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A framework for net zero in low turnover credit

Mahmoud El-Shaer, CFA, Fixed Income Portfolio Manager
2022-06-30
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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

We believe that climate change poses a material risk to both financial markets and societies at large. In our view, investors have a meaningful role to play in helping achieve the goal of limiting global warming to 1.5 degrees and, in doing so, mitigate risks in their portfolios. Long-term holdings, such as low turnover credit portfolios, are particularly vulnerable as physical and transition climate change risks may, over time, substantially affect the fundamental credit quality and investment risk of issuers.

Finding an effective solution

Investors looking to decarbonise their portfolios can opt for low-carbon approaches and net-zero solutions, ranging from carbon offsets to net-zero emissions targets over time. Both can play a role in portfolios, with the best fit depending on asset allocators’ specific circumstances. Net-zero solutions can be potentially less constrained in how they eliminate carbon and may be better able to capitalise on opportunities and finance the climate transition. Here we outline a practical framework for those investors who are looking to implement net zero in low turnover credit portfolios, which we believe:

  • Contributes meaningfully to the climate transition; and
  • Does not compromise on investment return and resilience.

Why net zero, and not low carbon?

A too-narrow focus on optimising portfolios for low carbon may lead to restricting investments in carbon-heavy parts of the market, such as utilities, and materially tilt exposures towards sectors like financials and technology, without solving the broader issue of decarbonising the economy. Not only could this expose investors to concentration risk due to lack of diversification, but, importantly, it means they are not directly financing or benefiting from the climate transition. For cash-flow-aware investors, there are also possible limitations on a portfolio’s ability to match future liabilities. Data quality is another major area to consider as climate change data — particularly Scope 3 emissions — is still imperfect. Low-carbon solutions based solely on quantitative data inputs may be vulnerable to unintended outcomes.

We believe it is possible for net zero portfolios to offer diversification, while helping to manage climate risks and accelerate the transition. We advocate a two-pronged approach involving:

  1. Informed top-down portfolio construction; and
  2. Bottom-up analysis and engagement.

Portfolio construction

IDENTIFY HIGH-INTENSITY SECTORS

Across the credit universe, different sectors face different levels of transition risk. Analysing sectors by Scope 1+2, and Scope 1+2+3 emissions is a useful starting point to assess such exposure (see Figure 1), as a high-weighted average carbon intensity (WACI) suggests high levels of risk. However, Scope 3 emissions data needs to be interpreted thoughtfully as disclosure is still relatively poor, with the market heavily reliant on third-party estimates.

FIGURE 1

a-framework-for-net-zero-in-low-turnover-credit-fig1

UNDERSTAND THE IDIOSYNCRASIES OF EACH SECTOR

We believe a qualitative evaluation of exposure to transition risk is also essential to determine where each sector is on its transformation journey, and how much decarbonisation is already taking place. This is where our dedicated sector-focused analysts can play a crucial role.

Take the auto industry, for example: carbon emissions are relatively high, particularly when considering downstream and upstream emissions. However, based on our fundamental research, we believe there are fewer associated transition risks than in other industries with similar levels of emissions because the transition is already well under way, with transition plans embedded in many companies’ strategies and capital allocations.

Sector-level emissions data can also mask fundamentally different risk profiles at industry level. For example, within energy, renewables clearly face less transition risk than the broader sector and, within utilities, electricity networks are likely to benefit from a steep drop in their current high emissions as the economy transitions away from fossil fuel to greener energy sources.

Where sectors face the highest sustainability risks and greatest uncertainty on their transition, therefore presenting the greatest risks to financial returns, we expect to only invest in the leaders within each sector, with the aim of mitigating those risks. Net-zero portfolios can also impose restrictions on absolute sector exposures or on the maturities held.

Based on this qualitative and quantitative framework, we have identified several sectors, which we believe are subject to increased transition risk. We believe financial markets are not yet focused on the extent of the impact climate change can have on corporates in these sectors which, among others, include aerospace and defence, utilities, transport and a number of basic Industries.

Analysis and engagement

STOCK SELECTION

We think it is also crucial to differentiate between companies based on their transition risk through rigorous bottom-up credit analysis and engagement. Fundamental analysis may also help investors uncover opportunities to benefit from and finance the transition away from fossil fuels. Take the example of a large German energy conglomerate: current carbon intensity data suggests that the company should be viewed as a laggard relative to its peers. Yet, with ~85% of its capital expenditure spending focused on renewables and a clear plan to decarbonise and move away from its dependency on coal and lignite, the company may face lower-than-assumed transition risk.

ENGAGEMENT

We believe engagement is the most powerful tool for advancing a net-zero transition and decarbonising portfolios — particularly where investors have a long investment horizon. Divesting from heavy emitters could decarbonise portfolios but may not reduce real economy emissions; portfolios and the overall economy would still be impacted by physical climate risks resulting from those emissions. By getting companies to adopt a credible transition plan, investors can have a broader impact on the net-zero goal and reduce physical risk exposure.

This includes encouraging companies to adopt science-based targets (SBTs). As more companies adopt SBTs, there is a multiplier effect along global value chains, as suppliers will need to set their own targets for the companies they serve to meet their net-zero objectives. The number of companies with SBTs, or that are committed to taking action, has increased from fewer than 100 in 2017 to over 1300 today1.

Figure 2 illustrates how companies with SBT commitments could grow towards making up 100% of a relevant index over time.

FIGURE 2

a-framework-for-net-zero-in-low-turnover-credit-fig2

Conclusion

Reducing the carbon footprint of investment-grade credit portfolios can be achieved solely with divestment, but at the risk of hindering financial objectives and restricting capital to those companies essential to — or with the biggest potential to accelerate — the low-carbon transition. We believe a net-zero approach should offer a more effective road map to manage climate risks by combining rigorous fundamental research with informed top-down construction and active engagement. While divestment can be used as an escalation strategy, this allows investors to tap into potential opportunities by identifying companies with credible transition trajectories across all sectors and engaging with high-emitting ones. We believe deep company research can help overcome the shortcomings of current climate metrics and uncover underappreciated idiosyncrasies in companies’ transition plans. The transition pathway of the corporate universe is complex, and, as investors, it is our role to identify, research and support those companies willing to change and challenge those which are not.


1As of 30 April 2021. | Source: Science Based Targets Initiative (SBTi). The SBTi is a partnership between CDP, the United Nations Global Compact, World Resources Institute (WRI) and the World Wide Fund for Nature (WWF)

IMPORTANT INFORMATION

Our clients can opt-in to adopt in the Net Zero goals in their portfolios, however, not all client accounts and Wellington Management sponsored funds will necessarily participate in this initiative.

For client accounts, participation will be at the discretion of our clients. For Wellington Management sponsored funds, participation will be directed through engagement with the Investment Manager in the best interests of the funds and their underlying investors.

Investors should contact their Wellington Management Representative to learn more about this commitment.

Investors should consider the risks that may impact their capital before investing. The value of an investment may increase or decrease from the time of the original investment.

Our approach to sustainable investing

Authored by
mahmoud el shaer
Mahmoud El-Shaer, CFA
Fixed Income Portfolio Manager