What is the scale of the problem?
While climate change has taken center-stage in recent years, it can be overwhelming to understand both the magnitude of the challenge that lies ahead of us, as well as the limited time at our disposal to act and transition towards a net-zero economy. According to the Intergovernmental Panel on Climate Change (IPCC), global warming scenarios of 1.5°C and 2°C will both be exceeded during the 21st century unless deep reductions in emissions occur in the coming decades. As shown in Figure 1, the reduction in global emissions will have to be drastic to stay consistent with 1.5°C and 2°C scenarios. To keep the 1.5°C target within reach, the world needs to halve emissions over the next decade to reach net zero emissions by the middle of the century.
What is the current situation?
To assess how companies are currently aligned to these different scenarios, we can use the MSCI Implied Temperature Rise assessment, which provides an indicative temperature alignment for companies which can easily be compared to global warming scenarios depicted in Figure 1. Unfortunately, a substantial portion of listed companies are still misaligned with these goals. According to MSCI[1], and as shown on Figure 2, less than 10% of the MSCI ACWI IMI constituents are aligned with the goal of limiting temperature increase to below 1.5°C, while less than half are aligned with a below 2°C target.
If we break down the implied temperature rise of listed companies by region, Figure 3 indicates that none of the regions are aligned with the Paris Agreement target, and by quite a wide margin. Companies in developed markets are showing lower temperature rise levels compared to emerging markets, but they still fall short of global targets.
MSCI Climate Paris-Aligned indexes aim to be aligned with a 1.5°C scenario by 2030, which can support investors with their net-zero commitments. Thanks to their 10% self-decarbonization trajectory, we can already observe how they are moving towards their target. For example, the implied temperature rise of the MSCI ACWI Climate Paris-Aligned index is equal to 2.12°C, while the MSCI ACWI index exhibits a rise of 2.97°C [2].
The role of corporates in transitioning to a more sustainable future
Corporates will play a significant role in the transition towards a more sustainable economic future as they will have to significantly decarbonize their business operations and products. To help financial-market participants understand, manage, and disclose their exposure to climate risk (physical and transition) and climate opportunities, the Task Force on Climate-related Financial Disclosures (TCFD) recommends that firms enhance their climate disclosures along four dimensions[3]:
- the role of the board of directors in assessing and managing climate risks and opportunities (Governance)
- identifying the types of risks and opportunities posed by climate change (Strategy)
- disclosing firm processes surrounding core risk management steps (Risk Management)
- disclosing climate metrics and targets used to identify climate risks and opportunities (Metrics and Targets)
The MSCI Climate Paris-Aligned indexes are aligned with the recommendations of the TCFD. This is important, as the four dimensions holistically integrate how corporates are assessing the impact of climate change on their businesses, how they are adapting their strategies accordingly and how they manage climate risks / opportunities. Setting emission reduction targets and reporting on emissions is a crucial step for corporates, as we will show in the next section.
The importance of setting emission reduction targets
As corporates decarbonize their business operations and products, one of the key pillars to achieve this goal is linked to how they will be setting their emission reduction targets. One way to assess the credibility of these targets is to leverage the work performed by well-recognized organizations such as the Science Based Targets initiative (SBTi), or from ESG data providers such as MSCI ESG Research.
1) Science Based Targets initiatives (SBTi)[4]
Since the launch of the Science Based Targets initiative (SBTi) and the Paris-Agreement reached in 2015, there has been a surge in corporate climate ambition, with SBTi companies leading the way. Over 1,000 companies spanning 60 countries and over 50 sectors – including one-fifth of the Global Fortune 500 – are working with the SBTi to the transition to a net-zero economy by setting emissions reduction targets grounded in climate science through the SBTi.
Considering data from the SBTi, it is interesting to observe the significant increase in the number of companies committing to 1.5°C and Net-Zero targets. Figure 5 shows how from December 2019 to November 2021 the number of commitments increased from 117 to 1045.
As we can see in Figure 6, there has also been a paradigm shift between companies previously setting 2°C, or well-below 2°C targets from 2015 to 2019, to more recently where we have seen a significant increase in companies setting more stringent 1.5°C targets.
Setting science-based net-zero emission targets
Net-zero emission targets have rapidly moved to the mainstream: in 2019, net-zero pledges covered just 16% of the global economy; by 2021, nearly 70% had committed to net-zero by 2050. Rapid, deep cuts to value-chain emissions are the most effective and scientifically-sound way of limiting global temperature rise to 1.5°C. Most companies will require deep decarbonization of 90-95% to reach net-zero under the SBTi Net-Zero Standard.
2) MSCI ESG Research[5]
To assess emission reduction targets, MSCI ESG Research has developed an analytical framework which breaks down targets by three main dimensions: comprehensiveness, ambition and feasibility.
- Comprehensiveness: The model analyzes whether a target covers all emissions scopes, but more importantly it also looks at the percentage of the company footprint covered by the target.
- Ambition: Understanding the rate at which a corporation is planning to reduce its emissions, as well as the residual emissions by the target end year, is key.
- Feasibility: By looking at a company’s track record in meeting previous targets or their progress on currently active targets, one can gain an understanding of how current targets are likely to be met.
MSCI Climate Paris Aligned indexes support investors by overweighting companies setting credible emissions reductions targets by at least 20% compared to their corresponding parent indexes.
The role of investors in the transition to net-zero emissions
Now that we have highlighted the daunting task of transitioning to net-zero emissions, we can consider the role of investors. According to a McKinsey report, all members of society, including the investment community, will have to contribute to achieve net zero emissions, as they estimate an annual increase of 3.5 trillion USD in physical assets spending will be required. To put this figure in perspective, this 3.5 trillion USD corresponds to about half of global corporate profits, one-quarter of total tax revenue, and 7 percent of household spending.
How can asset owners contribute to this effort and play a role in the transition? As shown in Figure 7, they can increase their exposure to companies with credible net-zero targets, while also engaging with firms to influence them to pivot their business models towards lower carbon emission strategies. In addition, they can divert their capital towards businesses that provide green opportunities while at the same time reducing their exposure to companies exposed to climate risks and stranded assets.
To facilitate this process, the European Commission’s climate benchmarks can support investors to reallocate capital towards a low-carbon and climate resilient economy. The minimum requirements for EU Paris-Aligned benchmarks provide a legal framework which helps legitimize climate solutions. Investors can use this benchmark as an instrument to stay at the forefront of the transition, favoring today the players of tomorrow’s economy.
The MSCI Climate Paris-Aligned indexes not only meet, but exceed the minimum requirements for EU Paris-Aligned Benchmarks. Their methodology integrates a 50% carbon footprint reduction, together with a 10% year-on-year self-decarbonization glidepath, with the aim to achieve a 1.5°C temperature pathway by 2030 and support investors in meeting their net zero commitments. We can already observe that the indexes have achieved their first annual self-decarbonization. In Figure 8, we can see that all exposures have achieved this objective which started in June 2020 with the inclusion of Scope 3 emissions in the index methodology. Interestingly, for broader exposures like ACWI, EM or USA, the indexes have even achieved a higher self-decarbonization.
[1]Source: MSCI. Breaking Down Corporate Net-Zero Climate Target, May 2021. [2] Source: McKinsey Global Institute. What it will cost to get to net-zero. January 2022. [3] Source: MSCI. Index holdings as of 28 February 2022, Climate data as of 03 March 2022. [4] Source: MSCI. FAQ-Understanding MSCI Climate Indexes. November 2021 [5] Source : SBTi website and 2020 Status Report.
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