Usefulness of the article: This article focuses on the commitment made by the world’s major financial institutions to align their investment portfolios with a +1.5°C trajectory[1]. It aims to provide an initial understanding of the potential consequences of this commitment, its potential for effective implementation, and its impact on investment culture, tools, and finance professions.
Summary :
- Ahead of COP26 in Glasgow in 2021, a coalition of hundreds of financial institutions from around the world has been created: the Glasgow Financial Alliance for Net Zero. It brings its members together around a shared commitment to achieve net-zero greenhouse gas (GHG) emissions by 2050.
- This target corresponds to a global warming trajectory of +1.5°C. It is therefore ambitious, in line with the Paris Agreement, and would amount to a structural transformation of the financial industry, the scale of which may not be fully appreciated today by the players involved. However, in a global context of highly carbon-intensive economies, these investment portfolios are currently just as carbon-intensive.
- Three essential elements of this transformation are: 1. a paradigm shift in investment, currently focused on the risk/return ratio, which is set to change; 2. the adaptation of tools and models to a very long-term climate objective; and 3. the human dimension, through significant changes in the finance industry.
The implementation of the Paris Agreement involves limiting the rise in global average temperature to well below +2°C above pre-industrial levels by 2100 and continuing efforts to limit this increase to 1.5°C over the same period[2]. By establishing the common goal of limiting global warming to +1.5°C and +2°C, the Paris Agreement has led to the global spread of the concept of « global warming trajectory. »
In the period that followed, the bodies responsible for setting standards and regulations gradually incorporated this concept into regulations and market practices[3]. Investors were particularly affected by these developments. For example, many of them are now required to disclose their portfolio alignment strategy with the Paris Agreement objectives, particularly under European[4] and French[5] regulations. The majority of the world’s major financial institutions have also committed to achieving net-zero greenhouse gas (GHG) emissions by 2050.
One conclusion to be drawn from the commitments made by states under the Paris Agreement is the significant difference between committing to a target to be achieved by the end of the century and actually fulfilling that commitment in operational terms. In fact, in October 2022, the United Nations (UN) estimated that all the actions and programs implemented by the signatory states to the Agreement to date (the « nationally determined contributions ») would lead the global economy to a 2.5°C rise in temperature by 2100. However, the established goal of net-zero emissions by 2050 corresponds to a warming of 1.5°C over the same period[7].
In this context, have financial institutions measured the scale of their commitment? While we can see today that the States, which have been committed since 2015, are still struggling to bring the global economy’s trajectory closer to the 2°C global warming threshold for 2100?
1. The commitment of financial institutions
1.1. The Glasgow Financial Alliance for Net Zero (GFANZ)
In 2021, ahead of COP26 in Glasgow, major financial institutions announced measures to redirect their investments and capital towards achieving net-zero emissions by 2050. Together, they form a coalition—the Glasgow Financial Alliance for Net Zero(GFANZ)—which brings together financial institutions representing a large proportion of the world’s financial assets.
While the coalition had 160 members when it was formed, the latest GFANZ progress report indicatesthat it had more than 550 members by the end of 2022. Among these members are 291 management companies managing USD 66 trillion, including major French companies such as Amundi, AXA IM, and BNP AM. In the same document, the progress made and reported by the coalition focuses on the number of members that have implemented « science-based » 1.5°C targets and scenarios[8]. By November 2022, 310 GFANZ member institutions had adopted such targets (GFANZ, 2022).
These targets are validated by the Science-Based Target initiative(SBTi), which assesses the GHG emissions reduction plan and verifies its ambition to ensure it is aligned with a 1.5°C warming scenario. For GFANZ and SBTi, a company aligned with a 1.5°C trajectory is one that has committed to this trajectory and has communicated a plan deemed relevant to achieving this goal. These commitments are listed on the SBTi website, but the operational approach for meeting these commitments is not publicly disclosed.
In a context where the global economy is heading towards a 2.5°C rise in temperature if all the commitments made by the signatory countries to the Paris Agreement are met, it seems relevant today to question the realism of the commitments made by these financial institutions and to pay more specific attention to the practical implementation of projects that enable a concrete reduction in GHG emissions.
1.2. The impact of financial actors on the real economy
It is first relevant to analyze the commitments made by GFANZ signatories in light of the overall impact of the financial sector on the real economy, distinguishing in particular between the impact of the primary market and that of the secondary market. In these markets, financial institutions, particularly banks, provide the necessary means for companies to invest and grow. It seems logical that these activities should contribute directly to financing companies’ adaptation to climate change. Secondary markets[10] have a less established impact on the real economy and therefore play a less direct role in the transition.
