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Net Zero: What is the financial market doing?

November 4, 2022

The Glasgow Financial Alliance for Net Zero (GFANZ) is a global coalition of financial institutions committed to accelerating the transition to a net zero economy. WTW work with GFANZ closely across a number of its workstreams. Anja Ludzuweit from GFANZ and Jeff Chee from WTW compare notes on portfolio alignment – why it is important to consider, how we can measure it and examples of how to tackle it in reality when it comes to measuring climate performance.
Climate Risk and Resilience|ESG In Sight
Net Zero: What is the financial market doing?

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Net Zero: What is the financial market doing?


SPEAKER 1: Welcome to WTW's ESG In Sight Spotlight Series.


JEFF CHEE: So, hi, my name's Jeff Chee. I'm the Head of Portfolio Strategy for Willis Towers Watson. And my role largely focused around our portfolio construction process, and importantly more recently, how we integrate net zero and broader sustainability considerations into portfolio decisions.

Very pleased to be joined today by Anja Ludzuweit, who is the Technical Lead for the GFANZ Portfolio Alignment Stream. So Anja, welcome. And could you just please give us a bit of an intro to yourself, your role more broadly and, also your role within GFANZ?

ANJA LUDZUWEIT: Yeah. Thank you so much for having me. Yeah, so I'm currently leading the workstream on portfolio alignment measurement. And previously, I was active as executive director at MSCI's Climate Risk Center, where I worked with clients on climate risk and opportunity analysis, but also TCFD disclosures, and most importantly, also, portfolio alignment.

And prior to that, MSCI actually acquired the Climate Risk Center. So it was an acquisition that was done of an environmental fintech in Zurich called Carbon Delta. And I helped Carbon Delta with business development and—

JEFF CHEE: No, that's great. It sounds like you're very, very, well-placed to be leading this work. But I guess, many of the people watching this won't actually be that familiar with portfolio alignment metrics. So I was wondering, could you just give a brief description of what portfolio aligned metrics are, and the sorts of inputs and kind of drivers that go into producing them, and kind of what they look like?

ANJA LUDZUWEIT: Yeah, for sure. So for one, portfolio alignment measures are really helping financial institutions to assess how aligned investment, but also lending, and underwriting activities with the goals of the Paris Agreement. But also critical 2050 net zero goals that we have set.

And the process of measuring this alignment is really underpinned by crucial key questions or key decisions that one has to take. And they are also known as judgments, and they've been put together by the portfolio alignment team. And these key design judgments are really about comparing a specific company's alignment to an emission benchmark that has to be built.

So there's a number of critical decisions that have to be made. But one key decision is really the focus on the forward-looking perspective of this framework. So there's really the need to project corporate emissions into the future. And therefore, one critical key component is how we are actually projecting these emissions into the future.

So I think one crucial difference when we compare portfolio alignment to simply doing an emissions assessment is that we are actually looking at the transition readiness of companies. We are looking at what transition plans have companies in place.

JEFF CHEE: Yeah. I think that's really important because so much time has been spent on measuring financed emissions, which are essentially this backward-looking construct. And what really matters is the forward-looking pathway and pathway for companies.

And so I guess once you've kind of understood that kind of potentially the gap between a company's pathway and what it needs to be aligned, how can we then potentially use these measures to kind of drive real-world emissions, which after all is the goal of all the net-zero pledges that are out there at the moment?

ANJA LUDZUWEIT: Yeah so I mean, the importance of really of this framework is there's a number of things. And one important thing is really the transparency that it provides. So when we measure alignment, it will really provide transparency on whether the financial sector is really reallocating the capital in order to get to net zero.

And then secondly, what's really important here is also to understand progress that's being made. So we want to actually track progress over time. How much progress are we making towards that goal of net zero? And because the portfolio alignment metrics are forward-looking, they can really help us to track that progress.

So it's not just about carbon-intensive companies that have been carbon-intensive in the past, but also what are companies doing in the future to actually help achieve that goal? And in that way, portfolio alignment measurement if done correctly, could then ultimately also help to contribute to real economy reductions. Because we are actually taking into account that transition readiness. So the measurement actually allows investors to focus on those companies that are committed to the net zero transition.

JEFF CHEE: I guess one other thing that you and I have definitely talked about on the workstream has been around climate solutions. And when we're sort of talking about driving real-world emission reductions, it's not just about decarbonizing existing operations, but enabling other sectors to transition or developing the technologies required in order for the broader economy.

