Environmental Finance: What is the thinking behind the development of MSCI’s Implied Temperature Rise [ITR] assessment?
Edward Allen: Financial institutions are increasingly making net-zero commitments that involve aligning their lending and investing with net-zero emissions by 2050. For instance, around 500 institutions have joined the Glasgow Financial Alliance for Net Zero. This represents a reshaping of the way that the financial system thinks about allocating capital, and it involves a forward-looking perspective over a long-term horizon.
What does this mean in practice? MSCI’s ITR tool was created to answer that. It assesses the alignment of invested real economy companies with science-based pathways to net zero (for example, what the IPPC [Intergovernmental Panel on Climate Change] implies in terms of global emissions reductions). It thus enables financial institutions to a) measure their portfolio ambition: what does it mean to be aligned with a net zero pathway? and b) track progress: how well is my portfolio doing against a forward-looking decarbonisation pathway?
MSCI ESG Research’s ITR follows best practice, as indicated by the report from the Portfolio Alignment Team, commissioned by the Task Force for Climate-related Financial Disclosures [TCFD] and published in 2021.
Its forward-looking perspective is extremely important: companies that are serious about decarbonising need capital to do so. So, if an energy or steel company is high-emitting today – just because of the sector it operates in – but is credibly committed to developing a low-carbon model tomorrow, divesting from that company would not help the net-zero transition. Conversely, focusing a portfolio on services or tech companies because they are ‘clean’ today may not support transition efforts; smart capital allocation might.
What makes ITR particularly intuitive is that alignment is expressed as temperature. The logic here is to extrapolate the degree of alignment or misalignment with climate objectives of a company if the same degree of alignment or misalignment was applied to the whole economy. Given that climate goals are expressed in temperature terms, such as the Paris Agreement’s 2ºC and 1.5ºC objectives, users can easily relate the ITR to global climate objectives, and benchmark investments.
EF: What is the ITR temperature score based upon?
EA: Alignment assessment is based on two main inputs. The first is the company’s current emissions, to which we add its projected emissions. If the company has decarbonisation targets, we can forecast its future emissions; if not, we assume a 1% emission growth rate per annum, reflecting average global emissions growth from 2009 to 2019.
The second is the company’s carbon budget. This is derived from the global 2ºC budget trajectory, adapted to the company’s country and sector (some countries and sectors can decarbonise faster than others), and sized to the level of revenue of the company. This means that a small company doesn’t have to slash its emissions by the same absolute amount as a large company – just by the same proportion.
The question is then whether a company’s projected emissions overshoots its carbon budget, leading to an ITR greater than 2ºC, or undershoots, resulting in an ITR lower than 2ºC.
EF: How can investors use the score?
EA: There are several use cases for ITRs. Right now, a particularly important one is disclosure, as regulatory pressure increases in this space. But investors can use ITRs to better inform their allocation of capital, construct portfolios and engage with companies. While ITR is not primarily a risk management tool, it can serve as one risk indicator among others – a more misaligned company is more likely to be affected by certain transition risks, such as carbon pricing.
EF: How does it align with growing regulatory focus on the issue?
EA: As a forward-looking metric, ITR is ideally placed to help users seeking to meet the TCFD’s recommendation that all financial institutions disclose the alignment of their activities with a well-below 2ºC scenario. Users may have difficulties addressing this recommendation with backward-looking metrics: today’s carbon footprint in your investments could either increase or decrease in the coming years, depending on what the portfolio finances. For example, Exxon and Shell might have a similar carbon footprint today, but their plans to decarbonise are very different.
Several jurisdictions have put in place financial institution disclosure requirements involving forward-looking metrics. These include Article 29 of France’s Energy-Climate law for financial institutions; the UK Department for Work and Pensions regulations for pension funds; and Switzerland’s proposed TCFD-aligned framework for financial institutions.
EF: The ITR assessment is primarily aimed at investors. How should companies understand and use the assessment?
EA: Given that financial institutions might use ITRs for capital allocation and company engagement, companies may expect that their investors will engage them on decarbonising in line with a net-zero future, for example by requesting that they set science-based targets. For about 3,000 companies, ITR scores can be found on the website of MSCI: decarbonisation shortcomings are plain to see. Of course, ITR generally rewards transition leaders, who can expect “cooler” ITR scores (e.g., close to 1.5ºC) to shine a light on their performance.
In certain situations, some companies might be divested because they perform badly on ITR, as one metric among others showing that the company is not making the efforts required to align with the net-zero ambitions of the institutions that fund them.
Edward Allen is managing director and head of ESG & climate client coverage for the Americas at MSCI.
For more information, see: www.msci.com/our-solutions/climate-investing/net-zero-solutions/implied-temperature-rise