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ESG

Perspective published on September 19, 2022

There's Nothing Passive About Net Zero in Fixed Income

Summary

  • Our view is that bond investors who are concerned about the potential for climate change to cause extraordinary market dislocation in the future need to be proactive today.
  • Many long-term investors are considering strategies to transition portfolio holdings to net zero greenhouse gas (GHG) emissions by 2050. [1]
  • Breckinridge believes this is forward-looking investing that demands a strong sense of stewardship, engagement, and collaboration.

Breckinridge believes there is a solid investment case for long-term investors to transition portfolio holdings to net zero greenhouse gas (GHG) emissions by 2050, consistent with global ambitions to limit global warming to 1.5 degrees Celsius above pre-industrial levels.

We believe that climate transition risks are not adequately assessed, or priced into many investments and, that the financial materiality of these risks will only increase over time. In conversation, we have found that corporate bond investors, including pensions and endowments, who are responsible for the reliability of future cash flows are particularly focused on the evolving risks and opportunities associated with a low- or no-carbon economy.

We also believe this is forward-looking investing that demands a strong sense of stewardship, engagement, and collaboration.

For investors taking the added step of committing to reduce portfolio emissions intensity, passive investing and divestment are too blunt an instrument, in our view, and leave the due diligence (and opportunities) to active capital.

It is our conviction that net zero is not a passive investment approach. Indeed, we think it is more than active management.2 Investors who are concerned about the potential for climate change to cause extraordinary market dislocation in the future need to be proactive today.

In this commentary, we review some traditional passive approaches and what we consider to be intrinsic limitations within a net zero framework. Then we discuss Breckinridge’s process and why we believe an investment process that comprises a strategy based on proprietary analysis and active portfolio management is better aligned for a net zero framework.

Traditional passive approaches have limitations in a net zero framework

  • Fossil fuel-free strategies can be passively or actively managed investments that exclude companies that produce, transport, and refine fossil fuels. By excluding such investments from a portfolio, investors effectively exclude themselves from expressing their views on a carbon transition. Equity or debt ownership can enhance an investor’s standing to engage with an issuer to encourage real world emissions reductions. A decision to forego that enhanced standing could limit the opportunity to engage. The exclusionary approach restricts access to capital without discretion, effectively penalizing even the best positioned companies that have viable strategies to transition their businesses and are investing in climate solutions.
  • Passively indexed net zero investment strategy choices at this time are limited. Based on our research, just one fixed income index offers similar yield and duration characteristics as the Bloomberg U.S. Corporate Investment Grade (IG) Index (the “U.S. Corporate IG Index”),3 which is a common benchmark for investors in U.S. corporate bonds. That is the Bloomberg MSCI US Corporate Climate Paris-Aligned ESG Select Index (the “ESG Select”).4

    A passive indexing approach for net zero alignment in fixed income, based on the ESG Select index, may limit an investor’s pursuit of net zero goals. For example, the ESG Select index reduces or eliminates allocations to energy and utilities that are present in the U.S. Corporate IG Index (See Figure 1). Constraining exposure to two sectors that are central to pursing net zero goals poses several investment issues.

First, excluding the energy sector from investment theoretically increases the cost of capital for sector constituents by incentivizing asset managers with low tracking error requirements to avoid lending to companies within the sector. In our view, the ESG Select index’s reduction or elimination of allocations to the energy and utilities sectors, ignores the fact that fossil fuel energy is necessary in many applications at this point in time. A transition to low- or no-carbon operations in these and other sectors will take time, innovation, thoughtful execution, and access to the capital markets to finance the transition. Limited or no access to capital may cause the cost of the transition to increase, and its viability to suffer.

Second, the ESG Select index’s limited or lack of exposure to certain sectors relative to the U.S. Corp IG index, could increase idiosyncratic risks for passive investment strategies, as there are simply fewer companies to invest in. In addition, challenges may exist for sourcing longer duration investments; specifically, in the 20-year or longer portion of the yield curve. The utility and energy sectors currently account for 15 percent of total outstanding debt (by market value) in the U.S. Corp IG Index, but they account for a larger 22% of the index when looking at the 20-year or longer portion of the index (as of August 31, 2022).

Third, reducing or eliminating exposure to certain economic sectors constrains an investment manager’s opportunity to leverage active engagement with company management teams. Similar to the fossil fuel-free strategy, an investor forgoes an opportunity to advocate for an improved climate profile.

  • What is sometimes referred to as “Active indexing” approaches include passive indexing with an overlay of some element of active portfolio management. For example, beginning with the reduced opportunity set presented by the ESG Select index, an active indexing net zero approach might increase allocations on a regular basis to companies with GHG emissions-reduction targets or disclosures encouraged by a third-party organization.

    While not passive by definition, in our view, investing in issuers that will contribute to the required GHG emission reductions to reach the 2050 goal demands a more holistic view of risk. An active indexing strategy generally does not incorporate an analyst’s expert judgement, which can take into consideration a more comprehensive view of any given company’s credit or net zero profile.

Why an active net zero strategy is different

Breckinridge chose to develop an analytical and actively managed approach to a net zero mandate that is available as a customization to certain investment strategies that we offer. Here’s why.

Our analytical and actively managed approach, in our view, combines three key elements that are essential to reaching net zero goals:

  • Active, independent research that drives security buy/sell decisions, inclusive of net zero targets that may impact portfolio construction over time,
  • Strategic engagement with security issuers, and
  • A commitment to methodology transparency and reporting.

