With climate change continuing to follow the pace predicted by scientific models, Breckinridge’s net zero approach works to manage transition risks for Investment Grade corporate bond portfolios across all sectors, including sectors with higher greenhouse gas (GHG) emissions.
The key tenets of our approach are as follows:
- The growing threat of climate change will create a much more demanding policy environment for companies, increasing costs for carbon activities while heightening regulatory scrutiny, potential litigation, and reputational risks.
- By decarbonizing in alignment with a credible net zero pathway, a company is more likely to minimize the risks associated with a disorderly transition from fossil fuels, positively impacting its overall credit quality.
- The assessment of a company’s long-term credit quality will integrate an analysis of its alignment with net zero goals, examining quantitative data to track progress along its transition pathway while periodically engaging with management.
- We believe a net zero investing strategy can more positively influence the transition from fossil fuels if portfolios are diversified across all sectors, without requiring entire divestments from higher GHG emitting sectors, though a more discerning approach is required.
- Ongoing reporting of the portfolio’s transition toward net zero emissions will track the portfolio’s financed emissions and each company’s progress toward net zero alignment.
The net zero1 transition is underway. The impact of the immense commitments made by governments and corporations to reduce emissions in line with the Paris Agreement undoubtedly has profound impacts on the global economy, financial markets, and corporate finance with implications that need to be considered by all investors. Net zero pledges now cover 92 percent of gross domestic product and 88 percent of emissions worldwide.2 About $2.8 trillion is set to be invested globally in energy in 2023, of which more than $1.7 trillion is expected to go to clean technologies. The remainder, slightly more than $1 trillion, is going to coal, gas and oil. The International Energy Agency (IEA) notes that investment in solar is set to overtake the amount of investment going into oil production for the first time.
The shift to higher global investment in clean technology compared with fossil fuels represents meaningful progress on the goals of the United Nations Paris Agreement and the Net Zero Asset Managers Initiative (NZAM). Still, the pace of implementation has been slower than needed. The amount of investment must accelerate in order to limit the temperature increase to 1.5°C, with the goal of net zero greenhouse gas emissions by 2050 or sooner.
According to a 2022 report by McKinsey, financing this transition will require an average annual spending of $9.2 trillion on physical assets over the next several decades. Most of that investment needs to be front-loaded, as the overwhelming consensus in climate science is that the window to avoid far more dire impacts from climate change is narrowing quickly. Further delay allowing more carbon to accumulate elevates the risk of crossing a critical threshold or tipping point. Investors who are committed to supporting the transition to net zero need to move quickly.
Breckinridge’s net zero approach works to identify risks and opportunities arising from climate change and the transition from fossil fuels. We believe an eventual 2°C rise in temperatures above pre-industrial levels presents significant potential for uncertainty and volatility, which has yet to be reflected in market pricing. At the same time, the transition offers an enormous opportunity for the companies best able to develop and harness new technologies. Our net-zero approach leverages the significant advances in climate-related disclosures, including GHG emissions data, to build an analytical framework for examining these factors across all sectors and industries.
Two Key Elements of Our Net Zero Investing Framework
The research approach involves quantitative and qualitative assessments that Breckinridge analysts have developed to assign company-level net zero categorizations.3 These net zero categorizations are informed by our data-driven climate transition risk framework and ongoing engagement with companies. These categorizations help to inform net zero portfolio construction as we seek to increase the proportion of market value towards companies that are “aligning” towards net zero over time.
Our net zero research framework includes, for example, ongoing analysis of a company’s research and development program into low-carbon technologies, as well as capital expenditures plans that advance decarbonization. Our research into material quantitative and qualitative factors that measure a company’s net zero progress also involves active engagement with management. (For an example of how material considerations help distinguish companies that are making progress on a pathway to net zero, please see the accompanying article “Clear Goals, Measurable Progress Differentiate Companies.”)
- Climate Transition Risk Framework: a quantitative and qualitative approach that includes a cross-sector relative assessments across four categories:
- Exposure to climate risk,
- Track record of emissions reduction,
- Climate-related goals and the strategy to achieve them, and
- The quality of a company’s climate governance approach
- Direct and/or Collaborative Engagement with companies
Based on analyst assessments of a company’s net zero pathway alignment, portfolio managers consider securities for client portfolios across five categories (See Figure 1):4
Additionally, we can calculate the financed emissions of a portfolio and the financed emissions intensity per $1 million invested, using a reporting standard from the Partnership for Carbon Accounting Financials (PCAF).5
The Role of High Emitting Sectors in a Net Zero Portfolio
An active and more balanced net zero investing strategy requires a discerning focus on high-emitting sectors. Including the full breadth of economic sectors expands the investment opportunity set as we seek to identify outliers. Outliers can include outperformers that warrant increased allocations, and laggards that may be candidates for engagement and potentially divestment if no progress is made.
In our article There Is Nothing Passive About Net Zero in Fixed Income, we examine what we consider to be intrinsic limitations to some traditional passive approaches and within a net zero framework.
Specifically, some passive approaches exclude companies that produce, transport, and refine fossil fuels. By doing so, some passive net zero investment approaches may limit investments in energy or other high-emitting sectors like materials, energy, or utilities.