And I guess, where do climate solutions fit within the portfolio alignment construct? And where is the thinking at on that, and where might it be going?

ANJA LUDZUWEIT: Yeah. So we have many discussions on this topic of climate solutions, and the challenge there is that currently, this portfolio alignment measurement framework is focusing a lot on emission reductions. And when we try to assess providers of climate solutions, then the way that we currently assess companies may not be the correct one.

So we have really had many discussions in the workstream, but also more widely with net zero financial institutions on this topic. And we are now basically saying that at the moment, the providers of climate solutions are not adequately reflected in the framework.

And we have also found that it's technically difficult. So rather than going out there and already providing some guidance on that, we actually want to start the thinking and we want to stay really open on how it could be done.

So in the consultation report, we are actually providing a number of case studies that help us to start thinking of how providers of climate solutions might be captured in this framework. And the important thing to consider here is that a provider of a climate solution is on the one hand helping to reduce emissions in specific carbon-intensive sectors.

But what makes a challenge is that the provider of a climate solution might also be carbon-intensive in their production process. I mean, a simple example is, for example, a manufacturer of solar panels. And depending where the solar panel is manufactured, if it's manufactured in China, it might actually be produced with coal power.

Therefore, in the production, it's really carbon-intensive. And therefore, the alignment score might not come out adequately because what we really want to focus on is not these operational emissions, but the amount of emissions that the panel manufacturers are actually helping to save over the lifetime of the panel.

So that's really the crucial thing here. So, Jeff, I'd like to know from you how Willis Towers Watson is actually helping its clients to include portfolio alignment measures into the analysis. So how are you approaching that at the moment?

JEFF CHEE: Yeah. So I mean, from WTW, our clients are essentially asset owners of varying types of pension funds, insurance companies, so managing their asset portfolios towards net zero goals. And the way that we tend to think about it is that we all know that climate is a complex multidimensional topic.

So we think about multiple metrics, but critically, we recognize that at the end of the day, a net zero goal is really a long-term reference target. And the way that we get there from a forward-looking perspective is to ensure the bottom-up alignment of all of the assets in our portfolio.

So that's the ultimate metric for success. And we sort of think about the decarbonization goals as more, are we on the right trajectory? And so when we're assessing the climate performance of our portfolios, that's really where we bring portfolio alignment measures.

So what we can do is we can assess the alignment of each of the individual components of a portfolio and then think about where are the emissions of this portfolio coming from, but critically, which of those emissions are aligned and which of those missions are misaligned?

Because if we have high conviction that a particular strategy or particular manager has a high emitting portfolio, but if that portfolio we've got conviction and that comes to the credibility assessment that you talked about earlier on here that it is aligned, then we have confidence that it will be on the correct pathway.

Whereas we might have another part of the portfolio that has relatively lower emissions but is completely misaligned. And that is where we would focus a lot more of our attention in terms of engagement, either with underlying managers or with individual companies through overlay providers and the like.

And so that's kind of the first part, to understand where are the most material sources of misalignment in the portfolio. But again, we also need to recognize that there are certain things that alignment measures in isolation can't capture. So one area that's quite important is the climate solutions dimension that we've talked about.

So there will be certain parts of the portfolio where the investments that asset owners make will contribute either to the decarbonization of the economy in isolation. So whether it be via solar panels or other renewables or by facilitating other sectors of the economy to achieve their transition. So green hydrogen, greener steel, and cement, et cetera, et cetera.

And what we don't want to do is overly penalize emissions in those parts of the portfolio, if they are genuinely contributing to solutions. And so that's one area where we would look to kind of triangulate these multiple metrics in the form of a dashboard.

The other area that we think is very critically important is to recognize that asset owners, for example, pension funds, their goals are ultimately to deliver financial returns to beneficiaries. And so we also need to overlay considerations of exposure to transition risk in the portfolio.

So a strategy that has high emissions is misaligned and has high transition risk, is going to be the most critical area for engagement because we also can sort of think about transition risk as being almost a different lens into alignment in the sense of if a company has a misaligned business model, it should be subject to higher economic costs in a transition.

