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The sleeping giant - part 2

Kris Atkinson & Sajiv Vaid

Kris Atkinson & Sajiv Vaid - Portfolio Manager

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Bond markets are critical in the fight against climate change (part 2)

Fixed income investors have a vital role to play in accelerating the shift to a net zero world by 2050. In the first of this two-part series, Kris Atkinson and Sajiv Vaid, portfolio managers of our actively managed climate focussed fixed income strategies and our sustainable sterling corporate bond strategy discussed the challenge of climate change for bond investors and how debt markets are uniquely positioned for investors to support the transition to net zero and to influence companies towards net zero. In this second part, Kris and Sajiv explain the practical steps and strategies required to incorporate climate risks in bond investing and include several engagement case studies.

How to incorporate climate risks

More and more investors are setting climate targets, for example 5% annual emissions, for their investments. Meeting this target can be achieved relatively easily by excluding a few high emitting companies or industries from the universe. Other investors allocate to green bonds to achieve climate objectives.

We believe an exclusionary approach and/or allocating to sustainable debt instruments is not enough. The transition to a low carbon world needs to encompass the entire economy - all sectors, asset classes and geographies - and if we ignore the decarbonisation challenge for whole groups of companies and industries, we are simply transferring the problem. The onus will then be on non-climate focused investors to fund these companies and there is a real chance that ‘business as usual’ will continue, and real-world emissions will not be reduced. In fact, emissions tend to be concentrated in specific sectors - ensuring that these sectors are captured is essential to make a meaningful difference and achieve net-zero targets.

A truly transformative decarbonising investment strategy should be built on rewarding capital to companies that explicitly demonstrate climate best practices today or are on the path towards it. This helps “raise the climate bar” for the whole industry. Maintaining the breadth of the investment universe helps to maximise investment opportunities and ensures strong candidates for transition are not overlooked.

Australian mining company Fortescue Metals is an example of a company that would be overlooked in an exclusionary approach but offers a credible plan towards transition, an outsized positive impact on decarbonisation and has an attractive investment profile. Fortescue is the fourth largest seaborne iron ore producer in the world and aims to be carbon neutral by 2030. It allocates 10% of net profits to a dedicated green energy and industry subsidiary, has strong credit quality and its net leverage is zero. The company also has enormous cashflow generation resulting from robust iron ore prices and we expect it to be upgraded to investment grade in due course.

Fortescue Metals plan for carbon neutrality by 2030

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Source: Fortescue Metals Group Sustainability Financing Framework, 2022. Note: Image is illustrative, and timing does not directly correlate to decarbonisation activities.

The engagement X-factor

Many investors associate engagement with equity markets given the attention awarded to shareholder votes on company resolutions. But most shareholders trade stocks on the secondary market where contact with company management is less frequent. Fixed income investors have more direct interaction with issuers as the primary market features more prominently. Therefore, fixed income investors can be just as engaged with companies as their equity counterparts and the two approaches are in many ways complimentary. In addition, bondholders can engage with a more diverse corporate base than shareholders, such as private companies.

We think relationship building through ongoing dialogue is the most effective way to improve the attitude of businesses towards corporate and climate responsibility. We can help issuers focus on decarbonisation or other sustainability matters and ultimately attract the type of capital that supports these issues. This can ensure transition is part of a company’s overall journey rather than a one-off project.

Suzano is a Brazilian pulp and paper manufacturer that we have been engaging with since February 2021. Working together with Fidelity’s Equity and ESG teams, we initially sought to understand why Suzano’s emissions reduction targets were, in our opinion, unambitious. We also wanted to know what the company was doing to promote biodiversity - an integral part of fighting climate change. Suzano did not include any biodiversity targets in its 2020 sustainability report. Following our engagement with the company, Suzano released its first ever explicit targets to improve biodiversity in the Brazilian rainforest.

