The financial industry is facing a great challenge: that of deploying capital in the real economy with a net-zero mind-set. Today, investors need to know how to truly align their portfolios with a net-zero economy.

In order to reach the goals set by the Paris Agreement to limit global warming to 1.5°C, CO2 emissions need to reach net zero by 2050. It is a daunting task but it remains the single most important component of the sustainability transition across all companies and industries. Across sectors, companies must wean themselves off fossil fuels. 

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This transition offers extremely fertile ground for investors. We need to build transition-fit portfolios that are resilient to, and positioned to benefit from, the seismic shocks of a net-zero world. And we believe that companies that are on the pathway to creating a net-zero economy will thrive and those who are left behind may not survive, while demand for climate-relevant solutions, products and services will escalate.

We believe that companies that are on the pathway to creating a net-zero economy will thrive and those who are left behind may not survive

why is it so important?

We, at Lombard Odier, believe we are at the dawn of the next great economic revolution, one where sustainability will be at the core of all investment decisions.

At present, we live in a Wasteful, Idle, Lopsided and Dirty (WILD) economy. One where 92 billion tonnes of natural resources5 are extracted from the planet every year to feed an ever-hungry model of consumption. From this comes pollution, greenhouse gas emissions and great inefficiencies. The need to convert to an economy which is Circular, Lean, Inclusive and Clean (CLIC®) grows ever greater. Reaching net-zero carbon emissions by 2050 is the lynchpin of that transition.

 

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Net zero is the only solution to prevent the bathtub overflowing6

The shift is coming from many directions as there are powerful forces creating momentum. Regulation wise, CO2 emissions are becoming more costly and there is a need for increased transparency. Consumers and employees are demanding that companies adopt sustainable solutions. Market forces are driving down the costs of technology and investors want firms to report on climate-related risks and effectively redeploy capital. The solutions to transition to a CLIC® economy are becoming cheaper and more widespread.

climate exposure.

Our industry is faced with three major issues in the transition to net zero. First, climate is creating real financial exposure for companies. Second, assessing this climate-related exposure is incredibly complex. And third, there is a major discrepancy between greenhouse gas emissions trends in the real economy and governments’ pledges and commitments.

Climate-related financial exposure comes in three different forms: transitional exposure, such as consumers moving towards more sustainable products; physical risks, such as weather-related damages; and liability risks, such as companies being forced to take responsibility for climate change.

We believe that mitigating climate-related financial exposure in our clients’ portfolios by investing with a net-zero mind-set is part of our fiduciary duty. While almost three decades may seem like a long time to reach this target, the scientific community says we must first cut our emissions in half by 2030 – which is less than nine years away.

But to achieve this, we must go beyond carbon footprint analysis, the European (EU) Taxonomy, climate benchmarks or Environmental, Social, and Governance (ESG) data, and focus on rigorously assessing the valuation impact that such exposures could have on any company.

The scientific community says we must first cut our emissions in half by 2030 – which is less than nine years away

the investor question.

The shift towards net zero is now becoming one of the most fundamental issues for investors. Can a company continue to perform its activity without emitting CO2? Can it run a profitable business model in a post carbon world or as it transitions to net zero?

As investors, we at Lombard Odier embrace a more forward-looking perspective, where we identify the companies that are fit for the transition and those that are not. We believe that actual climate-related financial exposure should be our guiding principle for allocating capital, and that we should stop simply focusing on low-carbon companies.

Investors must now make the net-zero trajectory a condition for investment

How do we do that? By understanding companies’ specific transition trajectories and assessing how aligned they are with the goals of the Paris Agreement. Having a granular understanding of how companies are approaching their decarbonisation pathway helps us evaluate the structure of their future cash flows and the likely impact on their valuations. 

We call this Climate Value Impact, or CVI. This approach allows us to deploy capital across all sectors and regions of the global economy without creating real biases and with a clear focus on the actual financial exposure of companies to climate change.

To further optimise the sustainability of our portfolios, we use the Oxford Martin Principles - a rigorous, scientific net-zero framework that helps us decide how we engage with companies:

1

Company sets a net-zero goal.

2

Company outlines plan to remain profitable at net zero.

3

Company sets mid-term target (e.g. 50% reduction in emissions by 2030).

Low carbon strategies that avoid rather than address the problem, the excessive use of carbon offsets and shorting high emitters, will not solve the problem. While these represent some of the common approaches taken by investors today, it is only by investing in reductions in the real economy that the transition can be accelerated and that is where climate opportunities lie.

allocating capital with a net-zero mind-set.

