Decarbonising the 7IM Strategic Asset Allocations
The key goal of the 2015 Paris Climate Agreement is that global warming should be limited to 1.5 degrees Celsius, via global greenhouse gas emissions being greatly reduced and cut to zero around mid-century.
The UK has set a net-zero target by 2050, and domestic businesses like 7IM will be encouraged to support the transition to a low-carbon economy.
In 2020, 7IM’s Executive Committee agreed to a programme by which the carbon emissions of the Strategic Asset Allocations (SAAs) of all portfolios will be steered down over time. We aim to reduce emissions by 30% at the SAA level over the next five years (by mid-2026) and are working on a programme to lower them further after that.
The SAA is the long-term mix of assets that is the cornerstone of our portfolios and is the most consistent performing and longest-horizon element in our investment process. The SAA process is run and reviewed every year to ensure that it remains sound. Integrating ESG into our SAA research was one of our crucial projects in 2020-21. We have developed a framework that shows the ESG exposures/risk our SAAs are exposed to, particularly carbon risk.
When measuring carbon in the SAA, we have focused on Scope 1 and 2 emissions, as recommended by the Task Force on Climate-related Financial Disclosures (TCFD). While Scope 3 emissions are broader, covering all indirect emissions in a company’s value chain, measuring them is still in its infancy and questions remain regarding disclosure, incomplete reporting and data quality.
We use Weighted Average Carbon Intensity to measure carbon emissions. This is the most effective metric for comparing different multi-asset portfolios and, again, comes recommended by the TCFD. In 2020, the carbon intensity of our Balanced SAA was 162 tons equivalent per million dollars of sales (tCO2E/$M Sales), which was broadly in line with those competitors for which carbon intensity data are available.
There is a natural long-term alignment of time horizons between ESG issues and a SAA, as in our first investment belief from earlier.
This makes the SAA a logical starting point for any ESG-aware investment framework. By focusing on the SAA, any changes that come about through ESG integration will flow through to all our portfolios.
We began by gathering and storing in our quantitative infrastructure the key ESG metrics of interest for all asset classes in our SAAs, focusing on carbon emissions in 2020. We could then combine these with our quantitative-based SAA processes to explore how we could adjust portfolios to reflect our views on carbon reduction and broader ESG factors. Extensive quantitative simulations indicated that the emissions-intensity of our SAAs could be significantly reduced at modest risk, i.e. without letting final portfolios diverge too much from starting portfolios.
Two recommendations followed from this work. The first was a switch from traditional market-cap weighted indices into ESG-screened benchmarks where liquidity, product availability and data availability allow it. The second was a potential reallocation within the credit component of SAAs from emerging market debt into global high yield debt. This research project is ongoing, and its results will be incorporated into our SAA revision in mid-2021.
ESG-screened and low carbon products and derivatives are becoming available in many markets. Thus far, though, they tend to be illiquid and expensive to trade. As these products develop and costs fall, we expect to use them more and more across our portfolios, and they will assist in our drive to decarbonise the SAAs further in years to come.
We are keenly aware of the need to support the transition to a low-carbon economy, and as part of our stewardship commitment we support the UK government's drive to achieve carbon neutrality by 2050. We are researching ways of decarbonising our SAAs to and beyond 2026, which we expect to report on in future stewardship reports. We will also investigate investment opportunities that will support a more sustainable global economy, e.g. in clean energy, electrification and ways of using resources more efficiently, like better heating/cooling systems and recycling.