The “Net-Zero pitfall”

In many ways the last year has been remarkable to me. Besides geopolitical and economic events, the heated public debate on ESG (environmental, social, governance) is one that I will always remember. It adds a new dimension to my job, as head of the ESG and Sustainable Investment team of a bank with over 5 million clients and high visibility in the markets where we operate. Internet search engine requests for ESG information have skyrocketed — and so have stakeholder questions.

In 2022 ABN AMRO communicated its climate strategy. Again, this raised questions, most notably around the “real world outcomes” of our net-zero approach (i.e. how do we make sure that net-zero on paper is also net-zero in the real world).

Why would you want to invest using a net-zero approach? From my perspective, there could be (at least) two reasons: 1) to reduce financial risk in portfolios (the effect of climate change on investments) and 2) to support the sustainability transition that is necessary to limit global warming (the effect of investments on climate change). Respectively, these approaches to sustainability can be categorised as single and double materiality.

Let’s take a look at single materiality (related to financial risk for the company). Companies with high carbon emissions may be required by (future) laws and regulations to reduce carbon emissions or to offset them. In some cases, companies will be subject to paying a carbon price or carbon taxes and this will affect their financial results, especially if they cannot pass this cost on to their end-clients. In addition, companies may be hurt financially by physical damage caused by extreme weather, such as heat waves and flooding. When this is a material risk, it threatens the financial goals of the company and its investors. We therefore aim to understand how vulnerable a company may be to these risks, by forming an opinion on sectors and public policy development. As this focuses on financial risk, we believe it should be something that every investor would want to address in any portfolio – although there is no market consensus on this, considering relatively high valuations for some high risk companies.

In 2022, I had several conversations with asset managers on their climate strategies. Most of them have a plan to structurally lower portfolio company carbon emissions and to estimate and monitor how these emissions may differ from general capital markets, i.e. measuring their “tracking error”. In addition, some asset managers screen a company’s vulnerability to extreme weather. From a single materiality point of view, this all makes sense.

From a double materiality point of view (related to risk for society, in addition to financial risk for the company and investor), I believe we should be more critical. Selling a high polluting company from a portfolio, for example, may reduce the carbon risk in the portfolio, but it does not necessarily change anything in the real world.

Carefully stated, divestment is at least a debatable investment strategy in terms of its ultimate effectiveness.

In the summer of 2022, Robert Eccles (visiting professor at Oxford’s Said Business School and formerly at Harvard Business School and MIT) wrote a tutorial for investing in oil and gas companies, triggered by the US debate on ESG. He explained that selling stocks has no direct impact on companies. The stocks that are sold simply get bought by others. These new shareholders may not care about the environment and vote against change at the company. According to Eccles, it is much better to work with companies to stimulate the transition to net-zero. I call this the “net-zero pitfall”. In periodic reporting, a divestment will register as a reduction in portfolio carbon emissions, while outside the portfolio, nothing has really changed. There may also be a risk of divesting from or denying capital to companies that are essential to enabling the energy transition. Carefully stated, divestment is at least a debatable investment strategy in terms of its ultimate effectiveness.

In April 2022, the UN-convened “Net-Zero Asset Owner Alliance” published a paper in partnership with the World Wildlife Fund (WWF) stressing that “Facilitating the net-zero transition in the real economy requires that investors also actively support decarbonisation efforts through engagement with companies and their stakeholders” by means of a “forward-looking, systematic stewardship approach”. It supports allowing companies to work on climate targets and plans. If the progress lags, ultimately divesting can give a final signal to the company.

It may be easier to meet carbon reduction targets by simply selling companies in portfolios. From a reporting point of view, you do not see a difference. However, to prevent that net-zero strategies are relegated to “net-zero blah, blah, blah,” it is essential to consider the difference between single and double materiality and for asset managers to be transparent to their stakeholders regarding their intentions, approach, engagements and voting behaviour at AGMs.

Evaluating financial risk related to net-zero goals is a good start. But for real change to be made – to achieve the goal of a net-zero world – more work and engagement are required. Engagement with companies allows for a better fundamental qualitative analysis and may allow to influence portfolio companies directly. Something on the list for when you speak with your asset manager.

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By Vincent Triesschijn, Global Head ESG and Sustainable Investments ABN AMRO

If you would like to read further articles in the 'Governance and Climate Change' series, click here

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