We believe companies that are on a viable pathway to achieve carbon neutrality and manage transition risks will benefit from growth opportunities, premium valuations and cheaper, more plentiful access to capital.

But this doesn't mean we avoid high-emitting sectors.

Given that climate exposure is a reality, our industry does not have a common framework, and there isn’t sufficient pressure from policymakers on the real economy, how do we approach net-zero investing? We, at Lombard Odier, believe we should stop focusing on low CO2e companies and start relying on actual climate-related financial exposure as our guiding principle to allocate capital. To do this, we use the concept of Implied Temperature Rise (ITR) or Temperature Alignment.

We must look beyond a company’s footprint today, and understand its trajectory and alignment to the transition

Although carbon data are widely available, focusing only on low-carbon companies is a flawed approach. This strategy considerably narrows the universe of companies that would be eligible for investment, fails to encourage companies’ real reduction of GHG emissions over time, and does not provide a genuine path towards a global, well-functioning net-zero economy.

Industries such as steel and cement are highly emitting. But we will continue to need these materials. These sectors need to invest in greener manufacturing processes to reduce their emissions. Starving them from capital at this point, isn’t the answer. To support this objective, we use the ITR framework, which enables us to focus on projected rather than current emissions. To do this, we must first determine the different transition pathways (TPW) to net zero for each industry. Then, we have to understand the specific trajectories individual companies are on, taking into account the steps they are already taking to decarbonise as well as the nature and credibility of their targets, commitments, strategies and financing plans. We can quantify all of this using a simple ITR or Temperature Alignment metric, which is more useful than CO2 footprint analysis as it evaluates the emissions of a company today and calculates whether the its emissions are expected to fall in line with sector-specific transition pathways.

Once we understand the direction of a company’s emissions, we can assess the potential financial impact that the transition to a net-zero economy could have on that company. This is the Climate Value Impact. And we’re expanding this to integrate physical and litigation risks. All of this analysis ultimately helps us produce a valuation impact for each company as a result of the transition to a net-zero economy.

We assess companies for our portfolios based on:

1

emissions

2

decarbonisation required

3

company's own trajectory

4

regulatory pressure

But this doesn't mean we avoid high-emitting sectors. For us, what matters is whether or not a company is moving in the right direction - and moving quickly enough.

building net-zero portfolios.

We aim to build portfolios resilient to any shocks as the shift happens and are positioned to benefit from them. 

Therefore, we classify companies into four categories.

Burning logs

Highly exposed companies with an urgent need to decarbonise, yet failing to do so.

Ice cubes

Companies in similarly-exposed sectors, but taking appropriate action and transitioning.

Solution providers

Companies whose products and services help enable the transition across the economy.

Companies insulated from climate risks

These companies may support diversification and other portfolio objectives.

In order to create net-zero aligned portfolios we use a forward looking approach in order to identify Climate Value Impact in a four step process:

  • We begin with an assessment of a portfolio’s carbon exposure, across scope 1, 2 and 3 emissions, recognising that transitional risks may be linked both to a company’s direct as well as indirect emissions.
  • Next, we consider how the portfolio’s emissions are likely to evolve as a result of investees’ decarbonisation strategies, using our proprietary implied temperature rise (ITR) methodology, which assesses alignment of companies to the Paris Agreement.
  • As part of this analysis, we consider a company’s own commitments, as well as exposure to internal, industry and regulatory pressure that may lead a company to accelerate its climate commitments.
  • Finally, we continually review our positions in the portfolio, updating our climate analysis on a monthly basis.

where we are.

Our heritage is Swiss, yet our outlook and mind set are resolutely international. With over 25 offices globally, we are able to serve our clients all over the world.

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1 https://www.lombardodier.com/contents/corporate-news/investment-insights/2021/june/carbon-costs-and-the-g7s-fossil.html
2 World Resources Institute; excludes land use change.
3 https://www.clientearth.org/latest/latest-updates/stories/fossil-fuels-and-climate-change-the-facts/#:~:text=In%202018%2C%2089%25%20of%20global,source%20of%20global%20temperature%20rise.
4 Lombard Odier calculations
https://www.resourcepanel.org/sites/default/files/documents/document/media/unep_252_gro_2019_summary_business_leaders_web.pdf
6 Bill Gates: My green manifesto | Financial Times (ft.com)

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