Tickers and thermometers: decoding the complexities of portfolio temperature alignment

With the release last March of the final installment of the Intergovernmental Panel on Climate Change (IPCC) Sixth Assessment Report (AR6), 2023 marked a turning point in the global climate change narrative. Across its nearly 10,000 pages, the highest authority on climate change science brought into sharp focus the pressing reality that global warming is now more likely than not to reach 1.5°C in the near to medium term.

The final installment fed the United Nations Framework Convention on Climate Change (UNFCCC) Global Stocktake report which highlights that the 1.5° C trajectory now requires global emissions to fall by 43% by 2030 vs. 2019 levels and 60% by 2035. In the aftermath of both landmark reports, the role of financial institutions has never been more crucial, and the financial sector has found itself further thrust into the epicenter of the action. The influence of the finance industry over global capital allocation provides it with a unique opportunity to drive the transition towards a sustainable, low-carbon economy. This, alongside ever-stricter global regulations, is leading to an increasing number of institutions pledging alignment with the Paris Agreement.

However, the journey towards ‘Net Zero’ is complex. As the window of opportunity to keep global warming below 1.5°C narrows, investors are grappling with one of the most critical tools in their climate strategy toolkit: portfolio temperature assessment. This measure is more than a mere symbol of the environmental impact of a portfolio; it is a tangible reflection of the potential degree of global warming that the emissions from the underlying investments could cause.

The portfolio ‘temperature’ provides investors with insights that are crucial on several fronts. First, it offers a means to monitor and measure progress towards decarbonisation targets. Regular temperature assessments can serve as a performance tracker, allowing investors to gauge whether a portfolio is on track towards achieving ‘Net Zero’. Secondly, assessments help identify and mitigate climate-related financial risks. A portfolio skewed towards high-emitting assets is not only environmentally unsound but could also face significant financial risks – regulatory, market, reputational and litigation – in a world transitioning towards lower carbon alternatives. Lastly, a robust temperature assessment can enhance accountability and transparency, addressing the rising demand of stakeholders for comprehensive climate disclosures and ethical investments.

However, determining a portfolio’s temperature is not a straightforward task. The absence of a universally approved approach implies navigating a complex landscape of methodologies, each with its unique strengths, limitations and inherent biases. Be it the “Climate Disclosure Project (CDP) - World Wildlife Fund (WWF) Temperature Rating”, S&P’s “Trucost Portfolio 2°C Alignment Assessment” methodology, “The Paris Agreement Capital Transition Assessment” (PACTA), MSCI’s “Implied Temperature Rise” (ITR) model or Carbon4’s “Carbon Impact Analytics” (CIA) methodology, investors are faced with a diverse suite of tools to guide their journey to ‘Net Zero’.

But how do these methodologies compare, and what are their relative merits and potential pitfalls? How do we navigate the inherent uncertainties? And, as investors, what conclusions can be drawn from the various outputs relative to the contribution of portfolios to a low-carbon future?

Understanding the array of methodologies is a necessary first step. The choice of methodology will obviously shape investors’ climate strategies, thereby influencing divestment decisions, capital allocations, shareholder engagements and policy advocacy. In a world facing unprecedented climate challenges, these decisions could make the difference between a future char- acterised by runaway climate change and a ‘Net Zero’ world.