The effect of a negative screening approach on an investor’s portfolio can be two-fold. First, a decision to exclude investments in high-emitting sectors dismisses the potential that there will be winners and losers in certain sectors, as the transition to a low/zero carbon world economy advances. By choosing not to allocate investments to certain sectors investors reduce access to capital (debt capital for fixed income investors) that companies could dedicate to help fund their transitions. The largest emitting sectors have the most work to do in their efforts to achieve net zero. Rescinding the necessary capital will likely make their work harder.
Second, from an investor’s risk management perspective, excluding some sectors from portfolios creates sector concentrations that can limit or eliminate the benefits of risk diversification across economic sectors.
Giving Clients Insight to Progress on the Net Zero Pathway
The data-driven Breckinridge research framework allows us to customize a portfolio that seeks to achieve net zero financed emissions intensity by 2050 or sooner, while remaining below the required net zero-aligned emissions intensity pathway of the portfolio’s strategy benchmark index. Our willingness to share those insights with clients provides the transparency that we believe net zero investors deserve and should demand.
For investors in Breckinridge’s net zero approach, we report key portfolio statistics, including the portfolio’s financed emissions and exposure across the five alignment categories. In addition, we also report net zero alignment of portfolio holdings and benchmark constituents in top emitting sectors.
In managing the portfolio, we seek to increase the proportion of companies, based on market value, within the portfolio that analysts categorize as “aligning” or higher towards a net zero pathway over time.
A Commitment to Long-Term Investing
As a fixed income investor and fiduciary, Breckinridge recognizes our responsibility to look beyond the often short-sighted horizon of markets to assess potential longer-term risks and costs. Ranking highest among these are the overwhelming scientific consensus on the threat of climate change and the cost associated with transitioning from carbon. After more than a decade of analyzing factors related to climate risk and leveraging the significant improvements in disclosure, we have developed a net-zero approach that includes diversification across market sectors, which we believe is important for making progress in transitioning to a low-carbon economy. We welcome the opportunity to explain this approach more fully to investors who share our commitment to working toward a successful transition.
 Net zero means achieving a balance between GHG released into the atmosphere those removed from it.
 “Why set a science-based net zero target,” Science Based Targets, August 27, 2023.
 Net Zero terminology is defined in the Net Zero Implementation Guide published by the Institutional Investors Group on Climate Change (IIGCC). Companies and other advisors may use different classifications, definitions, and methodologies. Investors should consider these differences when comparing Net Zero application and strategies. Target and goals for Net Zero can change over time.
 The five alignment categories are defined in the Net Zero Investment Framework Implementation Guide published by the Institutional Investors Group on Climate Change (IIGCC). Breckinridge’s classification of companies to the net zero categories is based on our internal research process, including the Corporate Transition Risk Framework. Our classifications may not align with the conclusions of other advisors or firms. Investors should consider these differences when comparing Net Zero application and strategies.
 Using PCAF’s Financed Emissions Standard equips financial institutions with “standardized, robust methods to measure financed emissions and enables them to assess climate-related risks in line with the recommendation of the Task Force on Climate-related Financial Disclosures (TCFD), set science-based targets (SBTs) using methods developed by the Science Based Targets initiative and other science-based methodologies, report to stakeholders, and inform climate strategies and actions to develop innovative products that support the transition toward a net zero emissions economy.” (PCAF (2022). The Global GHG Accounting and Reporting Standard Part A: Financed Emissions. Second Edition.)
PCAF accounting for financed emissions addresses Scope 1 GHG emissions (direct emissions, as from fossil-fuel combustion) and Scope 2 GHG emissions (indirect emissions, as from purchasing electricity, heat, or steam). Incorporating Scope 3 GHG emissions reporting is challenging due to prevalence of estimated data, lack of company reporting, and the potential for double counting, and further work in this area is needed.
This material provides general and/or educational information and should not be construed as legal, tax or investment advice. It does not include all of the information necessary to make a decision to invest with Breckinridge. The content is current as of the time of writing or as designated within the material. All information, including the opinions and views of Breckinridge, is subject to change without notice.
All investments involve risk, including loss of principal. Diversification cannot assure a profit or protect against loss. Fixed income investments have varying degrees of credit risk, interest rate risk, default risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Income from municipal bonds can be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the IRS or state tax authorities, or noncompliant conduct of a bond issuer. There is no assurance that the customization or the approach will meet their objectives.
Breckinridge believes that the assessment of ESG risks, including those associated with climate change, can improve overall risk analysis. When integrating ESG analysis with traditional financial analysis, Breckinridge’s investment team will consider ESG factors but may conclude that other attributes outweigh the ESG considerations when making investment decisions.
There is no guarantee that integrating ESG analysis will improve risk-adjusted returns, lower portfolio volatility over any specific time period, or outperform the broader market or other strategies that do not utilize ESG analysis when selecting investments. The consideration of ESG factors may limit investment opportunities available to a portfolio. In addition, ESG data often lacks standardization, consistency, and transparency and for certain companies such data may not be available, complete or accurate.
Breckinridge’s ESG analysis is based on third party data and Breckinridge analysts’ internal analysis. Analysts will review a variety of sources such as corporate sustainability reports, data subscriptions, and research reports to obtain available metrics for internally developed ESG frameworks. Qualitative ESG information is obtained from corporate sustainability reports, engagement discussion with corporate management teams, among others. A high sustainability rating does not mean it will be included in a portfolio, nor does it mean that a bond will provide profits or avoid losses.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.
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