Aligning portfolios with climate goals: A new approach for financial institutions
Portfolio-alignment tools will help financial institutions chart more scientifically robust, realistic, and profitable climate strategies.
To achieve the goals of the Paris Climate Agreement and restrict further increase in global average temperatures to well below 2°C, human society needs to reach net-zero emissions of long-lived greenhouse gases by midcentury. To keep average global temperatures from rising more than 2°C between now and then, we will have to limit cumulative carbon emissions on the path to net zero to fewer than 1,000 gigatons; to prevent a rise of more than 1.5°C, no more than 400 gigatons can be emitted. Both targets require substantial near-term reductions in emissions levels, which are around 40 gigatons annually. To reach the 1.5°C target, the world must cut present emissions levels by two-thirds over the course of the next decade.
This great transformation will only be possible if we replace, at scale, the global economy’s productive asset base with non emissive technologies. Financial institutions understand that the capital needs for this historic undertaking are enormous. Success in the transition to a net-zero society depends on the ability to keep capital flowing to emissive industries engaged in decarbonizing activities while redirecting funding away from activities that do not support the 1.5°C ambition.
The financial sector consequently needs appropriate tools and metrics to set climate targets and measure progress against them. In cooperation with leading financial institutions, McKinsey joined the Portfolio Alignment Team, set up by Mark Carney in his capacity as the UN special envoy for climate and finance. Our collective purpose has been to enable measurement of the relative alignment of investor and lender portfolios with the objectives of the Paris Agreement. We emphasize that these technical supports are being designed in ways that engage with counterparties and facilitate their transition. Only through engagement, rather than divestment, can we ensure the transition to a 1.5°C future.
The financed-emissions approach and its challenges
Today, the tool most widely used to measure climate impact across the global financial sector is the calculation of financed emissions. The concept of financed emissions is fairly straightforward. It begins when a financial institution invests in, lends to, or insures a company. That company goes on to produce emissions. The financial institution then accounts for a proportional fraction of that company’s emissions in its own carbon footprint. The climate impact of a financial institution can be measured as the sum of the emissions it finances across all the companies in its lending book, investment portfolio, or insurance portfolio.
The financed-emissions calculations are an important and useful tool. The bulk of climate commitments made by financial institutions—now representing nearly $100 trillion in assets under management—is made in terms of financed emissions. Most infrastructure for managing and analyzing climate data produces these metrics.
The use of financed emissions creates three challenges related to the development of effective climate strategies, however. First, by calculating financed emissions, institutions can tell where they are now but not where they need to go. The physical science makes clear that attaining a warming limit of 1.5°C or 2°C is dependent both on achieving net-zero emissions and on limiting the cumulative amount of greenhouse gases we emit en route to the goal. To align with the ambition of the Paris Agreement, the world needs a climate strategy built around a total carbon budget, not only a net-zero target for some point in time.
The second challenge is the complexity of determining portfolio-level carbon. To achieve an effective net-zero transition, we must recognize that different geographies and sectors will need to decarbonize at different rates, based on their different capabilities and needs. Industries in developed economies must reduce emissions more quickly than the global average; financed emissions in portfolios focused on these economies can and should reflect the faster rate of decarbonization. For emerging economies and the portfolios focused on them, the rate will be necessarily slower. Failing to account for these crucial differences can lead to climate strategies that are impossible to carry out or inadequate to slow global warming.
The third challenge for the financed-emissions approach is that this metric would discourage financial institutions from funding decarbonization and the responsible retirement of existing emitting assets. By simply measuring emissions, institutions would be encouraged to avoid large emitters in favour of smaller emitters, taking no account of decarbonizing companies versus nondecarbonizers. Institutions extending financing to a rapidly decarbonizing emitter would raise their financed-emissions levels, negatively affecting their measured climate impact. Thus the approach would constrain the strategic space available, forcing a focus on green growth only while deprioritizing the greening of “brown” assets. Yet right now, the transformation of brown assets into green ones is a problem (and opportunity) at least as large and important as the fostering of new green growth.
The refined approach: Portfolio-alignment tools
In response to these challenges, the Portfolio Alignment Team has worked with leading institutions, method providers, and thinkers across the financial sector to codify a new approach to measuring climate impact: using portfolio-alignment tools. Portfolio-alignment tools are computational models that use forward-looking climate scenarios to estimate the division of the global carbon budget by sector and geography. This allows users to measure emissions performance along a trajectory rather than at points in time; it further permits measurement down to the level of each counterparty in the portfolio.
Portfolio-alignment tools can resolve the three challenges of the financed-emissions approach. First, financed emissions are evaluated in the context of a carbon budget or emissions trajectory. This helps institutions plot their course toward the Paris Agreement’s goals. Second, the carbon budget or trajectory is built as a composite of the trajectories of the portfolio’s constituent companies. The overall trajectory thus reflects a portfolio’s unique sector and geographical composition. This helps reveal whether an institution’s climate strategy is both achievable and sufficient for the collective goal. Third, the trajectory analysis allows financial institutions to differentiate between decarbonizing and nondecarbonizing companies. This frees them to extend decarbonization financing to high emitters—provided that they are achieving necessary climate progress by retrofitting, replacing, or retiring existing assets. To achieve an effective net-zero transition, we must recognize that different geographies and sectors will need to decarbonize at different rates.
To achieve an effective net-zero transition, we must recognize that different geographies and sectors will need to decarbonize at different rates.
Portfolio-alignment tools thus provide much-needed context to financed-emissions metrics. In doing so, they can guide financial institutions in building climate strategies based on science, informed by economic and technological realities, and open to addressing the financing needs of decarbonizing companies.
What the new approach means for financial institutions
Leaders of financial institutions know that this decade is critical for climate action. Portfolio-alignment tools can help facilitate needed changes to existing approaches to climate strategy and to decision-making processes. It is important, then, to begin thinking now about these changes, even though the tools are still very new.
Commitments to cease financing in specific industries could, for example, be reconsidered. Portfolio-alignment tools give financial institutions the freedom to extend financing to heavy emitters, provided that the financing goes toward the responsible retirement or decarbonization of emitting assets and that the decarbonization or retirement is successfully achieved. It is also worthwhile to begin thinking about how to tell the portfolio-alignment story to shareholders, customers, and regulators. The story is complicated but essential, because it reveals a clearer picture of the path we need to take to achieve the goals of the Paris Agreement. Leaders can also begin investing in improving the data environment and technical fidelity needed to support portfolio-alignment tools at scale.
Culled from McKinsey& Company
ABOUT THE AUTHOR(S)
SudeepDoshi is a partner in McKinsey’s New York office, Cindy Levy is a senior partner in the London office, Dickon Pinner is a senior partner in the San Francisco office, Carter Powis is a McKinsey external adviser and an alumnus of the Toronto office, and Dan Stephens is a senior partner in the Washington, DC, office.
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