True decarbonisation is a complex process and involves many different drivers that can introduce unintended risks to the portfolio. Sam Grantham of abrdn gives a few insights into what can go wrong in a fixed income portfolio
Decarbonisation of fixed income portfolios needs to take place in the context of the overall energy transition and not be an exercise done in isolation from the broader economy, abrdn says.
If the objective is to decarbonise the entire economy rather than merely the portfolio, then investors need to thoughtfully analyse a company’s emission policies, apply a mixture of measurements and engage with company management to understand their intensions for the future.
It also involves keeping a close eye on any changes in the risk profile of the portfolio from any carbon mitigating measures taken, he says.
“Everyone talks about wanting to reduce carbon emissions in their portfolio, but there are a lot of ways of achieving this and not all methods are appropriate, depending on your risk profile, return expectations and desired outcomes,” Sam Grantham, Investment Director for Global Credit & Climate Transition at abrdn, says.
“For example, I could sell all of my utility exposure, but if you think about the sector risk profile of utilities, especially if we are going into a recession, then a lot of these are non-cyclical companies which perform well in times of market stress relative to the broader market.”
Everyone talks about wanting to reduce carbon emissions in their portfolio, but there are a lot of ways of achieving this and not all methods are appropriate
“They generate decent recurring revenues and have strong cash flow visibility so, from a risk perspective, utilities play a core part in retaining the return potential of the portfolio especially at the moment given we are seeing global economic data start to deteriorate,” he says in an interview with [i3] Insights.
An easy way to decarbonise a fixed income portfolio would be to sell companies in the heavy industry sectors and instead increase exposure to banks and technology companies. But this reduction in diversification could come back to bite an investor in more challenging economic times.
“Banks in general have a very low carbon footprint. Their main emissions come from their lending and investment portfolios, which are considered indirect scope 3 emissions, whilst most carbon footprint methodologies only include a company’s scope 1 and 2 emissions.
“Technology company emissions tend to stem from their energy consumption and therefore can easily reduce this by switching to renewable energy.
“So what you could do is go overweight banks, you could go with technology companies, but is that actually the right thing to do going into a period of increased uncertainty? Banks traditionally have underperformed in past recessionary scenarios and clearly some technology companies are very geared towards advertising revenues, which could be under pressure if we see current economic forecasts materialise.
“So there are many unintended consequences of potentially decarbonising your strategy,” he says.
Managing Risk
Becoming too preoccupied with just reducing the carbon footprint of the portfolio can lead to a false idea of how much risk there is in your strategy, Grantham says. In fixed income, duration is an important risk driver and needs to be considered in any changes to the portfolio.
For example, a less scrupulous investor could simply reduce the weighting to carbon intensive companies but extend the duration in those names in an effort to keep an exposure to them.
They might have reduced the overall emissions of the portfolio without divesting completely, but they have also increased the risk of the portfolio dramatically.
“In general, the carbon footprint formula is the weight of a company in your portfolio times the emissions. So I can reduce the weight of carbon intensive industrials in the one-to-five-year part of the maturity spectrum in my portfolio, I can reduce it by as much as 50 per cent, and take more risk by buying 20- or 30-year debt,” Grantham says.
“Taking that 30-year debt versus a two-year, three-year or four-year bond results in more tracking error and a higher risk profile.
“A lot of these companies might face stranded asset risk over the longer term, especially as regulations evolve, or they haven’t done a great job in cleaning up their direct and indirect emissions, but yet you are now taking that risk in the 30-year debt,” he says.
Investors also need to be careful in how a company’s carbon intensity can fluctuate over time for reasons that have little to do with any changes in the emissions profile. Therefore, basing any investment decision purely on carbon metrics can be dangerous.
For example, a commonly used method of determining an entity’s carbon intensity is simply emissions as an expression of revenue, but what if revenues are temporarily down while emissions remain steady or even decline somewhat?
“What is interesting is that the carbon footprint of your portfolio could change based on non-carbon related data,” Grantham says. “During COVID, a lot of companies essentially shut down, especially on the services side. So, if your revenue halves but your absolute emissions stay the same, then your carbon intensity doubles. A similar problem can occur when companies undergo M&A transactions.
“There are different drivers of why your carbon footprint increases that could have no impact on whether that company’s doing a better job in terms of their climate agenda. They could have actually reduced absolute emissions, or they could have phased out a certain kind of fossil fuel.
“So it’s [about] understanding the drivers of your carbon footprint and looking at different metrics because not one metric is perfect, honestly,” he says.
Looking Towards the Future
Data on carbon intensity is improving as more companies disclose their emission profile, but data on emissions is not enough to understand how a company’s emissions may evolve in the future.
Carbon data is inherently backward-looking and so it says little about how companies and sectors are tackling their impact on the environment over time.
“You can’t look at carbon emissions data in isolation to justify a position in the portfolio,” Grantham says. “Imagine looking at a company’s P&L statement from two or three years ago and making an investment decision based on that, because that is essentially what carbon data is. It’s backward looking; it doesn’t tell you how it’s going to perform in the future.
You can't look at carbon emissions data in isolation to justify a position in the portfolio. Imagine looking at a company’s P&L statement from two or three years ago and making an investment decision based on that, because that is essentially what carbon data is
“You’re not incorporating carbon targets, you’re not incorporating maybe an M&A transaction, where they’ve sold their entire coal base, because that hasn’t been reflected in carbon emissions data when purely looking at the carbon footprint of a portfolio at a point in time,” he says.
To get a good idea of how a company’s carbon profile might change you need to engage with it and understand the policies and drivers behind management choices.
“What we do is we meet with management and we look at their carbon targets over the next three, five, 10 and 30 years, and we look at their track record. Have they, for example, been using CAPEX purely towards greener solutions, or are they still spending 50 per cent on fossil fuels in terms of building capacity?” Grantham says.
“Do we think they are leaders in this space? Do we think they are outperforming? Do we think they are on a trajectory to net zero? If so, then we’re happy to own these companies in a portfolio,” he says, “but we will continue to engage and monitor these companies especially the ones most at risk in our view.”
The Bigger Picture
Finally, the energy transition is a broad-based societal shift and will require input from many sectors to end up with a low carbon economy, even from carbon intensive businesses. For example, the production of many of the raw materials needed to build new electrification infrastructure are carbon intensive too.
“If you think about the steel sector, then steel is a key input into the EV (electric vehicle) industry, into electrification in general, it is a key input into solar, PV (photovoltaic) cells and wind turbines. This is a material that is essential to the transition to a low carbon economy. So starving capital from the steel sector will have more negative consequences than we currently are accounting for,” Grantham says.
“I’m happy to own a steel company if I think their carbon emissions are trending down and their key clients are enabling renewable energy output, or enabling the electric vehicle industry,” Grantham says.
Again, it comes back to looking beyond merely counting emissions in the portfolio and towards drivers that benefit to the wider move to a low carbon economy.
“It is about decarbonising the broader economy versus decarbonisation of your portfolio. There is a difference there. Just because I sell out of a company it doesn’t mean that we are reducing emissions in the economy,” he says.
Samuel Grantham will speak at the investor roundtable ‘Decarbonising Fixed Income Portfolios’ to be held online on 25 August 2022. For more information, please click here.
This article is sponsored by abrdn. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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