We believe a strategy based on proprietary analysis and active portfolio management recognizes the value and importance of credit research in fixed income portfolio construction and management. Independent insights generated by experienced research analysts are essential to identifying the “best actors” in the net zero transition.

When considering a net zero allocation, it is also our belief that a robust analytical approach with active management can be enhanced by the inclusion of environmental, social and governance (ESG) analysis. Awareness is increasing amongst regulators, consumers, investors, and companies of the intensifying effects of a warming planet and its impacts. We view climate change as a material, systemic investment risk that is impacting financial markets today and will likely accelerate in scale over time.

Over the long-term we believe that climate risk will have increased influence in valuation models particularly among the large-emitting sectors. Carbon transition poses risks to carbon-producing assets and creates opportunities in cleaner technologies all of which can influence the outlook for different companies. For many investors,5 climate change—and the expected government and regulatory responses—is among the most material of ESG risks.

We use our corporate climate transition risk framework to assign company-level net zero alignment categorizations through an ongoing quantitative and qualitative process. We believe that climate transition risk analysis is a natural extension of our research process as it is grounded in financial materiality.

Our approach integrates a strategic engagement effort that is driven by our research team. Engaging with corporate fixed income issuers, organizations and other subject matter experts can provide a robust view of progress on a net zero pathway and prospects for future advancement.

An actively managed strategy allows an investor to advance a transition to a net zero emissions future and, just as importantly, assesses measurable steps on the pathway to that goal.

Conclusions

The net zero transition is accelerating, according to the United Nations, with more governments and corporations making commitments to net zero goals of the Paris Agreement6 and COP26.7 Decarbonizing corporate operations will be expensive and will require vast commitments of capital. The capital markets have a vital role in financing the transition to a net zero economy. We believe much of that capital will be raised in the bond market.

Our opinion is that passively indexed, and actively indexed investment strategies are not appropriate vehicles for net zero-aligned fixed income investing. These approaches can limit investment manager discretion in sector allocation, security selection and the ability to engage with issuers to advocate for the transition. In effect, investors in these approaches abdicate their role in the net zero transition, because if index constituents fail to decarbonize, even investors with the most genuine intentions can fall short of their goals using a traditional approach.

In our view, directing capital towards issuer companies that are leaders in their sectors from a climate transition risk perspective, regularly measuring progress and consistently engaging with issuer management teams, will drive progress and performance. Actively managed strategies that include a multi-faceted plan to incorporate sector-specific pathways, climate governance, company goals/targets, and measurement of a company’s execution against its stated goals and targets are better aligned to offer investors a more comprehensive solution to a net zero-aligned mandate.

 

[1] Asset Owners with $8.5 Trillion Commit to Net Zero Emissions, United Nations Climate Change, March 10, 2021.

[2] Net zero alignment is only one consideration between active and passive investing. Others include fees, costs, and suitability in an investor's overall financial goals. See the disclaimers for more information between passive and active investing.

[3] The Bloomberg Barclays U.S. U.S. Corporate Investment Grade (IG) Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility, and financial issuers. Investors are not able to invest directly in any index.

[4] Bloomberg MSCI US Corporate PAB Index is designed to meet the standards of the EU Paris Aligned Benchmark (PAB) Label. The index sets an initial 50% reduction of absolute GHG emissions relative to the standard Bloomberg US Aggregate Corporate Index1, followed by an annual 7.5% decarbonisation relative to the baseline emissions. The index uses an exclusions-based approach to achieve the decarbonisation trajectory. To be included, securities must be investment grade, fixed-rate, corporate bonds. The index was created on April 8, 2022.

[5]  Asset Owners with $8.5 Trillion Commit to Net Zero Emissions, United Nations Climate Change, March 10, 2021.

[6] The Paris Agreement (French: Accord de Paris), often referred to as the Paris Accords or the Paris Climate Accords, is an international treaty on climate change, adopted in 2015. It covers climate change mitigation, adaptation, and finance. The Agreement was negotiated by 196 parties at the 2015 United Nations Climate Change Conference near Paris, France. The Paris Agreement's long-term temperature goal is to keep the rise in mean global temperature to well below 2 °C (3.6 °F) above pre-industrial levels, and preferably limit the increase to 1.5 °C (2.7 °F), recognizing that this would substantially reduce the effects of climate change.

[7] The 2021 United Nations Climate Change Conference, more commonly referred to as COP26, was the 26th United Nations Climate Change conference, held at the SEC Centre in Glasgow, Scotland, United Kingdom, from October 31 to November 13, 2021. The conference was the first since the Paris Agreement. The result of COP26 was the Glasgow Climate Pact, the first climate deal to explicitly commit to reducing the use of coal. It included wording that encouraged more urgent greenhouse gas emissions cuts and promised more climate finance for developing countries to adapt to climate impacts.

DISCLAIMER

This material provides general and/or educational information and should not be construed as a solicitation or offer of Breckinridge services or products or as legal, tax or investment advice. 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.

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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.

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.

Net Zero alignment and classifications are defined by Breckinridge and are subjective in nature. Although our classification methodology is informed by the Net Zero Investment Framework Implementation Guide as outlined by the Institutional Investors Group on Climate Change, it may not align with the methodology or definition used by other companies or advisors. Breckinridge is a member of the Partnership for Carbon Accounting Financials and uses the financed emissions methodology to track, monitor and allocate emissions. These differences should be considered when comparing Net Zero application and strategies.

Targets and goals for Net Zero can change over time and could differ from individual client portfolios. Breckinridge will continue to invest in companies with exposure to fossil fuels; however, we may adjust our exposure to these types of investments based on net zero alignment and classifications over time.

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