Introduction: the net zero imperative for financial institutions
The pursuit of net zero investment is not a simple extension of traditional investment practices; it represents a new investment paradigm. Climate change presents a systemic risk to financial markets, making climate risk the top priority for asset owners and managers overseeing trillions in assets. This has led to global commitments, such as those made by the Net Zero Asset Owner Alliance (NZAOA) and Net Zero Asset Managers Initiative (NZAM), to align portfolios with net zero emissions by 2050.
To succeed, investors must move beyond static carbon footprint assessments and adopt a forward-looking, integrated strategy that anticipates transition risks and identifies competitive opportunities in a rapidly changing, low-carbon world. Fundamentally, a genuine net zero investment policy must address two complementary goals: deep portfolio decarbonization and actively financing the transition to a low-carbon economy.
Measuring the carbon emissions of an investment portfolio
To implement effective net zero investment strategies, financial institutions must first accurately measure the carbon emissions embedded within their holdings.
Understanding financed emissions
Corporate emissions are traditionally categorized using the Greenhouse Gas (GHG) Protocol:
- Scope 1: direct GHG emissions from sources owned or controlled by the company.
- Scope 2: indirect emissions from the consumption of purchased electricity, heat, or steam.
- Scope 3: all other indirect emissions across the value chain.
For financial institutions, most of their carbon footprint (often over 95%) comes from financed emissions. These are classified as Scope 3, Category 15 under the GHG Protocol and represent the proportion of emissions attributable to the investment portfolio. Although measuring Scope 3 emissions is crucial for achieving net zero investment alignment, concerns remain regarding the lack of reliability and transparency of the underlying data.
Key portfolio carbon metrics
Portfolio emissions are typically measured using relative, static metrics:
Carbon Intensity (CI): calculated as a company’s carbon emissions normalized by an output indicator, commonly revenue, sales, or market value. This metric is widely used because its distribution is generally less skewed, making it more comparable between issuers.
Weighted Average Carbon Intensity (WACI): the standard metric for aggregating carbon intensity at the portfolio level, widely used for portfolio decarbonization tracking.
Carbon Footprint: emissions normalized by enterprise value.
However, reliance solely on Carbon Intensity presents methodological drawbacks. Specifically, intensity measures are not always additive, and they can be susceptible to manipulation—for example, carbon intensity can improve due to M&A activity without reducing absolute global emissions. For robust goal setting based on physical climate limits, working with absolute carbon emissions is often considered more consistent, especially when implementing a carbon budget approach.
Portfolio decarbonization: the transition vs. the illusion
Defining net zero investment
Net zero investment aligns the portfolio with the goal of limiting global warming to 1.5°C above pre-industrial levels. Net Zero itself refers to the planetary state where anthropogenic GHG emissions are balanced by removals (sequestration). An investor or company can only claim to contribute to this global trajectory.
The flaw of simple portfolio decarbonization (divestment)
For many investors, the initial impulse toward portfolio decarbonization involves excluding or divesting from high-carbon issuers, particularly in the Energy, Materials, and Utilities sectors. This action, while reducing the portfolio’s reported footprint, often achieves little-to-no real-world impact on global emissions.
Divestment merely transfers ownership of polluting assets, risking significant capital shortfalls for the heavy-emitting sectors that desperately need financing to transform their processes. If net zero investment is reduced purely to a portfolio decarbonization exercise, the main risk is that the investment universe becomes too small, potentially causing difficulties for the asset management industry.
The true net zero approach: funding reduction
The complexity inherent in achieving net zero alignment means it cannot be reduced to a portfolio decarbonization exercise. The core objective of a net zero investment policy is to transform the high-carbon economy, meaning investors must shift their focus from reducing financed emissions to actively financing emission reduction in the real economy.
This necessitates articulation of the approach as a “feedback loop between the portfolio and the planet” to maintain investment integrity while maximizing impact. Portfolio decarbonization must therefore be coupled with meaningful engagement and transition finance to drive real-world emissions reductions.
Building a true net zero portfolio: strategy and implementation
A robust net zero investment strategy requires incorporating both a decarbonization dimension and a transition dimension. This can be implemented either through a single integrated approach or a segregated core-satellite strategy.
Strategic pillars for net zero investment
- Allocation to climate solutions and transition assets
This involves direct investments in companies that enable deep decarbonization, such as those focused on green hydrogen, battery storage, and renewables. This active funding of low-carbon products and services is crucial to the transition dimension of portfolio decarbonization.
- Engagement and active ownership
Prioritizing engagement over exclusion is key to accelerating portfolio decarbonization of existing high-emitting portfolio companies. A strong engagement strategy, including defining climate demands and escalation steps, is a crucial component of driving real-world impact in net zero investment.
