Five principles for building a climate-aware Buy and Maintain strategy
- 12 May 2022 (5 min read)
Buy and Maintain strategies are designed to be a sustainable and resilient core holding for pension funds and other institutional investors. The goal is to enhance returns from the investment grade credit market over the longer term through highly diversified portfolios that mitigate against turnover and transaction costs. Over recent years it has become increasingly clear that to do this effectively, risks from climate change and the global policy response must be actively addressed.
The world is navigating the effects of the Ukraine crisis, highlighted by the imperatives around energy supply and management. But we firmly expect the political momentum around net zero by 2050 to endure and believe that an opportunity has opened up for investors to structure their portfolios to match the pace of change across the corporate world and in credit markets.
To do this successfully great care must be taken. Our view is that pension schemes using Buy and Maintain strategies could potentially benefit from applying a climate-aware lens to their portfolios using these five principles:
Complement your financial objectives
This is the first priority. Climate integration, such as risk-mitigation and net zero alignment, should be used to improve, or at the very least maintain, financial performance. Our view is that the integration of climate takes greater account of emerging and material risks – including from consumer trends and regulatory penalties – and that these risks could increase the potential for defaults and downgrades.
We favour a process where scenario analysis helps build our framework of understanding and a team of fundamental credit research analysts integrates climate into the research process for both financial and ESG (environmental, social and governance) factors. Meanwhile, portfolio managers structure portfolios to minimise climate risks at longer maturities. The goal is to deliver an improved climate risk profile that minimises forced sales while wider environment-related benefits can feed through over time. This can be integrated into the structuring of a pension scheme's cashflow-driven investing (CDI) strategy where appropriate.
It is not about being ‘green at any price’. This is a low-turnover approach to Buy and Maintain investing that seeks to reduce costs and skew climate risks toward shorter maturities, where reinvestments can reshape portfolios steadily toward net zero alignment and reward transition leaders.
Invest in the Transition
Every portfolio, even if entirely net zero aligned, is likely to feel the effects of the physical risks of climate change. By financing the transition, we believe that pension funds can retain a wider opportunity set, potentially maintain better spread levels and reduce turnover as well as helping to drive high-emitting companies towards net zero – which should help mitigate those wider physical risks from climate change and help build more sustainable economies.
We think holdings in Climate Buy and Maintain strategies should therefore range from issuers that are already aligned with net zero, to those that are in the process of aligning and those that offer climate solutions – such as green bonds – which provide direct financing to companies and projects that aim to mitigate or adapt to climate change.
It is true to note that reducing carbon intensity within portfolios is relatively simple. A fire sale of the most high-emitting names would see emissions drop sharply – an example from our standard portfolio shows that selling the worst 5% of emitters would lead to a 40% cut in emissions. That said, we believe investors should be wary of wholesale exclusions that may sideline carbon-intensive companies progressing towards net zero alignment, but which perhaps have further to travel. Too exacting a policy could sharply reduce the investable universe, increase concentration risk and deny capital to businesses that may be on a genuine transition pathway.
Of course, excluding or divesting from climate laggards if they have shown insufficient progress or willingness to commit to a net zero strategy – or at a client’s request – remains an option, especially if they are exposed to an increasing degree of climate-related risks.
Every wider sector can play its part in the transition. Best-in-class utility companies will be as essential in the future as they are now – and their successful transition will be an essential part of the road to net zero.
We also believe that it will be crucial to support a ‘Just Transition’ that is sensitive to the social effects of declining industries and changes in our energy mix. Violent swings in where and how people are employed could leave communities adrift and sharpen inequalities. We think pension schemes can help soften the impacts, and mitigate against social risks to long-term holdings, by broadening out their analysis of the transition in this way.
Putting it to work
Our approach and analysis have direct effects on portfolio decision-making. We divested from a company in early 2022 that offered renewable energy solutions but decided to invest in a coal power plant which then constituted a significant portion of revenues. Despite its continued presence in the clean energy space, we decided the new direction was incompatible with climate-aware portfolios and sold out. We were able to reinvest into a name better aligned with net zero and which offered more favourable financial characteristics.
Align to Net Zero
Our Climate Buy and Maintain credit strategies all target net zero by 2050 or before – but it is the nature of this alignment that is crucial. Some clear examples of how we have seen pension fund clients target net zero include:
- Setting a goal for the portfolio to be 100% net zero aligned by 2050, with an interim target of 50% emissions reduction by 2030.
- Setting a series of goals for the degree of alignment of the portfolio over time. For example, by having all issuers either aligning, aligned or at net zero by 2030, based on the six Institutional Investors Group on Climate Change (IIGCC) categories.
