Understanding Net Zero Transition Pathways
Following the Paris Agreement to limit global warming to well below 2ºC and preferably to 1.5ºC, governments around the world have increasingly committed to achieving net-zero emissions reduction targets by 2050. Companies, too, have been updating their strategic goals to reflect this ambition, bolstered by increased regulation, but also investors’ need to understand how companies will transition to a low carbon future.
Investors may choose to invest in heavy emitters to drive decarbonisation efforts in those companies or to invest in low carbon and climate solutions. Each approach offers different risk-return profiles to investors and needs to be balanced with how they contribute to a 2ºC world.
A key component of working towards portfolio decarbonisation targets is ensuring companies have a well-articulated decarbonisation strategy which includes well-defined interim emissions reduction targets. Take the oil and gas (O&G) sector as an example. Unless reduction targets include scope 1, 2 and 3 emissions, these companies will never be in alignment with the Paris Agreement goals. Scope 1 and 2 are the emissions generated by a company itself, whether through direct burning of fossil fuels, or the use of electricity, while Scope 3 includes the emissions that occur in a company’s value chain.
The O&G sector has been evading the issue of scope 3 emissions despite downstream emissions from burning fossil fuels accounting for between 70 to 90% of lifecycle emissions from oil products. European oil majors, however, are starting to take a leading role in changing this trend. Shell, TotalEnergies and Eni include Scope 3 emissions in pursuing carbon intensity targets that are closest aligned with a 2ºC warming scenario (though still above 2ºC). Intensity targets (emissions reductions relative to a unit of economic output), however, need to be accompanied by absolute reduction targets to ensure carbon emissions into the atmosphere fall over time. While TotalEnergies and Eni already do this, Shell is catching up after a court ordered the company to reduce emissions by 45% by 2030 to add credibility to its intensity targets.
Targets for renewable power capacity are also key for O&G companies. TotalEnergies has a renewable generation target of 35GW by 2025 with the ambition to increase this to 100GW by 2030 from a current gross capacity of 7GW. Such an ambitious target makes sense for TotalEnergies, as a rapid growth in renewable energy sales that overtakes that of fossil fuel sales will drive its carbon intensity target lower.
Other important markers of good decarbonisation strategies involve the inclusion (and quality of ) carbon offsets, capital expenditure and research and development (R&D) that align with delivering emissions reductions. This includes investment in low-carbon technologies, such as green hydrogen, biomethane carbon capture and storage (CCS) as well as battery storage capacity. Here, TotalEnergies outperforms peers, investing a third of its R&D spend in low carbon mitigation technologies in 2019.
Despite the important steps taken by O&G companies to decarbonise, experts warn their efforts remain off track to meet 2050 net zero targets and will burn through the sector’s carbon budget of 1.5ºC by 2037.As it currently stands, the O&G sector is practically out of reach in net zero portfolios.
Building Net-Zero Portfolios
Investment in climate solutions needs to be scaled up significantly while reducing carbon emissions in the real economy to achieve the greatest impact in the climate crisis. This requires setting clear medium-term targets at portfolio level to reduce carbon emissions while building exposure in areas such as renewable energy, energy storage, transportation, recycling and circularity, agriculture and foods, energy efficiency, and so on. This may lead to the exclusion of companies such as those exposed to stranded assets like coal, but it can also allow investment in companies which are not yet on a clear decarbonisation path, but where engagement and voting strategy can accelerate this process. In this case, setting clear milestones to assess whether a company is on track to achieve its transition plans or targets is paramount, as failure to progress will inevitably lead to divestment.
Making a clear distinction as to what constitutes low carbon and what are climate solutions companies in the portfolio is also important. The reason: they will produce different risk/return profiles which can improve portfolio diversification. A recent study by the Harvard Business School found that in the past 10 years, a low carbon portfolio displayed a low tracking error and can thus easily track and obtain market rate returns. The returns from a climate-solutions portfolio, meanwhile, showed little correlation with a low carbon portfolio, outperforming the market considerably in the last 10 years. While a low carbon portfolio aims to reduce exposure to transition risks such as carbon prices and regulatory changes, climate solutions companies provide exposure to innovative and growing businesses, with higher revenue growth, capital expenditure and investment in R&D than their industry peers.
The current energy crisis, although appearing to derail the energy transition by creating investment needs in short-term energy issues, will accelerate energy independence as a further and now more immediate objective of a low carbon future. The energy crisis of the 1970s saw the price of oil rise nearly 300%. It was also a turning point, signalling the peak of the global oil intensity of GDP. As we witness the horrors of war in Ukraine, this may also mark a watershed moment when we begin to decouple growth from fossil fuels.
Carolina Angarita-Cala is Sustainability & Responsible Investing Manager at Cantor Fitzgerald Ireland.