- Residual neutralization
The Net Zero Standard from the Science Based Targets initiative (SBTi) mandates that, after achieving 90-95% deep reduction, remaining residual emissions (5-10%) must be balanced by permanent removal or sequestration measures.
Dynamic Metrics for Transition and Alignment
Effective net zero investment requires dynamic and forward-looking measures to assess progress, going beyond static carbon footprints. These metrics are essential for understanding whether portfolio decarbonization is genuinely contributing to the transition.
Temperature Rise (ITR) / Temperature scores
These metrics translate corporate GHG reduction targets into temperature scores (e.g., 1.5°C or 2°C alignment). They serve as a synthetic scoring system, often based on the PAC framework (Participation, Ambition, Credibility).
Carbon Momentum (CM)
This is a dynamic measure assessing the historical trajectory of an issuer’s absolute or intensity-based emissions—their past self-decarbonization. Carbon Momentum is a critical metric because a portfolio can only truly be labeled as pursuing net zero investment if part of its portfolio decarbonization pathway is endogenous, explained by the self-decarbonization of the holdings, not just by continuous portfolio rebalancing (sequential decarbonization).
Green Revenue Share (GRS)
Represents the portion of a company’s revenue derived from activities defined as “green” according to established taxonomies. GRS serves as the primary measure of green intensity and is essential for quantifying the transition dimension of net zero investment.
Avoided Emissions (“Climate Dividends”)
Used for measuring the impact of investments in climate solutions. These are emissions prevented by a product or service compared to a business-as-usual scenario. When reporting emissions avoided by investee companies, this is referred to as “Financed Avoided Emissions” or “Climate Dividends.”
Modeling forward-looking carbon emission pathways
The construction of forward-looking carbon emission paths is a crucial element of net zero investment. Unlike traditional backward-looking assessments, these dynamic methodologies aim to anticipate future emissions and measure alignment relative to climate goals.
Extrapolation of historical trends
This approach projects an issuer’s future trajectory by relying on its past performance—the concept of self-decarbonization.
Carbon trend modeling: the future carbon trajectory is typically built by extrapolating the issuer’s historical emissions track record, commonly using a linear constant trend model due to its simplicity and tractability.
Carbon Momentum: derived from the linear trend model, this metric measures the issuer’s historical effort toward portfolio decarbonization. Long-Term Carbon Momentum is defined as the ratio between the slope coefficient of the trend model and current carbon emissions, while Carbon Velocity measures the normalized change in the trend slope over a recent short period.
Scenario-based budgeting and target setting
This method builds future paths by comparing the issuer’s self-declared intentions against globally recognized scientific scenarios for net zero investment.
Reference scenarios: the methodology is based on a scenario-based budgeting approach where the pathway projected from the emissions track record is explicitly compared to the expected pathway from a Net Zero Emissions (NZE) scenario. Examples include IEA sector-specific CO2 emission pathways.
Key metrics derived:
- NZE Gap: the expected distance between estimated carbon emissions and the NZE scenario at a future date.
- NZE Budget: the carbon budget remaining between a start date and a target date, computed relative to the NZE scenario.
Dynamic alignment scenarios
These measures quantify the dynamics required by the issuer’s trajectory relative to net zero investment alignment:
Zero-velocity scenario: quantifies the issuer’s leeway in the short term, projecting a trajectory where carbon velocity is zero.
Burn-out scenario:a stress scenario calculating the carbon emissions reduction required in the next year to satisfy the NZE scenario on average.
Transition planning and economic viability
Reduction Capacity Assessment Framework (RCAC): assesses a company’s ability to reduce emissions by determining how much abatement is economically viable using proven technologies under different carbon pricing scenarios. This approach focuses on mapping the actionable route to portfolio decarbonization.
Emissions avoided for climate solutions: for companies providing climate solutions, the forward-looking path relies on comparing emissions over the solution’s lifespan to a baseline scenario, dynamically accounting for factors like projected energy mix decarbonization.
Practical challenges and essential tools
Implementing a comprehensive net zero investment strategy faces complex regulatory, data, and financial hurdles.
Challenges to implementation
- Data quality and scope
Reliable data, particularly for downstream Scope 3 emissions, is often insufficient, forcing asset managers to rely on estimations and proxy data. The inclusion of Scope 3 emissions, though mandatory for comprehensive portfolio decarbonization, significantly increases the risk of replication error and calculation complexity.
- Methodological heterogeneity (greenwashing risk)
A lack of consensus on definitions and metrics creates a risk of unintentional greenwashing in net zero investment claims. When multiple constraints are simultaneously imposed on an optimization problem, the existence of a viable portfolio solution is not guaranteed, as these metrics can be negatively correlated in the short term.
