Contributed by Conor Hartnett, Tim Herzig, Sebastian Lehner and James Sieyes.
As the world grapples with the urgent need to address climate change, climate-conscious investors are increasingly looking to align their portfolios with the goals of the Paris Agreement. But how can we quantify and compare the climate impact of different investments? Enter two key metrics: Carbon Budget Divergence (CBD) and Implied Temperature Rise (ITR).
CBD measures the absolute difference between a company's projected emissions and its fair share of the global carbon budget. It's a tangible way to see which companies are overshooting or undershooting their emissions allowance. ITR takes this a step further, translating the relative overshoot into an estimated global temperature rise. If the whole economy behaved like that company, how much would the Earth warm?
While both metrics aim to assess Paris alignment, they illuminate different aspects. CBD emphasizes the bottom-line impact in tons of emissions, while ITR provides an intuitive, big-picture temperature score. Think of CBD as the raw data and ITR as the user-friendly visualization.
Unsurprisingly, high-emission industries like energy and materials tend to score poorly on both counts. But there's a twist. Under ITR, a big polluter making big relative improvements could look better than it does under CBD's unflinching lens. Investors must peek behind the numbers to grasp the full story.
A deeper dive into the data reveals the challenges of comparing apples to oranges. The imperfect correlation between CBD and ITR underscores how they capture different nuances. Navigating extreme outliers and data quirks requires both technical finesse and a keen understanding of what the metrics truly convey.
CBD shines for hands-on company analysis and engagement, especially for high-impact emitters where absolute reductions move the needle. ITR's elegant simplicity, though masking highly complex assumptions, suits big-picture portfolio assessment and stakeholder communication. The key is wielding both wisely, not dogmatically. Optimizing for the Earth and the Bottom Line
So how do we build climate-aligned portfolios? It's a balancing act. Chasing aggressive carbon targets can mean deviating from standard benchmarks. But research shows we can achieve meaningful alignment with modest tweaks—say, strategically underweighting climate laggards and favouring decarbonization leaders.
When it comes to aligning portfolios with climate targets, questions around the financial impact arise. We show that marginal active deviations from a benchmark can go a long way. A mere 50bps of Tracking Error vs. the MSCI World can bring a portfolio much closer to the Paris Agreement goals.
The road to carbon neutrality is winding, and no single metric is a silver bullet. And while the journey is complex, tools like CBD and ITR can help light the way. By thoughtfully applying these metrics, climate- conscious investors can enhance decision-making, drive corporate change, and better manage climate risks and opportunities. Armed with clarity, nuance, and conviction, climate-conscious investors can align both financial and climate goals.
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