three steps to effective climate

Three steps to effective climate-focused engagement

Mahmoud El-Shaer, CFA, Fixed Income Portfolio Manager
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The risks associated with climate change are becoming increasingly relevant for asset owners and their portfolios — even more so for approaches with a long-term investment horizon, such as low-turnover credit. While markets are gradually becoming better at pricing in climate risks, the reality is that it takes a much longer time for these to play out. Understanding these risks, and their potentially outsized impact on investments, gives investors the ability to address them.

From an engagement standpoint, this is where long-term-focused asset managers can uniquely add value. It is in asset managers’ best interests to work with their underlying issuers over time to ensure that issuers understand their climate-change risks and are actively seeking ways to improve their environmental impact. As part of that, we believe long-term credit managers that operate within a large, multi-asset structure have a further advantage. Larger asset managers with both share- and debt-holder status can have greater influence over corporations given their size and ability to engage via multiple contact points. This allows credit managers to speak internally with equity portfolio managers to discuss climate-related topics and enforce change via avenues that would otherwise be out of reach.

Finally, many asset owners face challenges from a regulatory standpoint, and asset managers can play an increasingly significant role in bringing these multidimensional perspectives to the issuer.

What are climate risks?

Climate risks fall into two categories:

  • Physical risks — heat, drought, wildfire, hurricanes, flooding and water scarcity. These location-based risks are more difficult to engage on than transition risks, but engagements can provide important information about the company’s potentially affected physical assets.
  • Transition risks — business-related risks that follow societal, regulatory and economic shifts towards a low-carbon and more climate-friendly future. Issuers typically have more control over these risks, and asset managers can meaningfully impact company behaviour.

Both risks are relevant to portfolios, and it is imperative for asset managers to ensure that they have an in-depth understanding of these risks, allowing for detailed and accurate analysis and subsequent engagement.

Analysing climate risk

An asset manager’s central research function lends itself well to analysing company fundamentals; however, specialised expertise may be required to deeply understand the climate risks that stem from a current or prospective issuer’s operations. With that in mind, by leveraging the support of climate-focused experts both internally, through Wellington’s ESG Research Team, and externally, via our collaboration with the Woodwell Climate Research Center and the Joint Program on the Science and Policy of Global Change at the Massachusetts Institute of Technology, we can facilitate more purposeful engagements.

What is effective engagement?

Established relationships with issuers allow for candid two-way conversations over the life of an investment. We see three components to effective engagement on climate.

1. Understanding the company’s approach

Initial engagements allow the asset manager to develop a better understanding of the company’s strategy, from which the manager can identify those areas that need further consideration.

In terms of evaluating physical risk, it is not only essential to understand where a company’s assets are based, but whether and how the company is considering its susceptibility to such risks. As an example, we engaged with a Danish firm that operates offshore and onshore wind farms as we were concerned with the location of its wind turbines. Despite being designed to endure wind speeds of up to 156 mph, the turbines could still suffer from hurricane winds. Upon engaging, we were able to find the specific locations of these turbines, which, after further analysis, were not considered to be at risk. Even if the turbines were at risk, an asset manager would likely treat assets located in an area expecting growing hurricane risks differently, depending on whether they were insured or not. As such, engagements are vital for information gathering.

2. Emphasising areas of focus

Asset managers can provide perspectives to a company that may have otherwise been de-emphasised, bringing their research on competitors, peers, sectors and regions as well as what they are hearing from clients to the conversation. On the latter point, regulatory regimes on ESG issues are increasingly shaping investors’ investment agendas, and as a liaison point between asset owners and portfolio companies, asset managers can play a role in ensuring these areas are being considered. For example, UK pensions schemes are increasingly required to demonstrate management of climate risks in their portfolios — including alignment of their governance processes and disclosures to the Task Force on Climate-related Financial Disclosures (TCFD).

One approach to mitigating climate risks and improving alignment through engagements is to encourage companies to set decarbonisation targets and seek validation of those targets by the Science-Based Targets initiative. Owning companies that set robust targets and execute against them allows for better analysis of portfolio alignment relative to the client’s decarbonisation goals, as well as lower transition risk over time as assessed via scenario analysis tools. As exposure to transition risks and portfolio alignment are recommended metrics for financial institutions by the TCFD, engagements that encourage science-based targets (SBTs) and transparency about the outcomes of those engagements should allow UK pension schemes to demonstrate adoption of these best-practice recommendations.

As an example, we engaged with a global REIT, discussing the company’s lack of SBTs as well as its high weighted-average carbon intensity. We were concerned by its unwillingness to set SBTs, believing the company would prioritise revenue generation over carbon-emission reductions. Following our engagement, where we expressed our concern to management, the company has since put in place SBTs. In this instance, we were able to communicate the importance of setting SBTs in defining decarbonisation goals, which also reaffirmed our firm’s stance on reducing carbon emissions among assets owned, in line with our commitment to the Net Zero Asset Managers initiative.

Finally, this coordination allows for a deeper understanding and action that spans beyond the individual issuer. For example, during engagements, we often ask how an issuer plans to tackle Scope 3 emissions1. These are typically more difficult to address and reduce because they relate to indirect emissions, which are harder to capture. By engaging with a plethora of companies, we can facilitate knowledge sharing, using the insights gained from issuers that have a particularly innovative approach to addressing topics like Scope 3 emissions, to better support to those that are struggling. This allows for better outcomes across the portfolio.

3. Active monitoring and taking action

As seen with the case of the global REIT example, once the parties understand each other’s objectives, engagements can be used to steer each partner towards the common goal. It is crucial to highlight that divestment alone does not achieve the broader decarbonisation goal — only long-term engagement can help with this. To that end, it is important that engagements do not comprise a single conversation. Once the climate-change discussion is initiated, asset managers should continue to monitor and re-engage — and potentially take action. As one of the objectives of engagement is to obtain information, if, throughout the process, the manager learns that no meaningful progress is being made, they may decide against reinvesting maturities into that issuer and, at the extreme, to divest, even in a low-turnover approach. Similarly, if a company has set an SBT, the manager should continue engaging to ensure execution against its stated pathway. It is, of course, also important to understand each company’s unique circumstances, as this will influence the manager’s approach to further engagements.

Bottom line

Direct engagement with the issuers held in a portfolio is a critical part of active ownership and we believe is best practice for managing corporate credit, particularly in mandates with a longer investment horizon. Specifically, effective engagement enables the advancement of the net-zero transition and can aid asset owners in accomplishing their goals and regulatory requirements over time.

1Scope 3 emissions encompass all indirect emissions, outside of Scope 2 emissions, that are generated as a result of a company’s operations, both upstream and downstream.

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