PERSPECTIVES SPECIAL | Decarbonizing portfolios: 10 key factors

Authors: Markus Müller, CIO ESG & Global Head of CIO Office - Daniel Sacco, Investment Officer EMEA

Introduction: why decarbonize?

Global temperatures continue to rise. In response, governments have committed to reducing their economies’ global carbon emissions to reach “net zero” emissions by 2050. Economies, governments and corporates are now in a process of transition towards more sustainable, lower carbon-emitting models. This is “decarbonization” – both a process and an outcome. 

Investors, for their part, may have several underlying objectives in decarbonizing their portfolio. For example, through investing in firms or sectors with lower actual or projected emissions, they may want to contribute to overall process of global decarbonization. They may want to gain from the investment opportunities that will emerge in the transition to a low carbon sustainable economy. Or they may believe that decarbonizing a portfolio can mitigate risks involved in this transition (through reducing the risk of investing in what might become stranded assets), with implications for long-term portfolio performance. 

In this report, we look at key factors involved in decarbonizing a portfolio. We start by discussing why a decarbonization objective needs to be carefully defined and the implications of this. We then look at challenges around portfolio implementation and management and possible ways to address them. These challenges include data availability, investment vehicles, security selection, optimisation and the two related issues of portfolio performance and risk. 

It is worth stating clearly at the start that there is no single perfect agreed metric or method for portfolio decarbonization. Approaches will be adjusted as the transition to a more sustainable economy continues. But we do think it is now possible to identify 10 key factors around decarbonizing portfolios and how to approach them. 

This report sets out several of the ways in which portfolios can be decarbonized. We do not assess the real-world impact of different carbon reduction options, or specific investment opportunities created by the transition to a more sustainable economy. Our emphasis here is in taking existing portfolios and decarbonizing them. 

The views expressed in this report are those of Deutsche Bank’s CIO Office. These are based on internal research as well as inputs from a program of joint discussions between Deutsche Bank and BlackRock’s EMEA Investment & Product Solutions and Sustainable Investment Research & Analytics teams. We thank them for their insights.

In summary: key factors and implications 

1. Emissions measure: relative emissions measures help select and manage investments in a decarbonization portfolio – but reducing absolute emissions levels must be the aim. 
2. Time perspective: carbon emissions measures need to be forward-looking but with progress closely monitored. Decarbonization pathways are key to achieving the endpoint. 
3. Target type: binary targets for decarbonization outcomes are complemented by benchmarking of progress and to validate some portfolio components.  
4. Asset class data: equities and corporate debt data availability means they will be at the heart of a portfolio strategy. Decarbonization data for other asset classes is more challenging. 
5. Investment vehicles: choosing between “active” and “passive” investment approaches will involve multiple factors and some potential compromises.
6. Exclusions: not investing at all in specific sectors can be a blunt tool, could affect portfolio performance and be counterproductive in encouraging the sustainability transition.
7. Switching: the ability to replace individual investments with others with better decarbonization metrics may be limited by the lack of alternatives and portfolio management considerations.
8. Performance: screening for decarbonization targets will reduce the investment universe, may skew portfolio composition, hence, some room for flexibility may be advisable.
9. Risks: decarbonization will require different short-term management of financial risks but could help reduce longer-term transition risks, e.g. around stranded assets.
10. Optimization and regulation: portfolios will require ongoing optimization in line with real-world decarbonization and changing regulation.