Clearing the air: Assessing climate transition risks in credit portfolios

As the world moves to mitigate the effects of climate change by transitioning to a low-carbon economy, capital markets will increasingly feel the effects, and fixed income investors should be prepared to manage the attendant risks and opportunities in client portfolios. In our view, it is especially important with longer-term, low-turnover investment strategies for investors to understand how climate-related transition risks affect issuer sustainability and credit quality, as well as bond prices and valuations.

We believe companies that are better equipped to navigate the evolving transition-risk environment may be attractive long-term investments, so assessing these risks has become integral to our credit research and investment process. In low-turnover approaches in particular, investors need to ask themselves if the issuers they invest in will be relative outperformers in 10 years’ time. Are their business models fit for purpose in a low-carbon economy, and if not, are they willing and able to pivot? Here, we share our approach to transition-risk analysis and how we think about investment opportunities in carbon-intensive sectors. Our aim is to identify material transition risks, quantify which sectors will be most affected and mitigate portfolio-level risk via our issuer- and issue-selection process.

Why transition risks matter for credit investors

While the physical risks of climate change — heat, drought, hurricanes and floods, among others — can directly impact companies’ tangible capital assets, operations and labor forces, transition risks — the costs associated with transitioning to a low-carbon economy — may require certain industries to consider even more sweeping changes to their operations and potentially business models. Regulation, technological disruption, litigation and changing consumer behaviour can affect a company’s economic stability, competitiveness, reputation and credit quality. We believe these risks are underappreciated and will continue to evolve, with lasting impacts as the investment industry reprices securities based on the lower terminal values of legacy assets and capital expenditures required for strategic transformation.

Our approach

Step 1: determine carbon intensity

An analysis of transition risks can begin with carbon intensity,¹ a metric used to normalise carbon emissions by sales. Comparing the Scope 1 and 2 emissions² data of issuers in the global corporate bond universe, we find that utilities, materials and energy are the highest-emitting sectors relative to their weight in market value (Figure 1). Utilities, for example, comprise 8.6% of the market, yet they are responsible for 62% of the index’s carbon intensity. Likewise, energy companies account for about 7% of the index’s market value, yet are responsible for nearly 12% of overall carbon intensity. We find that incorporating Scope 3 emissions into this analysis yields similar results, given the emissions associated with the downstream supply chain for these sectors.

We focus our research on carbon-intensive sectors for a number of reasons. Garnering the most attention from regulators, customers and capital providers, companies in these sectors will need to make the largest absolute-dollar investments and be the most innovative to survive and thrive during the transformation. Emerging business opportunities and risks will test high emitters’ ability to maintain historical levels of profitability as carbon is no longer considered an externality. We believe that the scope and scale of changes facing carbon-intensive sectors present myriad opportunities to identify potential long-term intra-sector out- and underperformers.

FIGURE 1

Step 2: know the regional landscapes

With an understanding of relative sector-level carbon intensity, investors next need to capture a clear picture of regional sector peer groups. The regulatory environment varies significantly from one region to another. Our ability to compare the transition-risk exposure of two European energy companies or two US utilities, for example, depends on our understanding of the environments in which they operate.

The UK and the eurozone are ahead of the global curve on climate change efforts, with stricter existing regulations, the impending EU Taxonomy and general support from consumers (and voting constituencies) for decarbonisation efforts. In 2019, more than 36% of the UK’s power supply came from renewables,³ underscoring the government’s view that these low-cost sources are central to the country’s energy strategy. The UK has targeted net-zero carbon emissions by 2050, in accordance with the Paris Agreement. The EU has also embraced energy transition, with a target to cut emissions by 55% by 2030 and ambitious policies in place and forthcoming.

As a result, our research has found that UK and European energy and utilities issuers are generally more carbon efficient relative to global peers, owing to the lower cost of capital, increased incentives, and financial success many companies have had by aligning their energy production with shifting demand towards lower-carbon power sources.

Step 3: conduct idiosyncratic analysis and engagement

Understanding the details of a company’s long-term strategy through a transition-risk lens is key to our credit research. Take European utilities, for example. While all companies in the sector produce and supply power, they often have fundamentally different approaches. While some still generate power with a mix that includes less than 10% renewables, others have transformed their energy mix to focus much more heavily on renewables generation, materially reducing their exposure to transition risks. Within a sector with high carbon intensity, we believe lower transition risk implies reduced business risk as well as improved fundamentals and preparedness to benefit from change.

In our view, high-emitting sectors should not necessarily be excluded from ESG-focused strategies owing to their transition-risk exposure. To the contrary, we think carbon-intensive sectors provide ample opportunity for investors to distinguish among corporates that are taking — or are willing to take — a proactive approach to mitigating transition risk. Closely examining a company’s climate policies, board and management commitment and track record of setting and meeting targets can help us determine potential outperformers or laggards. We use engagement to gain this information and to help companies better prepare for transition risk. Constructive engagement enables us to scrutinise a company’s level of accountability, carbon disclosures, decarbonisation objectives, risk-management decisions and potential decarbonisation opportunities.⁴

Step 4: continue research and development of analytics

We continually evolve our research process as related data sets improve. While high-quality data is a critical input for assessing transition risk, we believe making qualitative adjustments to our analysis is required. Relying solely on quantitative data can lead to backward-looking views and, as a result, suboptimal outcomes. Currently, the available data is difficult to compare, given the voluntary nature of emissions and other climate-strategy disclosures.

To supplement our qualitative views, we are developing an alignment scoring system, weighing multiple factors to assess how likely a company is to achieve its long-term decarbonisation targets. These include alignment of capital allocation, executive compensation and board oversight, as well as the quality and transparency of climate-related company climate disclosures.

Conclusion

Within a buy-and-maintain portfolio, we believe investors should seek to own long-term outperformers that help minimise downside risk and maximise income potential. Because long-term, low-turnover investors should be comfortable holding each security until maturity, we believe climate change considerations are an important input into investment analysis. In particular, given the complexities involved with the shift to a low-carbon global economy and related company-level financial risks, we view it as prudent to take top-down approach to identify sectors with higher transition risk and a bottom-up approach to identify potential leading names within each sector. In our view, these risks will have an increasing impact on the long-term valuation of many credit securities, so a deep understanding of what they are and how they will evolve is an important component of a sustainable, low-turnover investment approach.