Portfolio Net Zero Implementation and Return: Not Always a Trade-off

Empirically, decarbonisation in equity has been associated with a higher tracking error but also a higher risk adjusted return over the last 5 years based on benchmark studies.
Sector tilts have systematically contributed to the higher risk adjusted returns of climate indices over the last 5 years. The pricing of climate risks into equity valuation appears to be slow in the study period. Company performances between low carbon emitters and high carbon emitters in individual sectors depend more on the sector-specific dynamics. Hence, there is no evidence that the outperformance of climate indices associated with decarbonisation could persist in future, as sector returns may change, as could the carbon intensity and transition plan of individual companies.
When it comes to Portfolio Net Zero Implementation, therefore, a more dynamic approach is recommended. Investors could make tactical and strategic net zero investment decisions in conjunction with DWS’CIO View and Long-Term Capital Market Assumptions on a sector level.
It could be challenging to achieve sector neutrality irrespective of the chosen implementation of a portfolio net zero strategy, as both active and passive climate investing approaches have common sector tilts, in some cases even complete exclusion of sectors. While securities of heavy emitters may not be included in climate benchmarks and net zero portfolios, they are still important to consider from a traditional risk and diversification perspective

1 / Introduction

Net-zero aligned indexes or portfolios can be defined as those that follow emission reduction trajectories, reaching net-zero emissions no later than 2050. They aim to reduce their cumulative emissions by 2050, staying within remaining emission budgets.^[1] These budgets depend on emission scenarios and temperature goals. The lower the temperature goal (e.g. 1.5°C instead of 2°C), the tighter the budget, and the faster the portfolio must decarbonize.

More investors are committing to net zero emission by 2050.^[2] As part of these commitments, they align their portfolios with net-zero targets. However, a significant share of public market capital is still allocated to strategies that track traditional benchmarks that do not reflect the risk/return characteristics of climate investing.[Disclaimer: “Enhancing the Quality of Net Zero Benchmarks.” The Institutional Investors Group on Climate Change (IIGCC), 2023.]] This calls for the incorporation of climate considerations into benchmarks. Since the creation of Climate-transition Benchmarks (CTB) and Paris-aligned Benchmarks (PAB) by the European Commission in 2019, there has been an increase in the adoption of climate benchmarks by investors.

In a previous DWS publication “Navigating the Climate Index Jungle” authored by Michael Lewis and Lukas Ahnert, we introduced 5 different types of Equity climate benchmark, explained their key features, and demonstrated the return and portfolio characteristics when compared with the parent index, using MSCI World as an example. The paper also provided an indicative decision tree to help investors select the appropriate climate index benchmark based on tracking error and investors’ decarbonization objectives. The paper concluded that climate ambitions may come at the cost of a high tracking error. Yet, a higher tracking error does not necessarily translate to underperformance over the long term.

To provide additional insights to investors about the implementation of net-zero in equity portfolios, this paper aims to broaden the discussion to a wider range of equity indices that invest in different regions (World, US, EU, Emerging Markets). It examines the trade-off between risk-adjusted returns (particularly in relation to tracking error) and the reduction of carbon intensity, illustrating their empirical relationships.