Another recent engagement story is with Tank & Rast (DERST). It is Germany’s leading motorway concessions company for petrol stations, shops, restaurants and hotels and is privately owned meaning it is not subject to sustainable pressure from public equity markets. We have sought to engage with the company for some time but it’s only last year when DERST announced it was developing a formal ESG strategy that we started to see real progress. In October 2021 one of our Senior Credit Analyst’s spoke with DERST’s CFO, with our objective to be involved in the early stages of their ESG journey to ensure that DERST incorporates best practices, including setting targets and communicating a clear, achievable strategy for reducing their direct environmental impact. On both these points we expect updates to be announced in the coming months, which should be welcomed by the market. There are also other developments that we wish to see including alignment with the UN Sustainable Development Goals, external certification and better disclosure. We intend to continue monitoring their progress and to engage with DERST further if needed.

Passive or active climate investing?

It can be tempting to invest in a climate strategy via building a systematic data screen or a low carbon passive index that filters for issuers with the lowest carbon footprints. This is a relatively simple way of sustainable investing and suits many investors. However, this passive-led approach has its limitations.

It’s a fairly blunt method that cannot be applied to more finely tailored portfolios. For example, it can invest in low carbon emitters or companies with a set of superior ESG metrics, but it isn’t very good for supporting decarbonisation efforts or mitigating the disintermediation risk of decarbonisation solutions or balancing risk and return considerations. It doesn’t evaluate the direction of a company either and instead uses historical data with which to deliver outcomes that will occur in the future.

This approach can also compromise on diversification by excluding certain types of companies or industries. For example, one Paris-aligned benchmark excludes companies that generate over half their revenues from electric power generation via fossil fuel sources. This is a de facto exclusion of most utilities since their global share of fossil fuel generation is two-thirds. Electricity generation is the largest source of index emissions, and the decarbonisation of this sector is essential to global decarbonisation. Another example is the exclusion of companies generating more than 10% of revenues from fossil fuel production, exploration, distribution, and services. This dismisses all conventional energy companies from the index, ignoring a sector that is vital to decarbonise if we are to ever achieve net zero.

Another real risk is the bizarre anomaly where passive climate portfolios increase the weight of companies to reflect the benchmark despite those same companies having worsening climate performance scores or deteriorating carbon intensity. This occurs because these portfolios pick companies with a climate score above a certain threshold.

Active climate investing is more time consuming and research intensive, but that is compensated by the potential to make a greater sustainability impact and generate long term alpha. The active approach builds on the data sources used in passive investing by incorporating additional information that may be difficult to quantify, such as the credibility of decarbonisation strategies, the commitment of management to net-zero, the competitive landscape and the regulatory backdrop. Active climate investors can also engage and counsel companies towards transition.

What to look for in climate leadership and best-in-class transition companies

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Source: Fidelity International, April 2022.

Bondholders are waking up to net-zero

Active fixed income climate-aware investing is an important strategy in the fight against climate change. Debt markets play a crucial role in facilitating decarbonisation by allocating capital. This gives bondholders the ability to influence organisations, supporting them in developing their decarbonisation strategies and funding companies committed to transitioning.

Climate-led active fixed income investing should be based on two key building blocks - the decarbonisation profile of a business and engagement. Companies that are driving the decarbonisation agenda or are leaders in their field should be rewarded with more capital resources. Companies that are in high emission sectors or are laggards within other sectors, should be engaged with to support them in their transitions - after all, stewards of capital have a duty to push issuers to be ambitious and set targets to combat climate change.

We believe that investors who integrate a net-zero emissions strategy, which is backed by a forward-looking framework and positive engagement, will not only create value for a broad range of stakeholders but also enhance the sustainable returns in their portfolios. The potential of active fixed income climate investing is still relatively untapped, but it is growing fast.

Global capital markets won’t thrive when climate change-derived losses force defaults. The bond market has a privileged position with which to drive change, and investors are quickly waking up to the potential of this sleeping giant.

Risk Warning
 

  • The value of investments and the income from them can go down as well as up and investors may not get back the amount invested. 
  • Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.
  • Investors should note that the views expressed may no longer be current and may have already been acted upon.
  • Overseas investments will be affected by movements in currency exchange rates.
  • Investments in emerging markets can be more volatile than other more developed markets.
  • There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall.

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