This topic is addressed in depth in a study by I4CE[11] (I4CE, 2022), which highlights a significant paradox: the players most involved and active in secondary finance are also those most committed to « responsible finance, » managing considerable amounts of capital, even though their potential impact is relatively limited. In September 2022, the CDP[12] reported that 27% of GFANZ managers and investors had set an emissions reduction target, compared to 6% of banking institutions (CDP, 2022).
The conclusion of the I4CE study is that investors alone cannot influence the trajectory of the global economy in terms of GHG emissions, as they face significant structural barriers that limit their ability to produce effective results. For this specialized research institute, public authorities play an essential role in guiding private finance towards achieving climate goals.
2. A conceptual paradigm shift
Furthermore, through their commitment, financial institutions are taking on a new role. Until now, this role consisted of financing the economy by analyzing the financial health of its players and investing in the economy by analyzing the financial performance of these players. This was done through a two-dimensional risk/return analysis. Committing to the climate trajectory of their various financing and investment portfolios now means that financial institutions must focus on a third dimension. This is in addition to the historical analysis prism, including in academic financial literature.
In this context, an investment must also include a climate dimension. This contributes positively or negatively to the climate trajectory of the portfolio and therefore of the financial institution that manages it. This third dimension is all the more important given that the financial institutions managing the investment have committed to an ambitious trajectory.
However, the current paradigm for financial management and investment within these institutions is the result of a vast academic literature that has greatly contributed to the creation and functioning of financial markets as we know them.
The commitment of the largest financial institutions to limit their GHG emissions will necessarily influence their decision-making, and it seems logical to also question the possibility for these financial institutions to change this paradigm, which is rooted in decades of economic and financial theory.
3. Tools and models still under development
Such a commitment leads us to understand the extent to which the tools and analytical frameworks used by financial institutions will be able to adapt. At the heart of this issue, the subject of measuring portfolio trajectories is also essential. What does it mean, in operational terms, to align investment portfolios with a 1.5°C trajectory?
A closer look at the more technical aspects of this issue quickly reveals that there is currently little consensus on the methods used by stakeholders to assess the trajectory of their portfolios:
- The first step in the methodologies used is to define the scope of companies’ current GHG emissions, but approaches differ on this point.
- The second step is to estimate the GHG emissions that companies are likely to produce in the future. Methodologies vary depending on the data used and the economic, technological, political, and environmental factors that may influence these emissions.
- Finally, once the trajectory of each company has been calculated, these trajectories must be aggregated to obtain the portfolio trajectory, according to one of the various market approaches[15].
The various financial institutions involved have committed to achieving a net-zero target even before there is a consensus (both in terms of regulations and market practices and their theoretical foundations) on how to specifically measure the trajectory of their investment portfolios. The fact that such a consensus does not exist is problematic. Indeed, in such a vast and complex methodological universe, institutions can still use the approaches that are most favorable to them: those that allow them to calculate trajectories that achieve global warming targets that are overly optimistic compared to the reality of their portfolio. There are several reasons for this « choice, » ranging from reputation risk management to contractual transparency with clients who require targets that are in line with their investment objectives, or even to facilitate financial advice.
Furthermore, most of the tools, models, and modeling frameworks used today simply rely on companies’ commitments to calculate portfolio trajectories. In order to validate the relevance of these tools and models, it is essential to have a clear, transparent, and commonly accepted methodological measurement framework at the market level. This is the case for the various methods used to value assets and project companies’ financial performance. The presence of reliable institutions that can subsequently approve the portfolio trajectories resulting from these tools would also help to confirm their validity.
4. The evolution of the investor’s profession and expertise
4.1. Integrating climate risk into investors’ fiduciary responsibility
Through their climate commitments, the world’s major investors have helped launch an important debate on the integration of climate risk and sustainability management into their fiduciary responsibility. Investor fiduciary responsibility is a fundamental concept in finance, which states that investors must act in the best interests of their clients and make investment decisions objectively and impartially. This fiduciary responsibility applies to institutional investors, such as pension funds and insurance companies, as well as management companies that manage assets on behalf of third parties.
In 2015, the United Nations Finance Initiative published a report on the fiduciary duty of investors in the 21st century. This report led to the launch of a project aimed at clarifying the fiduciary obligations and duties of investors with regard to the incorporation of ESG issues—including environmental and climate issues—into investment practice and decision-making (UN, 2015). According to the UN, the findings of this project in 2019 provide considerable evidence of the critical importance of incorporating ESG and climate standards into regulatory conceptions of fiduciary duty. According to the United Nations, investors who do not take ESG and climate issues into account are not fulfilling their fiduciary duty and are increasingly likely to face legal action (UN, 2019).
