The Net Zero Investment Framework (NZIF) arguably put it best with its contention that, if responsible investors want to be of any consequence, their climate strategies should focus on “financing reduced emissions” rather than “reducing financed emissions”. In other words, by financing issuers that are on a robust decarbonisation path, investors can contribute to reducing both real-world greenhouse gas (GHG) emissions and climate-related systemic risks, while removing constraints on their investment universe and, hopefully, improving expected returns.

To do so, investors must assess the credibility of climate transition plans. This need has become widely acknowledged, to the point where assessment requirements are being included in sustainable finance regulation (beyond disclosure requirements), banking supervision, and labels.  

Despite this consensus, evidence of systematic forward-looking assessments of issuers’ climate transition plans remains scarce. Many investors are tracking the share of companies with validated targets from the Science Based Targets initiative (SBTi), which is good, but far from sufficient. To paraphrase Nobel Prize-winning economist Robert Solow, transition plans are everywhere but in statistics. 


Why aren’t more investors shifting their strategies?

First, net-zero alliances and climate frameworks such as the Net Zero Asset Owner Alliance have historically focused on reducing financed emissions, sometimes setting very rigorous and steady decarbonisation pathways to follow. However, tilting portfolios away from carbon-intensive assets and towards companies that are net-zero aligned results in so-called paper decarbonisation.

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Second, investors’ climate strategies were largely influenced by the tools and metrics available — mainly carbon footprinting and implied temperature rise — which are backwards-looking.

Third, the strength of inertia cannot be underestimated. Adapting a strategy takes time, especially when investors have put a lot of resources and effort into integrating GHG measurement and reporting tools, setting targets, building financial products, agreeing on mandates, etc., all of which are often based on portfolio decarbonisation and existing frameworks and tools.

Hurdles to assessing climate transition plans

Another possible explanation for the lack of transition plan assessments relates to the challenges of adopting a new analytical framework. Conducting assessments of climate transition plans at scale requires specialised knowledge, time, and resources, which investors may lack.

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Additionally, labels and frameworks do not always provide enough clarity on what should be assessed. For instance, the Net Zero Banking Alliance (NZBA) Guidance for Climate Target Setting only states:“Banks should disclose how they will evaluate their clients’ transition plans.” The German FNG Transition label formulates a tautology: transition investments can be investments in “companies with a credible transition plan”.

Even when clarity is given, investors then need to identify which key performance indicators (KPIs) match the various frameworks. This is where  data providers can help, if they offer a robust and transparent methodology. 

What’s more, investors are navigating a sea of diverging guidance, reporting frameworks, assessment tools, and labels. In 2023, the World Wide Fund for Nature (WWF) counted no less than 28 frameworks, and the number has since grown.

Many financial market participants are challenged by the fact that these frameworks are not aligned. They diverge with respect to assessment items and granularity. This misalignment can hinder reporting by companies and analysis of transition plans by investors.

Better alignment among assessment methods is of particular relevance to investors wanting to finance reduced emissions. For instance, the NZIF 2.0 refers to the Transition Pathway Initiative as a possible data source, and the latter provides a mapping between its management quality indicators and the NZIF recommendations.

More broadly, investors can focus on six assessment items which can be used with most climate frameworks, according to the World Benchmarking Alliance.

These six assessment items are aligned with the six “universal factors” that are recommended to assess the credibility of transition plans, according to the draft Transition Finance

Guidelines published by the UK Transition Finance Council. These universal factors are engagement, disclosure, governance, financial viability, implementation, and interim targets and metrics.
 
How investors can act now

Morningstar Sustainalytics’ Low Carbon Transition Ratings (LCTR) provide 85 risk management indicators, which are aligned with the aforementioned frameworks, and can be used to accommodate investor preferences and serve a variety of needs. These needs can be classified into four broad categories:

Meeting the demands of a given framework or label: In this case, investors need to ensure alignment with a specific framework they have committed to, such as the French SRI label or the NZIF 2.0. A growing number of asset managers are actually setting targets based on NZIF portfolio alignment, and could use, to that end, the NZIF solution developed by Morningstar Sustainalytics.

Feeding a proprietary ESG tool: Investors may want to enhance their own in-house ESG tool by incorporating data that addresses issuers’ ability to decarbonise over the long term and manage climate-related transition risks. An example of this is Lombard Odier’s sustainable investment framework, which assesses, among other things, the existence of a “clearly articulated and ambitious transition strategy to sustainable activities”.

Creating a proprietary and dedicated climate transition assessment: Some investors have developed or need to build in-house tools focused on the assessment of issuers’ climate transition readiness. For instance, Spanish bank BBVA has developed a transition risk indicator that assesses exposure to transition risks, ambition, and credibility of transition plans, while Dutch Bank ING is using its own “client transition plan” score.

Informing specific activities, such as banking advisory, research, and stewardship: These activities require granular data to identify on which specific items a discussion could be held. Alliance Bernstein, for instance, has developed a new framework that broadens the scope of risk called ESD, which stands for “Emerging, Strategic, and Disruptive”. In the automotive industry, those risks include, among others, carbon pricing mechanisms.

Conclusion

The need to carry out forward-looking assessments of climate transition plans, moving beyond analysing commitments, is undeniable. It makes economic sense for investors, is recommended by international organisations and standards, and is making its way into regulation and supervision.

By leveraging transition risk and management data, such as Sustainalytics’ Low Carbon Transition Ratings, investors can build and use a proprietary assessment tool that is aligned with leading climate transition frameworks and labels, while retaining enough flexibility to accommodate the specificities of each investor. 

Adrien Poisson is senior associate, client relations, client advisory at Morningstar Sustainalytics