Debunking net zero myths

The journey towards achieving carbon neutrality, or net zero, by 2050 is not only essential for the planet but also increasingly demanded by investors. Motivations for those seeking to align their portfolios with net zero often vary, spanning financial, societal and ethical domains. And yet, many investors hold a common set of misconceptions related to the implementation.

The two leading misconceptions in the market today are the beliefs that aligning with net zero requires a high level of active risk, and that it is incompatible with active or factor investing.

Our latest research debunks these myths, demonstrating that investors can achieve alignment with their net zero commitment without significant active risk and without compromising their return objectives.

The first misconception

The more deeply entrenched misconception of the two is that net zero is very high risk. This is understandable given that many net zero strategies exhibit high levels of tracking error. The issue is often due to sub-optimal portfolio construction.

For example, many climate-focused indexes are substantially underweight sectors such as energy and utilities. If sector volatility is high, for instance due to sensitivity to economic events, the tracking error may also be elevated.

To demonstrate the misconception that a net zero commitment requires significant active risk, we analysed the impact of a carbon intensity reduction on a portfolio’s active risk in the MSCI World Index universe. We calculated carbon intensity by dividing a company’s carbon emissions by the enterprise value, including cash.

Our research shows that investors can achieve significant reductions in carbon intensity with very little active risk. Specifically, just 50 basis points or 0.5% of active risk in a portfolio is required to achieve an 80% reduction in carbon intensity. This scale of reduction is well ahead of the existing pathway for global carbon emission targets.

However, carbon intensity reduction is retroactive by nature as it seeks to capture the impact companies are causing today as a result of their current operations and past decisions. Forward-looking measures of carbon risk such as the MSCI Low Carbon Transition Score or the ISS Carbon Risk Rating have a more material impact on active risk. For example, 100 basis points or 1.0% of active risk allows for a 17% improvement in the MSCI Low Carbon Transition Score and a 27% improvement in the ISS Carbon Risk Rating.

Putting it all together, we assess the impact of a representative set of net zero criteria relative to the MSCI World Index. These criteria include a variety of measures, such as companies achieving carbon emission reductions of 70% or more, and alignment with the United Nations’ Sustainable Development Goals. We found it is possible to accommodate a robust set of net zero policy requirements for only 50 basis points of predicted active risk, a level that many investors assume to be unattainable.

The second misconception

Our research also shows that investors can gain meaningful exposure to equity factors such as value in a net zero portfolio, contrary to the misconception that this isn’t possible

We find it is possible to maintain the vast majority of targeted factor content while achieving carbon intensity reduction levels above 70%. Integration of forward-looking measures has a bigger impact on factor content, but investors can achieve portfolio improvements if this is implemented thoughtfully.

As with the first misconception, we also applied our representative set of climate change criteria to the MSCI World Index to see how it would impact a multi-factor approach, while allowing for up to 200 basis points of active risk. We found that it is possible to retain over 85% of factor content while meeting significant sustainability goals.

A reality check

As the urgency to combat climate change intensifies, the momentum behind net zero commitments increases. To date, this has caused significant qualms as to whether traditional investing models will allow investors to do so without losing sight of their approach, whether that is index-tracking or factor investing. We have shown that although these challenges cannot be eliminated entirely, they are far from insurmountable as many believe.

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