- Financial trade-offs
Pursuing deep portfolio decarbonization and alignment objectives introduces significant non-financial costs:
- Higher tracking error: net zero investment portfolios diverge substantially from business-as-usual benchmarks, implying high active management costs
- Reduced diversification: portfolio decarbonization tends to systematically favor Financial issuers while underweighting Energy, Materials, and Utilities, resulting in significant sector allocation effects and concentration risk
Essential frameworks and tools
Asset managers rely on several global frameworks to standardize their approach to net zero investment:
GHG protocol and PCAF: the foundation for quantifying and reporting greenhouse gas emissions. The PCAF methodology provides a standardized approach for measuring and disclosing financed emissions.
SBTi and Net zero standards: the Science Based Targets initiative provides a global standard for setting rigorous, science-aligned emission reduction targets. The upcoming SBTi Financial Institutions Net Zero (FINZ) Standard aims to provide measurable and quantifiable engagement objectives for portfolio decarbonization.
PAC framework: evaluates three key pillars for individual issuer performance—Participation (historical efforts/carbon trend), Ambition (target alignment with NZE scenarios), and Credibility (plausibility of targets relative to past efforts).
NZIF (Net Zero Investment Framework): a widely utilized framework by the IIGCC (Institutional Investors Group on Climate Change) to screen assets, set targets, and structure engagement strategies for net zero investment.
RCAC framework: the Reduction Capacity Assessment Framework allows companies to assess the economic viability of their GHG reductions under different carbon pricing scenarios, offering a crucial forward-looking perspective on portfolio decarbonization potential.
Conclusion: integrating transition for long-term value
The path to credible net zero investment demands that asset managers recognize the fundamental difference between abstract portfolio decarbonization and the tangible imperative of financing emission reduction. Achieving alignment requires an integrated approach that uses dynamic metrics like Carbon Momentum to gauge self-decarbonization and Green Revenue Share to measure contribution to the green economy. By moving away from exclusionary tactics that merely shrink the investment universe, and embracing targeted engagement and transition finance, institutional investors can manage climate risk, fulfill their fiduciary duty, and maximize their authentic contribution to the global net zero transition.
More about portfolio decarbonization:
The following papers, reports, and methodologies address the core concepts of climate alignment, advanced metrics, and practical implementation challenges discussed in this article.
- International Energy Agency (IEA)
- Title: Net Zero by 2050: A Roadmap for the Global Energy Sector
- Relevance: Provides the fundamental, science-based net zero emissions (NZE) scenario that underpins global institutional commitments. It is crucial for understanding the physical concept of the carbon budget upon which financial alignment models are built.
- Guenedal, T., Lombard, F., Roncalli, T., and Sekine, T. (2022)
- Title: Net Zero Carbon Metrics (Amundi Working Paper/SSRN)
- Relevance: Defines key forward-looking measures, such as Carbon Momentum, NZE gap, and NZE budget, necessary for moving beyond static carbon footprint measures. This work focuses on using absolute carbon emissions for consistency in budgeting the reduction of CO2 emissions.
- Institutional Investors Group on Climate Change (IIGCC) (2021)
- Title: Net Zero Investment Framework 1.5°C: Implementation Guide
- Relevance: This is a crucial industry-wide framework (NZIF) offering practical guidance for investors to set targets and align portfolios with 1.5°C. It emphasizes the importance of increasing investment in climate solutions and prioritizing engagement.
- Bolton, P., Kacperczyk, M.T., and Samama, F. (2021/2022)
- Title: Net-Zero Carbon Portfolio Alignment (SSRN/Financial Analysts Journal)
- Relevance: Discusses the theoretical necessity of moving beyond simple portfolio decarbonization toward genuine portfolio alignment. This work is frequently referenced in the debate concerning divestment versus financing transition.
- CDP Worldwide and WWF International (2020)
- Title: Temperature Rating Methodology — A Temperature Rating Method for Targets, Corporates, and Portfolios (Report)
- Relevance: Presents the methodology for converting corporate GHG emission reduction targets into temperature scores (or temperature ratings), providing a crucial, widely adopted forward-looking metric for assessing a company’s Ambition and alignment quality.
- Carvalho, R. L. de, Ambachtsheer, J., Bernhardt, A., et al.
- Title: Aligning Investments with the Paris Agreement: Frameworks for a Net-Zero Pathway (Source document comparing NZ:AAA and PAB)
- Relevance: This paper offers practical guidance and direct comparison between the two leading investment frameworks: the Paris Aligned Benchmark (PAB) rules (which focus heavily on immediate decarbonization) and the Net Zero Achieving, Aligned, Aligning (NZ:AAA) framework (which focuses on forward-looking commitments and real-world impact).
Why this article?
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