Navigating the path to net zero for charity investors
Net zero refers to the balance between the amount of greenhouse gases produced and the amount removed from the atmosphere. Achieving net zero emissions is vital for mitigating climate change and its adverse effects, which include extreme weather events, rising sea levels, and disruption to ecosystems and communities worldwide. The urgency to address climate change has never been more pronounced, with scientific evidence pointing to the dire consequences of inaction.
But why should charities be investing in net zero? There are several reasons:
ENSURING FINANCIAL RESILIENCE.
With climate change posing risks to investments across portfolios, it's crucial for charities to review their investment strategy and adopt sustainable practices. Beyond this, opportunities from the shift to a low carbon economy, such as renewable energy and green technologies, offer avenues for potential growth and value creation within charity portfolios.RESPONDING TO STAKEHOLDER EXPECTATIONS. Events like COP-28 and the World Economic Forum in Davos highlight charities' role in financing complex climate investments and the need for diverse investors with varying risk profiles. Moreover, there is increasing pressure from stakeholders, including donors, who are increasingly aware of climate-related risks.
ADAPTING TO REGULATORY CHANGES. The current regulatory landscape highlights the growing expectation for charities to integrate climate considerations into governance, risk management and reporting practices. Mandates such as the Streamlined Energy and Carbon Reporting (SECR) require larger charities to enhance transparency and accountability in energy and carbon reporting.
Considering these challenges and the dynamic nature of the current environment, the focus should be not on whether charities should invest in achieving net zero emissions, but rather on how they can do so effectively and strategically. For the scope of this discussion, I have refrained from delving into the connections between climate issues and other sustainability themes, such as biodiversity. Nonetheless, it's important to recognise that these interrelations play a pivotal role in comprehending the enduring viability of sustainable investment strategies.
Net zero investment framework
Transitioning to or developing a robust net zero investment strategy can be challenging due to several factors. Notably, these strategies are relatively nascent, meaning there's a lack of established best practice and historical data to guide decision-making.
So as a help for charities navigating this new terrain, they might consider an investment framework that incorporates three key themes. While each approach has its merits, the convergence of these build the right foundational for financial outcomes while maximising impact. The three themes are:
1. PORTFOLIO INTEGRITY. The portfolio integrity approach centres on charities' investment ambition to generate sustainable, long term income for charitable purposes, in other words, generating market-rate returns rather than philanthropic investment. This approach prioritises the construction of diversified portfolios, balancing risk, return and liquidity in line with a charity’s objectives.
2. PORTFOLIO DECARBONISATION. Portfolio decarbonisation entails the conventional practice of transitioning portfolios towards a lower carbon footprint. This can be achieved by prioritising companies with robust transition plans, reallocating investments towards lower carbon alternatives or divesting from high carbon entities (notably those in the fossil fuels sector). The primary objective of this strategy is to mitigate financial risks associated with climate change, including but not limited to regulatory penalties, carbon levies, stranded assets and evolving consumer trends.
3. REAL WORLD TRANSITION. Unlike a focus on portfolio decarbonisation, the real world transition approach includes investment in proven and cost efficient transition technologies (e.g. renewables), disruptive technologies (e.g. carbon capture) and high carbon industries with the goal of actively engaging them in the decarbonisation process. While this approach is primarily recognised for its impact profile, it also offers substantial potential for financial returns. Additionally, investments in emerging markets and private market solutions amplify the potential of real world impact.
Own strategies and priorities
Charities may prioritise an approach based on their organisational strategy and priorities. For instance, an impact-driven charity might prioritise real world decarbonisation, whilst a smaller charity with lower risk and liquidity tolerances may favour portfolio decarbonisation.
While the importance of maintaining flexibility to accommodate the diverse and unique situation of every charity has to be acknowledged, the best financial and impact outcomes must surely arise from integrating all three approaches. Solely focusing on portfolio decarbonisation could inadvertently transfer responsibility to less climate-conscious investors and lead to “just transition” issues.
For instance, the unintended social impact stemming from unemployment, related to divesting from fossil fuel plants. Conversely, while real world decarbonisation prioritises impact, pursuing it in isolation risks encountering stranded assets and reputational risks. Similarly, independently pursuing portfolio integrity may fail to address the climate challenges we face, leading to sub optimal outcomes.
Net zero investment journey
Once charities have gained insight into the most suitable approach as discussed in the framework above, they would be well positioned to embark on their net zero investment journey.
By following these steps, charities can effectively implement net zero investment strategies while ensuring alignment with their financial and societal goals. So in detail here are the three steps:
STEP 1. NET ZERO TARGETING. This initial phase necessitates aligning the investment framework with the charity's strategic objectives. This involves setting science-based emissions reduction targets in line with the Paris Agreement, assessing emissions across different asset classes, and ensuring targets are measurable for effective monitoring and evaluation. For example, targets may include a 50% reduction in Scope 1 and 2 emissions for equity assets by 2030, a 30% decrease in carbon intensity per dollar invested for credit assets by 2030 and achieving net zero carbon emissions for real assets by 2050.
STEP 2. CAPITAL REPURPOSING. At this stage, the focus should shift towards strategically reallocating capital to investments that facilitate the transition to a low carbon economy.
Investment opportunities would span equity, credit, real assets and natural capital. Repurposing capital towards achieving net zero goals doesn't require compromising on the quality of asset allocation or portfolio resilience. Instead, it offers a comparable profile of return options and diversification across an evolving spectrum of asset classes. This means that charity investors can still pursue their financial objectives while aligning their investments with sustainability targets.
STEP 3. MONITORING, REPORTING AND ENGAGEMENT. This stage involves ongoing monitoring of progress towards net zero targets and active engagement with asset managers. This step is crucial to ensure continual alignment of the investment strategy against set sustainability objectives.
Most charities lack the resources and governance bandwidth to engage directly with investee companies, and they will expect their asset managers to do this for them. But charities will need to adopt certain approaches towards their asset managers. Such as:
ENHANCED DUE DILIGENCE IN MANAGER SELECTION. Charities should conduct thorough due diligence on a managers’ stewardship polices and processes when choosing asset managers, ensuring their stewardship activities drive robust net zero targets in line with their own.
CLEAR COMMUNICATION OF EXPECTATIONS. Charities should explicitly communicate their net zero expectations to asset managers, emphasising the integration of climate considerations into investment decisions. It's important to clearly outline expectations for responsible management, including reporting openly on environmental, social and governance (ESG) factors, and using voting rights to support sustainability goals.
ESTABLISHMENT OF MONITORING GOVERNANCE SYSTEMS. Charities can establish governance frameworks to oversee managers' adherence to both aligning the entire portfolio with net zero objectives and monitor their performance against predetermined targets. This entails reporting on Task Force on Climate-Related Financial Disclosure (TCFD) metrics, holding ESG priorities’ sessions, conducting periodic assessments of investment strategies, and introducing incentives linked to sustainable outcomes and stewardship practice
Addressing climate change
Charities are increasingly adopting net zero investments to address climate change and ensure financial resiliency. This shift responds to evolving risks, regulatory expectations and opportunities for impactful investments. If charities adopt the framework and investment journey outlined in this article and they should be able to effectively pursue net zero while supporting their financial and societal objectives.