We think any carbon reduction targets should not be at the expense of portfolio performance or of the broader pursuit of the new economic models sought by long-term responsible investors. The second example above is perhaps a good model for how an investor might steadily increase the proportion of issuers held that have ambitious but achievable net zero goals, backed by the in-depth research of our fundamental credit research team.
Ideally, and particularly for a low turnover Buy and Maintain portfolio, this process of increasing alignment occurs through natural cashflow re-investment and capitalising on any new client inflows rather than active turnover, to avoid unnecessary and costly transaction costs. At a total portfolio level, we only accept exposure to higher climate risks at shorter maturities, favouring issuers which are more aligned and have lower climate-related risks at the long end. Portfolio managers can then allow shorter-dated debt to roll off and decide whether to reinvest with the same issuer or seek companies in the same sector that have more convincingly proven their climate leadership credentials. This avoids our portfolios being left holding stranded assets, those with little to no economic value in a transitioning world.
Our view is that by making climate-focused changes to their assets, trustees could benefit their schemes irrespective of their end-game outcome. Those targeting self-sufficiency should have a greater resilience to climate change over the longer term while those seeking a risk transfer will have portfolios which may be more closely aligned to those of the insurance companies taking on their assets. This could potentially reduce the cost of any transfer, while also reducing near-term portfolio risks from regulatory regime changes and the impact on asset prices.
Engagement at all levels
Focused dialogue with company management is an essential part of the Climate Buy and Maintain process. We think engagement can help to shape company strategy and allow businesses to become more resilient to the impacts of climate change – and we are convinced that it must be a key component for transitioning companies, and therefore portfolios, to meet their climate objectives.
Voting at company meetings where we own equity holdings is only one tool at our disposal, in fact fixed income investors have an equally wide range of tools at their disposal to enact meaningful engagement initiatives.
We believe the most effective engagement is ongoing and takes place at multiple levels – from credit analysts engaging with issuing companies, to quantitative teams liaising with data providers, and engagement at corporate level with industry bodies and regulators. In the climate space, each of these interactions, in addition to industry partnerships with our peers, is designed help create more sustainable and net zero-aligned businesses.
In addition to the wider environmental and social benefits of contributing to net zero through engagement, we believe that over the medium to long term, engagement should help make the first three principles more achievable, while acting as a risk mitigation tool. Companies with a strong sustainability mindset could be quicker to respond to a more demanding consumer base, be less likely to face regulatory issues or labour issues such as strikes and should be less likely to be shunned by investors. That can potentially mean that such issuers experience lower drawdown or downgrade risks.
From a portfolio perspective, if more companies are chaperoned towards alignment and then to net zero then this should retain a wider investment universe from which portfolio managers can select bonds, maintaining the full diversification of the investment universe.
Transparency through reporting
Pension funds are faced with an increasingly heavy reporting burden and will need clear and timely data from their asset managers to manage this burden. We believe that progress related to each of the above principles should be clearly reported to clients, alongside traditional financial metrics. That way clients can see how a strategy may be improving outcomes and delivering real-world impact.
But which metrics should asset owners consider and request from asset managers? Right now, there is no single measure that adequately captures net zero alignment and therefore a dashboard of different data is required, together with clear explanations. We believe that, at a minimum, reporting should include a range of carbon emissions, degree of net zero alignment, and a measure of climate-related risk.
Further, these metrics should be:
- Simple to understand, so that investors and end-stakeholders can understand and appreciate their meaning
- Time-consistent, so that progress against the metrics can be monitored over a long time period
- Aggregable across mandates and asset classes so clients can report at a total portfolio - and most importantly:
- Relevant to the clients’ regulatory requirements and investment objectives
Using this framework, we believe that pension fund clients should be able to see in full the actual and potential impacts of climate change on their portfolio –and set climate-related objectives in light of this – all while aiming to deliver the sustainable long-term returns that will meet scheme liabilities for years and decades to come.
Disclaimer
This document is for informational purposes only and does not constitute investment research or financial analysis relating to transactions in financial instruments as per MIF Directive (2014/65/EU), nor does it constitute on the part of AXA Investment Managers or its affiliated companies an offer to buy or sell any investments, products or services, and should not be considered as solicitation or investment, legal or tax advice, a recommendation for an investment strategy or a personalized recommendation to buy or sell securities.
Due to its simplification, this document is partial and opinions, estimates and forecasts herein are subjective and subject to change without notice. There is no guarantee forecasts made will come to pass. Data, figures, declarations, analysis, predictions and other information in this document is provided based on our state of knowledge at the time of creation of this document. Whilst every care is taken, no representation or warranty (including liability towards third parties), express or implied, is made as to the accuracy, reliability or completeness of the information contained herein. Reliance upon information in this material is at the sole discretion of the recipient. This material does not contain sufficient information to support an investment decision.