Aegon Asset Management
Incorporating climate change in fixed income
Iain Buckle, Head of Credit UK and Rory Sandilands, Investment Manager at Aegon Asset Management
Climate change and low carbon transition are increasingly important themes for investors and it is broadly accepted that significant action is required to meet the goals of the Paris agreement. As regulatory and societal pressures drive greater awareness of climate-related risks, we are seeing growing scrutiny of climate-related exposures. This article addresses the question of how climate change can be incorporated within fixed income portfolios to align with clients’ net-zero goals.
We believe that fixed income investors have a dual role in helping manage climate change and the transition to a net-zero economy.
To identify and manage the risks associated with climate change, at asset and portfolio level.
More importantly, we have a role to play in funding the costs of climate transition and directing finance to those companies with strong and improving climate transition profiles.
Rather than simply exclude high-emitting companies, a more selective approach can be taken. Our Responsible Investment team have built a forward-looking research framework which looks beyond historic emissions to analyse transition readiness and identify companies that have robust and credible plans to transition towards a low carbon economy.
The research consists of a base assessment common to corporate issuers across sectors, followed by a sector-specific adjustment for those in pre-determined high influence sectors.
The base assessment focuses on three aspects: An understanding of a company’s GHG (Green House Gas) targets and ambition; their historic GHG emissions performance; and their overall management policies towards climate transition.
We then determine each sector’s ability to influence the low carbon transition and categorise into low and high influence sectors. Rather than focus on ‘impact’ — which has many definitions — we use the concept of ‘influence’.
High-influence sectors are those which have a greater ability to influence the transition to a low carbon economy and the achievement of global climate goals. This can be a result of their operational emissions (e.g. electric utilities), emissions from the products they sell (e.g. oil and gas) or more indirectly through their ability to influence the activities of others (e.g. banks).
Companies in those sectors are then subject to a further sector specific adjustment where the analysis focuses on the key climate issues for each sector, whether that is their direct operational emissions or emissions from products and/or supply chain.
The conclusion of the research is for companies to be categorised using a 1-5 scale from Leader to Laggard.
1. Leader
Ready for a low carbon future and actively driving the net-zero transition
2. Prepared
Policies, targets and actions aligned toward progress on net-zero
3. Transitioning
Demonstrating awareness of transition but a mixed degree of alignment
4. Unprepared
Policies, targets and actions misaligned or unaware of required transition
5. Laggard
Unprepared for a low carbon future or are actively working against climate goals
What makes a company’s transition plan credible?The first step to a credible transition plan is robust target setting. We expect to see companies make a commitment to net zero by 2050 at the latest as well as set short and medium term GHG reduction targets aligned to science-based sector-specific decarbonisation pathways. Having assessed the strength of the GHG reduction targets, companies should clearly set out the levers they intend to use to meet their targets. A truly credible plan should go beyond simply identifying these actions and should set meaningful timelines and KPIs in terms of how much each is expected to reduce emissions by and by when, and evidence that sufficient funds are being invested in the plan. In particular, transition plans should focus on absolute emissions reductions rather than offsets.
Turning theory into practiceOf particular importance for bonds is understanding climate change in the financial sector, given the dominance of issuance by banks and insurance companies, especially in the investment grade universe. Although they typically have low carbon footprints, from an operational perspective, they play a very important role in financing sectors that may be exposed to climate risks.
Engagement can be challenging as a bond investor, given the lack of economic ownership and voting rights. It is important to look closely at how one can engage with companies on climate transition matters, often leveraging our role as shareholders to benefit from wider engagement dialogue, or through collaborative industry initiatives.
The final step is to integrate climate research in portfolios, building a portfolio pathway towards net-zero alignment. Explicit climate-related guidelines can be applied with key milestones to steadily improve a fund’s exposure to companies who are better prepared for the transition to a net zero economy, and reduce the ability to own less prepared companies over time, so that by end of 2040, 100% of a climate focused portfolio is invested in companies who are aligned to net-zero.
Guidelines should reflect a reasonable pace of transition to encompass issuers from all sectors. They can be designed for compatibility with industry net-zero frameworks such as the Net Zero Investment Framework or Paris Aligned Investment Initiative.
Unlike traditional ESG research, such a framework is not based on financial materiality and therefore can be applied in both equities and fixed income, from investment grade to high yield and across maturities.
Disclaimer:
Capital at risk.
All investments contain risk and may lose value.
Responsible investing is qualitative and subjective by nature and may not reflect the beliefs or values of any one particular investor.
Opinions represent our understanding of markets; they are not investment recommendations or advice.
Aegon Asset Management UK plc is authorized and regulated by the Financial Conduct Authority.
AdTrax Code 5901950.1| Expiry: 31 August 2024.
