Working towards net zero, and being carbon neutral, are two distinct approaches to taking action on climate change. The problem is that the terms are often used interchangeably, but they’re very different.
For financial institutions, it’s important to understand the difference in order to make informed investment decisions. They’re two approaches that achieve different goals, require unique strategic approaches, and operate on distinct time-scales.
As pressure grows for financial services firms to assess their own operational emissions, as well as the carbon footprint of their investment and lending activities — their financed emissions — both net zero and carbon neutral approaches will need to be considered as part of a holistic approach to addressing climate-related risks and opportunities.
Key sections in this article include:
To become carbon neutral, a firm needs to buy or produce carbon offsets to compensate for its existing emissions. As a concept, it doesn’t necessarily require making any emissions reductions, though the Australian gold standard for carbon neutrality – Climate Active Certification – does require organisations to disclose plans for emissions reduction.
The use of carbon offsets is point-in-time and only applies for the period for which offsets are purchased – normally annually. If an organisation stops purchasing offsets, it'll revert back to its full emissions profile.
Carbon neutrality relies on a simple calculus, and while it does not structurally change global emissions profiles – or contribute to reaching net zero – organisations that pursue this climate goal will help to fund climate-positive projects that may not have otherwise gone ahead. Carbon neutrality also represents action that can be taken today, as opposed to direct reduction of emissions, which can take a long time.
The concept of net zero was established by the Intergovernmental Panel on Climate Change (IPCC), which defined ‘net zero by 2050’ as the target required to keep global warming to below 1.5°C.
Achieving net zero is a much more ambitious goal than carbon neutrality. It involves a continuous effort to reduce emissions as much as possible, coupled with responsibly offsetting any unavoidable residual emissions. The ultimate aim of net zero is therefore to proactively curb emissions at the source, prioritising emission reduction strategies and sustainable practices over relying on offsets after the emissions have occurred.
To achieve net zero at an organisational level, firms need to cut emissions using a wide range of strategies, such as transitioning to renewable energy, improving energy efficiency and adopting circular economy principles.
An organisational net zero strategy or target may initially be established for only part of an organisation’s emissions profile – often scopes 1 and 2. Most often, a net zero strategy is aligned with a climate goal, such as keeping global temperature increases below 1.5°C.
At a global level, achieving net zero will rely on three key elements:
Putting the use of offsets aside, the priority will be to quickly and consistently reduce the overall amount of global emissions being generated. Total global greenhouse gas (GHG) emissions currently amount to approximately 50 billion tonnes per year, a headline figure that must be reduced urgently. The ultimate goal is to drive this figure as close to zero as possible to make meaningful progress towards achieving global net zero and securing a sustainable and environmentally responsible future.
Despite significant efforts to reduce emissions, certain economic sectors will inevitably continue to emit them. Industries like construction, involving materials such as concrete and steel, while offering significant opportunities to reduce in intensity, pose unique challenges in their decarbonisation efforts and are commonly referred to as "hard-to-abate" sectors.
A global state of net zero therefore does not assume that every sector will reach zero emissions. However, though some sectors will remain emittive, the overall global position will be ‘zero’ as some sectors will reach ‘negative emissions’, a state where that sector absorbs more emissions than it generates, for example, forestry.
Actively removing emissions from the atmosphere can be achieved using natural means, such as restoring forests, or through technology such as carbon capture and storage.
Actively removing emissions from the atmosphere ‘offsets’ those emissions that do occur. Alongside the reduction of global emissions, a key part of reaching global net zero will be to increase the amount of emissions removal achieved annually. Currently, roughly 2 billion tonnes of GHG emissions are removed globally each year, and this figure must increase exponentially in order to contribute to an effective global net zero strategy.
A key distinction between net zero and carbon neutral is that the two approaches operate on different time scales.
Organisations can achieve carbon neutrality today by measuring their emissions and then offsetting the same amount of emissions that are generated.