This approach is currently being challenged in the United States, where, in August 2022, nineteen Republican attorneys general published a letter accusingthe investment company BlackRock of prioritizing « climate activism » over its fiduciary duty to their state pension funds[17]. Three of the largest US banks, JP Morgan, Morgan Stanley, and Bank of America, subsequently threatened to leave GFANZ because of the perceived strictness of the alliance’s recommendations, exposing them to the risk of legal action[18]. This is the crux of the issue surrounding the implementation of fiduciary duty in the United States, which requires acting exclusively in the interests of clients and exercising caution in investment policy in order to protect the long-term value of those investments. Since the Freshfields » report (2005), which stated that fiduciary duty did not limit the integration of ESG factors, US case law has often evolved, leading to key discussions (see here, President Joe Biden’s veto of the Department of Labor rule in March 2023), including on enforcement, given the significant legal risks in the US legal context.
While it is still difficult to determine whether US financial institutions will fully integrate the concept of sustainability into their fiduciary responsibility, the outcome of this debate is likely to have a significant impact on the investment profession for years to come. In the European Union, the integration of sustainability concepts into fiduciary responsibility is an integral part of the European Commission’s action plan for financing sustainable growth[19], although it does not apply to asset holders such as pension funds, as in the United States, but to asset managers[20].
4.2. The human impact of changes in the finance industry
The profession and expertise of investors have evolved despite this debate, as they gradually integrate sustainability and climate change into their investment decisions. Another essential aspect of financial institutions achieving net zero targets relates to the human dimension of this evolution. Financial institutions have committed their names and reputations to achieving this goal, but it is individuals who will be responsible for adapting their professions to this new strategic ambition. How will these individuals adapt, and how can these institutions frame this transformation?
Take, for example, an asset manager who must continue to be competitive in their market and offer profitable investments based on their client’s desired risk profile. They must also evolve their investment portfolio to align with a net-zero target. A key question is: are we expecting this manager to maintain the same level of financial performance even though they must also demonstrate a form of sustainable and climate performance, in a context where the link between ESG and climate performance and financial performance is not obvious and where different climate strategies[21] are available?
The literature on the relationship between ESG performance and financial performance has not reached a clear consensus, although in most cases it indicates a relationship that is more positive than neutral or negative (Fried et al. 2015, Whelan et al. 2021). Furthermore, to ensure positive ESG or climate performance, an investor can use seven investment approaches, which lead to different expectations in terms of ESG, climate, and financial performance[22]. Today, the reputation of managers and management companies is directly linked to the financial performance they deliver. In this context, will there be a shift in the expectations of the various stakeholders of these management companies to accept potential declines in performance linked to this new commitment?
Other issues naturally arise: is this manager expected to maintain an identical portfolio, but to engage more with the companies in his portfolio to reduce their emissions? Are his investors aligned with his climate approach? Will his compensation model be adapted to these changes, and if so, how? Will the new working conditions offered to this manager be sufficiently satisfying in a competitive environment that is potentially less ambitious in terms of climate action? Will his reputation in the market improve or deteriorate as a result of this adjustment? All of these operational questions must be taken into account when setting such a target, as they will apply to all financial activities carried out by the institutions concerned.
The commitments made by financial institutions to achieve carbon neutrality by 2050 are of paramount importance in ensuring financial stability in the face of systemic climate risks. By recognizing the reality of climate change, these commitments enable financial institutions to reduce their exposure to high-climate-risk assets, thereby strengthening their resilience to future disruptions. By mobilizing the resources needed to support the transition to a low-carbon economy, financial institutions promote the creation of sustainable economic opportunities and minimize potential financial losses. In addition, these commitments promote financial transparency and accountability, enabling a more accurate assessment of climate risks and facilitating informed decision-making.
Thus, committing to GFANZ should not be seen as joining yet another climate and sustainability initiative, but rather as taking responsibility for preserving long-term financial stability by mitigating climate-related systemic risks and promoting a resilient economy. This responsibility involves truly adapting the finance industry to climate issues. In this sense, the impact of this commitment on the operational aspects of all financial professions must be carefully assessed and managed.
Conclusion
As a financial institution, committing to meeting the temperature targets of the Paris Agreement helps to « improve » the image of the financial industry and its players. It is a powerful communication tool, which also represents a significant opportunity for these players to include this objective in their strategy and its implementation. In a context where the negative medium- and long-term impacts of climate change on the economy are increasingly recognized by the scientific community, knowing how to steer one’s climate trajectory can be a beneficial and differentiating element of governance and strategy. It can also be an important tool for medium- and long-term risk management, particularly in view of the regulatory dimension of this risk and the rapid evolution of the European and French regulatory context on this subject. This commitment is also an opportunity to create a new form of cooperation with public authorities that share this common objective.
