Produced in partnership with Northern Trust Asset Management.
If it were true that investors can’t achieve net zero targets without introducing an unacceptable level of tracking error to portfolios, that is by taking on an unacceptable level of active risk, then there would be a strong argument that achieving net-zero targets conflicts fundamentally with efficient active investing.
But the idea that net-zero strategies can’t exist within an active management framework is a myth that is easy to debunk, says Northern Trust Asset Management head of quantitative strategies, international, Guido Baltussen.
Baltussen says many popular net-zero strategies, both active and passive, do tend to diverge significantly from their benchmarks.
He says this can lead to high tracking error, such as in the example of Paris-aligned indices which exhibit pronounced sector biases, not only elevating tracking error but also introducing macroeconomic risks such as exposure to energy price volatility or shifts in policy.
“These characteristics have reinforced the belief among investors that aligning with net-zero objectives necessitates significant deviations from broad market indexes,” Baltussen says.
However, Baltussen says it is possible to construct portfolios with relatively small tracking error while still aligning with net-zero objectives, by leveraging quantitative portfolio optimisation techniques.
This way, “sustainability objectives can be integrated more efficiently without compromising key portfolio metrics”, he says.
Baltussen says taking on substantial active risk is not a prerequisite for aligning a portfolio with net-zero commitments. He says Northern Trust research suggests that effective strategies can achieve net-zero alignment even while maintaining modest active risk.
“This is achieved by careful portfolio construction that incorporates sustainability objectives without excessive deviation from the benchmark,” he says.
But he adds that “it’s important to recognise that the most ambitious targets – such as significant improvements in forward-looking transition risk scores may increase active risk”.
Striking the right balance is critical, Baltussen says.
“By setting clear objectives and leveraging advanced optimisation techniques, investors can align with net-zero goals while mitigating unnecessary risks,” he says.
Baltussen says the impact of net-zero strategies on factor tilts can be to inadvertently alter factor exposures. He says this was experienced by Australian asset owners who observed a growth tilt after implementing carbon screens, and this phenomenon is also seen on markets beyond Australia.
“Many high-emission companies often possess strong value characteristics, and excluding or underweighting them can unintentionally skew the portfolio toward growth stocks,” he says.
But he says this impact is not inevitable, and “thoughtful portfolio construction” can help investors manage such implicit tilts by “identifying and substituting excluded high-emission companies with value companies that exhibit strong environmental credentials”.
“This ensures that factor exposures remain intentional while still meeting carbon reduction objectives,” Baltussen says.
“Balancing sustainability goals with factor stability is a critical aspect of robust portfolio design.”
Net-zero targets do not necessarily and automatically conflict with active investing, Baltussen says. Northern Trust’s research paper, Carbon Misconceptions, illustrates how well-designed net-zero solutions can complement, rather than undermine, the active investment objectives.
“Active strategies aim to generate alpha by exploiting inefficiencies, and integrating net-zero commitments can create opportunities for innovative portfolio construction,” he says.
“Active managers can identify companies poised to benefit from the transition to a low-carbon economy or those with strong decarbonisation plans. By incorporating sustainability insights, active investing can align with net-zero objectives while delivering competitive returns. The key lies in rigorous research and robust design.”
There’s also a way around the impact of low-carbon investment on low-volatility strategies, Baltussen says.
“Low-volatility strategies often have significant utility exposure, which can complicate carbon reduction efforts,” he says.
Even so, “sizable carbon footprint reductions can still be achieved without compromising the strategy’s primary return and risk objectives”.
“The challenge intensifies when striving for ambitious improvements in forward-looking indicators as these objectives may require trade-offs,” he says.
Baltussen says strategies designed to address this issue should emphasise “precise quantification and management of these trade-offs”.
“Incorporating low-carbon substitutes within the utilities sector, such as renewable energy providers, can help preserve the low-volatility profile while meeting sustainability goals,” he says.
“Thoughtful optimisation ensures that the balance between low-volatility objectives and sustainability considerations remains intact.”
Baltussen says investors often express a lack of confidence in data relating to Scope 3 emissions, and with good reason. Potential double-counting of emissions is a real risk.
He says the impact of Scope 3 emissions is outsized because these measurements encompass a broad range of indirect emissions, including those from upstream and downstream activities in a company’s value chain. These emissions often dwarf Scope 1 and 2 emissions, which are more directly measured and controlled.
“However, the complexity and variability in calculating Scope 3 emissions make them particularly challenging,” he says.
“There is significant disagreement among Scope 3 data providers due to variations in estimation methodologies, data sources, and assumptions.”
Double counting of Scope 3 emissions is a genuine concern. Baltussen says
“Scope 3 emissions of one company often overlap with Scope 1 and 2 emissions of other entities within the same supply chain,” he says.
At the same time, “the reliance on proxy data and estimations further undermines the confidence in Scope 3 data quality”, he says.
“Despite these challenges, Scope 3 emissions are too substantial to ignore, and they require dedicated strategies for measurement, verification, and integration into portfolio decisions. Investors must remain cautious, supplementing Scope 3 data with rigorous due diligence and working towards improved reporting standards.”
Baltussen says carbon-intensity reductions below 70 per cent often have limited impact on a company’s transition readiness because they fail to signal “a decisive shift towards long-term sustainability”.
“Transition readiness requires a broader framework that incorporates forward-looking measures, such as investments in renewable energy, science-based net-zero targets, and innovations to reduce dependency on fossil fuels,” he says.
“While reducing current emissions is important, it represents only one aspect of climate preparedness.”
He says measures that potentially have the largest impact on transition readiness include alignment with forward-looking indicators, such as climate transition plans, green revenue generation, and alignment with Sustainable Development Goals (SDGs).
“These indicators capture a company’s ability to adapt to a low-carbon economy rather than just its current emissions footprint,” he says.
“Carbon transition readiness and emissions reductions are not interchangeable metrics. Emissions reductions reflect historical and current efforts, while transition readiness encompasses the ability and commitment to meet future climate goals. A multidimensional approach that balances both aspects is essential for assessing long-term climate alignment.”
Addressing climate change is a significant component of ESG investing but it is far from the only ESG issue. There’s a risk that prioritising climate change mitigation in portfolios could swamp other ESG considerations
“Investors should adopt a structured approach that balances competing objectives,” Baltussen says.
“First, it’s essential to clarify values and impact priorities, ensuring that the focus on climate aligns with broader sustainability goals.”
He says that in practice this may involve segmenting a portfolio to address specific objectives.
“Climate-focused investments could coexist with separate allocations targeting social or governance issues, ensuring that each area receives adequate attention without compromise,” he says.
“Investors should also leverage portfolio optimisation tools to balance multiple objectives within a unified framework, identifying opportunities where climate and non-climate ESG goals align or complement each other.”
Baltussen says continuous assessment is critical, including monitoring and revisiting allocations to allow for adjusting portfolios to remove unintended dilution of non-overlapping ESG goals.
“Clear metrics and periodic reviews help ensure that trade-offs are transparent and aligned with both short- and long-term objectives,” he says.
“This disciplined approach prevents any single priority from overshadowing others, enabling a holistic and effective ESG strategy.”
