Over the past few years, many of the world’s most important financial actors have pledged to reach net-zero carbon emissions across their portfolios by 2050.

The UN-convened Net Zero Asset Owner Alliance has grown to include 84 members with approximately $11 trillion of assets under management. Members of the alliance are required to set portfolio decarbonisation targets for 2025, 2030 and 2040, and get to net zero by 2050.

Although relatively few private equity firms have made explicit net-zero commitments, managers are under growing pressure from their LPs to measure and report emissions at portfolio companies. With so many LPs bound by net-zero pledges and interim targets, investments in carbon-intensive sectors are increasingly unpalatable for PE firms.

Devil in the detail

It may seem self-evident that the finance industry’s embrace of net zero is a huge step forward for efforts to curtail carbon emissions and ensure that the global goal of limiting warming to within 1.5C of pre-industrial levels is kept alive. In practice, however, a closer look reveals that the push for net-zero portfolios could produce unintended consequences. 

There are some parts of the journey to net zero that almost everyone can agree on. Coal must be phased out; renewable energy needs to be scaled up; polluting vehicles must be replaced by electric alternatives; buildings need to be more energy efficient.

But there are some activities that are harder to address. Many of the sectors that contribute significantly to emissions, such as mining, steelmaking and other heavy industries, cannot simply be phased out or replaced. Investing in ways to reduce emissions from these ‘hard-to-abate’ sectors is a vital part of the net-zero roadmap. The Net Zero Asset Owner Alliance acknowledges this, with its guidance that members focus on real world outcomes in their targets and planning.

Yet with asset owners committed to reducing their total portfolio emissions – and bound by interim targets – investing in carbon-intensive heavy industries carries reputational risks for asset managers.

Sarah Williamson, chief executive of FCLTGlobal, a non-profit promoting long-term responsible investment, told a conference at the London Stock Exchange in December that pressure for portfolios to reach net zero may conflict with the more important goal of reducing global emissions.

“Is there a conflict? The answer is yes, there is,” she warned. “We have to be careful that we are not pursuing portfolio decarbonisation at the expense of real-world decarbonisation. Because, of course, it does the world no good if I clean up my house by throwing my trash in my neighbour’s garden.”

The route to net zero

Carlyle became one of the first major private equity firms to make a net-zero commitment, issuing a pledge in February 2022. But Megan Starr, Carlyle’s global head of impact, says that the firm is mindful of how it implements its net-zero goals in practice. “There is an easier way to go net zero, and there is a more challenging way,” she says. “If we sold around a dozen companies, we could reduce our Scope 1 and Scope 2 emissions by about 95 percent. And not a molecule of carbon in the atmosphere changes.

“The harder way to go net zero is not portfolio allocation decisions, it’s not about which companies you’re invested in, or how many – it’s about the individual trajectory of individual assets.”

Instead of setting interim targets for portfolio-wide emissions, Carlyle established goals around ensuring its majority-owned portfolio companies set targets for emissions reductions that are aligned with the Paris Agreement goal of limiting warming to 1.5C.

“As an industry, we do need to have a moment of reckoning around the unintended consequences of how net-zero and decarbonisation targets are structured for actual carbon emissions,” Starr continues. “We almost need a new arithmetic in this space – it’s the carbon delta [the rate of change in carbon emissions] of individual companies that I believe we should be judged on as an industry. Because that is driving real emissions reductions in the economy.”

There is certainly room for debate about the practical value of portfolio-level net-zero targets, as opposed to focusing on the carbon intensity of individual assets. Clearly, it would be absurd if well-intended commitments resulted in sectors that have a key role to play in the net-zero roadmap being starved of the funding needed to decarbonise.

But attitudes could be changing, Starr says. “We’re increasingly having conversations with LPs around if we actually want to drive real world decarbonisation, what does that look like, and how do we roll up our sleeves and get that done?

“A lot of our LPs are recognising the financial arbitrage of investing in carbon-intensive sectors, which have really been abandoned by capital markets in recent years, and then actually driving an active change to increase the value of the company.”

Steel on a march to decarbonisation

The steel industry is a prime example of a hard-to-abate sector. The material, which plays an indispensable role in construction, car manufacturing and many other industries, is estimated to account for between 7 and 11 percent of total carbon dioxide emissions globally.

McKinsey estimates that $4.4 trillion is needed to decarbonise the sector by 2050. Shivakumar Kuppuswamy, policy and impacts director at ResponsibleSteel, an initiative to improve sustainability practices in steel production, says that investment is needed immediately if the industry is to decarbonise before climate impacts are irreversible.

“The next 8-10 years is very critical,” he says. “A large portion of this capital requirement needs to be made available to the industry in the next decade. It’s a very time sensitive matter.”

Several different approaches will need to be employed to get the industry to net zero. These may include electrifying blast furnaces or using green hydrogen in place of coal and installing carbon capture technology at
steel plants, as well as improving the efficiency of production methods and increasing the proportion of scrap steel that is recycled.