Climate alignment is a metric derived from mathematical models that can be used to define whether a company or a portfolio of assets is aligned with a trajectory to limit the rise in global temperature (to 2°C or 1.5°C, for example) within a defined timeframe.
The degree of alignment can be expressed :
Alignment-climate is a metric that forms part of a forward-looking approach, which involves projecting one or more scenarios over a time horizon.
This metric :
Numerous regulatory initiatives aim to promote (i) transparency, (ii) responsibility and (iii) the alignment of investments with a low-carbon trajectory. These include the European Taxonomy, SFDR, Article 29 of the LEC, MiFID II and DDA ESG, and the AMF Doctrine. The latter entail risks for financial players: backtracking, legal issues or marginalization of the offer.
Measuring the Climate Alignment of portfolios helps mitigate these compliance risks, particularly those associated with the SFDR regulation and Article 29 LEC. Since July 2022, the latter requires asset management companies to communicate on the alignment of their investment strategy with greenhouse gas mitigation objectives, based on 2 objectives:
The climate alignment metric includes all the above information in its methodology. In this way, you can turn this regulatory context into a differentiating force in your strategy!
The regulatory requirements of Article 29 LEC and the complexity of alignment-climate methodologies pose major challenges for financial players:
The degree of data quality control must be proportional to the use made of it!
1. Understanding: make the metric your own and use it as a relevant indicator in investment decisions
2. Stability and data: select an indicator based on a robust methodology to build a coherent and ambitious sustainable investment strategy
3. Regulations : meet all regulatory requirements to limit the risk of non-compliance in a context of rapid regulatory change
4. Transparency : build a transparent and comprehensible sustainable investment strategy that limits the black box effect
Be able to explain the metric to the end investor
While the definition of a common methodological framework is necessary, in reality there are as many possible approaches as there are combinations of these assumptions and methodological choices.
The key to an ambitious, holistic and differentiating investment strategy is to leverage complementary solutions to extract key insights and spot weak signals!
In short, you need to follow 3 steps to get there:
1. Clearly and transparently define the methodological framework and technical choices
The definition of the methodological framework refers to all technical choices of indicators, scenarios and the conversion of these scenarios into benchmark trajectories.
Strategic and methodological choices to be made :
2. Data to measure the climate performance of its assets and, by aggregation, of its portfolios
The methodological framework defined above is then used to determine a company's climate alignment by comparing its future performance with a benchmark.
Strategic and methodological choices to be made :
3. Set quantitative alignment objectives and develop tools to manage and report on "alignment-climate" metrics.
To obtain the portfolio's climate alignment, we need to determine the alignment of all issuers and aggregate the results at portfolio level.
Strategic and methodological choices to be made :
The above solutions have been put in place to help players cope with the methodological limitations encountered in measuring their climate alignment.
However, according to Luc Olivier of LFDE, this metric cannot be the only impact measure used:
"The calculation of this metric remains an imperfect model. Indeed, it is based on a large number of assumptions, the calculation methodology of which varies according to the provider chosen. We therefore believe that this indicator cannot guarantee a fund's impact, and should be used as a complement to other strategies, in particular through the implementation of a strong and ongoing shareholder commitment." Luc Olivier, manager of Echiquier Climate Impact Europe at La Financière de l'Echiquier.
The main weakness of portfolio climate alignment methods is the lack of data. Data availability and quality vary from company to company and from sector to sector. It is therefore common to be confronted with missing or poor-quality data for a number of reasons:
Points of attention for regulators:
- Take scope 1, 2 and 3 into account when calculating the alignment metric
- Be able to recalculate portfolio alignment once a year
- Source of data and portfolio coverage
- Reliability of data
- Management of missing data
1. Exclusion: it is advisable to exclude sectors or companies with too much missing data , as this can lead to an alignment result that is biased and out of touch with reality.
2. Penalize sectors or companies with too much missing data, for example, by assigning them a default score.
3. Start a dialogue with these companies.
4.implement data control :
5. Indicate the portfolio hedging ratio.
6. Indicate if and how data is estimated.
However, data is not the only limitation associated with this metric. Indeed, Axa IM's Yolande Poulou explains the complexity of calculating this climate alignment:
"Several limitations exist in the methodology for calculating a company's alignment. On the one hand, there is a lack of sector granularity in relation to decarbonization, resulting in a model that is even more approximate than it was. Secondly, there is a lack of qualitative analysis of the targets and commitments announced by a company. Indeed, each company should be analyzed to ensure that its carbon reduction target is realistic and in line with its sector of activity. Finally, data quality remains a considerable limitation in the calculation of this metric, but this may improve with the SFDR regulation. " Head of Responsible Investment Tools, Models & Solutions at Axa IM
For further details, please consult the appendices.