But a net zero approach typically takes longer to achieve. Depending on the sector, it could take ten, twenty or thirty years. Net zero is a future state, which is why the most common goal is to achieve it by a certain date, often 2050.
Carbon neutral is for today. Net zero is for the future. These approaches are not exclusive of each other, but complementary.
To achieve carbon neutrality, a firm will first calculate their emissions, then buy offsets to compensate for the same volume of emissions. Offsets can come in the form of emission removals or ‘sinks’. These can be natural, such as trees, or man-made, such as carbon capture or storage. Offsets can also come in the form of emission avoidance, such as flaring methane from landfill. However, offsets pose a number of challenges.
One limitation of a carbon neutral approach is that even though emission sources are matched with offsets, the emissions are still released into the atmosphere in the first place. Over time, the offsets purchased will theoretically lead to re-absorption or avoidance of the same volume of emissions emitted, but there’s potentially a lag of many years where the emissions remain in the atmosphere and contribute to warming.
There’s also a question of offset price. More complex technologies such as carbon capture and storage are currently costly, and the price of offsets can escalate rapidly with supply and demand. Relying on carbon offsets of any type can therefore present a significant financial risk for an organisation seeking or relying upon carbon neutrality. This, in turn, could drive organisations to abandon their goals when the cost is too high.
Reducing emissions by updating and improving business practices, as opposed to relying on carbon offsets, will reduce an organisation’s exposure to the carbon price and therefore reduce financial risk.
Investors need to think about the emissions from their own operations – their organisational emissions, as well as those from the companies they invest in – their financed emissions – which often reflect the majority of their emissions profile.
According to a report released by the CDP Financial Services Disclosure Report 2020, financed emissions are over 700x larger than direct emissions for financial institutions, and the risks of inaction are huge.
And compared to reducing their own organisational emissions, reducing financed emissions is typically a much more complex process for investors.
The levers that investment firms have to reduce financed emissions vary significantly depending on the type of investor. In the listed space, these can be limited to allocation decisions, or stewardship activities such as engagement and voting. In private markets, a much more involved and influential approach can be taken with investees.
As a result, the two approaches can be seen as complementary. Investors need to consider both carbon neutrality in the short term and net zero in the long term for their financed emissions. The risks associated with their portfolio will likely be gauged based on their long term net zero plans and those of their portfolio companies.
Science-Based Targets are closely linked to claims of aligning with the Paris agreement and a convergence towards net zero. It’s important that when commitments are made to reach net zero by a certain date, they are supported by rigorous scientific systems. This is where the Science-Based Targets initiative (SBTi) comes in.
The SBTi helps organisations set ambitious and meaningful emission reduction targets in line with the latest climate science. The organisation was established in 2015, and in 2021 it launched the SBTi Net Zero Standard. It offers a well-defined methodology to help financial services firms reduce emissions in line with the goals of the Paris Agreement, and reach net zero.
This standard offers a clear definition of what's expected, and a pathway to get there. Following its process will help to protect companies from unintentionally greenwashing.
The core process is setting both near-term and long-term targets, with most long-term targets expected to cut emissions by at least 90%. The remaining 5-10% of emissions can be managed with carbon offsets.
With the release of the ISSB S1 and S2 standards, investors globally are coming under increased pressure to consider their climate goals across both their organisational and financed emissions. In Australia, the Treasury released a consultation shortly after the ISSB release to seek input into how and when ISSB-aligned requirements could and should apply to Australian businesses. The largest organisations may be caught by disclosure requirements as soon as 2024.
Asset owners must begin setting appropriate and achievable climate goals for their own organisations, and advise on those of their portfolio companies – whether carbon neutral, net zero (or science-based targets to begin with), or all of the above.
Pathzero's team of sustainability specialists offers consulting services specialising in establishing science-based targets and providing guidance on effective emission reduction strategies. Asset owners can also benefit from Pathzero’s cutting-edge software, which accurately measures financed emissions within private market portfolios. This powerful combination of expertise and technology enables organisations to set – and align with – their unique goals and ensure they stay on track in their climate journey.