And therefore, be exposed to higher transition risks. So it's really that triangulation of portfolio alignment being the starting point, and then using other metrics like transition risk, climate solutions, and so on and so forth, to interrogate that further to then lead to informing our client's climate action plans, which will be about engage with this manager or understand this strategy in more detail.

Or if that engagement process doesn't work, then think about what are the portfolio construction responses. Could you change the mandate? Should you change the manager? Should you have some sort of asset allocation response

ANJA LUDZUWEIT: Yeah. So from what you're saying there, your line of thinking, there is very much on not just assessing a company based on a single metric, but you are pointing out that actually in order to assess alignment of underlying portfolios and also the companies in that portfolio, we actually need a multitude of metrics to get a more comprehensive picture.

So with the current dashboard approach that you have in place, what are your plans for actually evolving and expanding the use of portfolio alignment metrics in the short to medium term?

JEFF CHEE: Yeah. I think there are probably three main things that we're looking at. So one is just to improve the methodologies that we use to assess portfolio alignment. So one of the key challenges that asset owners have is the multi-asset context.

So once you move beyond corporate equity and corporate credit, finding the methodologies and the data to robustly assess alignment is challenging. Groups like the IGCC are doing great work in terms of expanding that coverage, and so we'll look to implement that over time as the guidance evolves.

I think the second important thing is setting formal targets on alignment. So we can think about the engagement process as wanting to kind of move companies or strategies through the maturity scale of alignment. So from something that's not aligned to something that is on the pathway to being aligned or aligning to something that is aligned.

And so the next thing that we need to do is having assessed where the alignment of our portfolio is. Think about what is a reasonable time frame and what's a reasonable engagement framework to move our managers through that cascade from not aligned to aligned. And therefore, set targets that we can use to hold ourselves and our managers to account for actually achieving those sorts of outcomes over the medium term.

And the longer term, what I think everybody should be doing is really formally integrating an assessment of alignment into capital allocation and portfolio construction decisions. So we kind of know that portfolio construction is multi-dimensional. So it's not just about Sharpe ratio, risk, and return.

We need to think about costs. We need to think about liquidity. We need to think about complexity, and essentially, we should think about alignment or climate characteristics as being another key element into that.

If I want to think about how do I most efficiently spend my carbon budget alongside my liquidity budget, my cost budget, well, I clearly won't spend that carbon budget on the most aligned strategies in the portfolio and also the most financially efficient strategies those least exposed to transition risk.

So how do we bring portfolio alignment more systematically and consistently into that framework for assessing portfolios through multiple dimensions is kind of the longer term goal that we're aiming towards.

ANJA LUDZUWEIT: Yeah. Thank you so much for that. One challenge that I also saw you point out, was that if you actually want to engage with companies that are transition ready, what can happen in some cases is that temporarily emissions are increasing, and therefore if we are not measuring portfolio alignment adequately, that could actually result in a less favorable alignment in a higher amount of emissions. So how are you dealing with that challenge currently?

JEFF CHEE: Yeah, it's a really good point because I think that it's actually one of the problems with the singular focus on emissions is it is that activity in isolation is potentially one of the biggest drivers of a disorganized transition because if we starve key sectors of the economy of capital, we can then actually cause a disorderly transition to a low carbon world, rather than an orderly one.

And I think from our perspective, it really comes back to the use of the multiple metrics and making sure that when we're assessing performance against a blunt measure, like say, a decarbonization pathway, that one, we set reasonable review triggers around that pathway. So that we sort of say we don't require this portfolio to be ahead of the pathway at all parts of the journey.

We know that this will be volatile. We know that in the near term, emissions may go up as solutions are developed, et cetera, et cetera. But that we make sure that for all of those material parts of the portfolio that we are using those multiple metrics. That we can explain that we understand why the emissions in this part of the portfolio are high or are increasing, that we have satisfied ourselves.

That they are aligned or that they're not aligned. That we've engaged with the managers of the companies, and that they are taking appropriate actions to kind of move things in the right direction, rather than as might otherwise happen. You just divest and then sort of create problems.

JEFF CHEE: Well, I mean, that's all the questions that I had for you today. So I wanted to just say just really thanks for your time. And I really appreciate you taking the time to provide the deep insights into portfolio alignment, but also into the broader work that GFANZ are doing. And just really encourage everyone who's watching this to get involved in the conversation and to contribute. So I say thanks very much and look forward to speaking to you soon.


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