. However, this may not reduce absolute emissions, which should be the underlying goal of a “true net zero” investment strategy.

Strategies that may not reduce absolute emissions:

Short selling. While this may reduce exposures to high carbon business models of investee companies, it does not actually remove CO2 emissions.

Divestment. This will reduce exposure to carbon risk in the portfolio but will not necessarily encourage decarbonization. Additionally, since most companies only report on their scope 1 and 2 emissions, you may still end up with a high carbon portfolio if you included scope. [3]

Carbon offsets. These can be used to get to a net zero portfolio. However, the offsets need to certified and should fall into the carbon removal category[6] .

Strategies that can reduce absolute emissions:

Security selection. Understanding the carbon exposure, business model design and net zero strategy of a firm will ensure the portfolio aligns to those companies that are implementing a true net zero strategy. [7]

Strategic engagement. Engaging and supporting investee companies that need to drastically transform their business models [8] can help to reduce global emissions.

Classification methodology for climate change assessments of securities

Climate change assessments are inherently complex. Before creating a net zero portfolio, managers can classify securities based on how they have been assessed for climate change risk. This can help identify the level of potential climate change risk in a portfolio. [9]

Conclusion

While net zero portfolios can be an effective way to mitigate carbon risk, it is imperative that investment managers understand the underlying path and strategy to get to net zero to truly reduce absolute emissions and avoid zero-washing.