The commitment of financial institutions to meet the temperature targets of the Paris Agreement is also an indication that they are becoming aware, albeit very gradually, of the risks associated with climate change. But this commitment implies a complete transformation of the culture, tools, and professions of finance, a transformation that today involves many unknowns. Financial institutions have now committed to an unprecedentedly ambitious goal: will they be able to maintain this level of ambition in implementing a transformation project for their industry that would also be unprecedented?
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[1]As investors wishing to comply with the Paris Agreement’s goal of limiting global warming to +1.5°C above pre-industrial levels, financial institutions around the world must adapt their investment portfolios so that the companies that make up these portfolios have an aggregate trajectory of +1.5°C.
[2]This wording corresponds to that used in the text of the Paris Agreement, Article 2, point 1.a. The text of the Agreement is available on the United Nations website: https://unfccc.int/documents/184656
[3]This is particularly the case for the European Commission in its action plan for financing sustainable growth and the various regulations that comprise it, as well as for the French legislature through the 2019 Energy and Climate Law. The main market transparency standard on this subject is promoted by the Task Force on Climate-related Financial Disclosures ( TCFD).
[4]The main European regulatory text specifically addressing this subject is the Sustainable Finance Disclosure Regulation (SFDR), which imposes climate reporting standards on all management companies in the European Union and their investment products.
[5]The French regulatory text that addressesthis subject most specifically is the decree of Article 29 of the Energy and Climate Law, which requires all management companies operating in France and managing more than €500 million in assets under management to « publish their strategy for aligning with the long-term objectives of Articles 2 and 4 of the Paris Agreement on the mitigation of greenhouse gas emissions, » and to do so for all their investment products with more than €500 million in assets under management. If a management company has no information to provide on the subject, it must publish an improvement plan.
[6]An annual UN reportspecificallyaddressesthe gap between current global GHG emissions and the levels required to stay within the Paris Agreement’s temperature targets.
[7]As explained in the IPCC’s6th report, meeting the 1.5°C target requires GHG emissions to peak by 2025 at the latest, followed by a decline until carbon neutrality is achieved in 2050. See the IPCC summary report or the summary from the Ministry of Energy Transition.
[8]These scenarios form the basis of the GHG emissions projections used by the scientific community to assess future vulnerability to climate change. The scenarios and corresponding pathways created by this community are used by financial institutions to create long-term roadmaps with which to align themselves in order to meet the 1.5°C target by 2100 at their level.
[9]The primary market, where new securities are issued and sold for the first time, is directly linked to the real economy through the granting of loans to businesses or the financing of capital investments.
[10] On which institutional investors and management companies, in particular, trade existing assets.
[11]I4CE (Institute for Climate Economics) is an independent research institute that works on the economic analysis of policies related to the fight against climate change, particularly in the areas of finance and investment.
[12]The CDP (formerly the Carbon Disclosure Project) is a non-profit organization that works with companies, cities, and states to measure and disclose their environmental impact and climate change performance.
[13]This concept is discussed in academic literature, such as Eccles & Serafeim (2013), suggesting that traditional financial measures may not fully capture the value of these sustainable strategies, and Kotsantonis & Serafeim (2018), arguing that ESG factors are not currently reflected in financial models.
[14]However, it is important to remember that, at this stage, the commitments made by these financial institutions are not legally binding, as is the case with financial regulation. Rather, this constraint is in the sense of transparency obligations regarding the means implemented, market and customer expectations, or possible internal strategic decisions within the company. However, these consequences are subject to less stringent penalties, mainly defined in financial regulation.
[15]The variety and complexity of these different methods can be seen in the report produced by the Institut Bachelier (Institut Louis Bachelier et al., 2020). Specific work to clarify and standardize these approaches has also been carried out by the TCFD (Portfolio Alignment Team, 2021).
[16]If, among a set of different methodologies applied by a financial institution to calculate the global warming trajectory of its portfolios, one methodology yields a trajectory corresponding to a 1.5°C warming target for 2100 (while the other methodologies yield a result closer to 2.5°C for 2100), that financial institution is likely to choose the first methodology.
[21]For example, a climate strategy that consists of investing solely in renewable energies, excluding nuclear power, will achieve ESG, climate, and financial performance that is very different from that of a similar strategy that includes nuclear power.
[22]These seven investment strategies are ESG integration, engagement, standards-based screening, negative screening/exclusion, positive screening/best-in-class, sustainability-focused thematic investing, and impact investing. See GSIA (2020).
