Net-zero finance? An investor’s guide to a net-zero portfolio

Authored by David Morrow, Director of Research, Institute for Carbon Removal Law and Policy

Prepared for the Institute for Carbon Removal Law and Policy

It’s relatively clear what it would mean for a company like, say, FedEx to achieve net-zero carbon dioxide (CO2) emissions: it means that the company does not emit any more CO2 in a given year than it removes and sequesters in that year. There are some questions, of course, about exactly which emissions to count, but the basic idea is clear.

But what does it mean for banks, pension funds, and other financial institutions to achieve net-zero emissions, as a number of major banks have recently pledged to do? That’s the question that a group called the Institutional Investors Group on Climate Change (IIGCC) set out to answer through its Paris Aligned Investment Initiative (PAII).

Recently, PAII released it Net Zero Investment Framework, which PAII says “is designed to provide a basis on which a broad range of investors can make commitments to achieving net zero emissions and define strategies, measure alignment, and transition portfolios.” The Framework covers a lot of ground, as summarized in the table on page 8, but I want to focus on the role that carbon removal plays in the Framework.

In an appendix on “emissions accounting and offsets,” the Framework says:

As a general principle, investors should not use purchased offsets at the portfolio level to achieve emissions reduction targets. They should also adopt a precautionary approach when assessing assets’ alignment with net zero and the use of offsets. Recognising the finite availability of offsets from land use in particular, and the need to rapidly decarbonise all activities within sectors to the extent possible, investors should not allow the use of external offsets as a significant long-term strategy for achievement of decarbonisation goals by assets in their portfolios, except where there is no technologically or financially viable solution. The PAII will undertake further analysis in Phase II to assess the appropriate use of offsetting in specific sectors. Credits purchased by participants within regulated carbon markets that are designed to meet the net zero emissions goal can be used. 

Decarbonisation and avoided emissions should generally be treated separately. Similarly, investors should not offset emissions in one part of their portfolio through accounting for avoided emissions in another part. Given the necessity of effectively reaching zero emissions from investments over time, trading these two against each other is not consistent with creating incentives for investors and underlying assets to maximise their efforts to decarbonise their portfolios to the full extent possible.

There’s also a relevant line in the Framework’s “Paris Aligned Investment Initiative Net Zero Asset Owner Commitment” in Appendix C. Investors undertaking the commitment pledge to do a number of things, including:

Where offsets are necessary [because] there are no technologically and/or financially viable alternatives to eliminate emissions, investing in long-term carbon removals.

Overall, this seems like a sound approach that rightly prioritizes cutting emissions. Basically, it says that investors should avoid using offsets “except where there is no technologically or financially viable” way to cut emissions, and that they should not use avoided emissions as offsets. In other words, the Framework seems to be advising investors to view carbon removal as a last resort when decarbonization isn’t feasible, to prefer “long-term carbon removals” when offsetting is necessary, and to avoid investing in carbon removal themselves as a way to offset emissions from the companies they’ve invested in.

One thing to note is that the appendix text here doesn’t explicitly mention carbon removal, but it seems to use “offsets” to refer only to carbon removal, and not to avoided emissions. “Avoided emissions” are emissions that would have happened if someone hadn’t intervened by, for example, buying electric heat pumps for someone else to replace their gas-fired furnace. That sort of action isn’t carbon removal because it doesn’t physically remove carbon dioxide from the air; it only reduces the amount of carbon dioxide going into the air. The term “offsets” has sometimes been used to include both avoided emissions and actual carbon removal, so it would be helpful for the next iteration of the framework to clarify what they mean by “offset.”

With that distinction in mind, let’s break this down point by point:

    1. “Investors should not use purchased offsets at the portfolio level to achieve emissions reduction targets.” What does this mean? Suppose a pension fund invests in a retail company, and the retail company emits more CO2 than it removes. This principle is saying that, as a general rule, the pension fund should not buy offsets to counterbalance the emissions from the retail company. This is an interesting approach in that it puts the burden on the companies themselves, rather than the investors, to clean up their own emissions. If this were widely implemented, it would mean that companies looking for investors would have a strong incentive to achieve net-zero or even net-negative emissions.
    2. Investors “should also adopt a precautionary approach when assessing assets’ alignment with net zero and the use of offsets.” This is saying that investors should also be cautious when the companies they invest in say they are going to use offsets to reach net-zero emissions. Exactly what a “precautionary approach” looks like in this case isn’t spelled out, but at the very least, it means scrutinizing companies’ claims about offsets. Are their offsets actually removing as much carbon from the atmosphere as the companies claim? How permanently is the carbon sequestered?
    3. “Recognising the finite availability of offsets from land use in particular, and the need to rapidly decarbonise all activities within sectors to the extent possible, investors should not allow the use of external offsets as a significant long-term strategy for achievement of decarbonisation goals by assets in their portfolios, except where there is no technologically or financially viable solution.” In other words, don’t let companies rely on offsets as a big part of their long-term net-zero strategies, except when there is no “technologically or financially viable” alternative. The phrase “financially viable” leaves some wiggle room, but hopefully it will be spelled out in more detail through the “further analysis” the PAII is promising.  
    4. “Credits purchased by participants within regulated carbon markets that are designed to meet the net zero emissions goal can be used.” The charitable reading here is that investors should avoid wildcat offsetters who operate outside of well-regulated carbon markets, but “regulated carbon  markets” aren’t necessarily well regulated, so there’s work to be done here.
    5. “Decarbonisation and avoided emissions should generally be treated separately. Similarly, investors should not offset emissions in one part of their portfolio through accounting for avoided emissions in another part.” For example, if a bank is investing in a coal company and a wind energy company, it shouldn’t count the emissions avoided by the wind energy company as offsetting the emissions from the coal company. In other words, don’t do what financier Mark Carney tried to do recently.

As the Framework acknowledges, there’s a lot of work to be done to clarify the approach to offsetting and carbon removal, including how to determine whether cutting emissions is “financially viable,” what counts as a “regulated carbon market,” and how to determine whether a particular approach or project offers “long-term carbon removal.” The fundamental approach, though, rightly prioritizes cutting emissions and rightly emphasizes long-term carbon removal over avoided emissions in cases where offsetting is the only way to get to net-zero.

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