Five principles for building a climate-aware Buy and Maintain strategy

  • 16 June 2022 (7 min read)

Buy and Maintain strategies are designed to be a sustainable and resilient core holding for pension funds and other institutional investors. The goal is to enhance returns from the investment grade credit market over the longer term through highly diversified portfolios that mitigate against turnover and transaction costs. Over recent years, it has become increasingly clear that doing this effectively means actively addressing risks from climate change and the global policy response.

The world is navigating the effects of the Ukraine crisis, highlighted by imperatives around energy supply and management. But we firmly expect the political momentum around achieving net zero by 2050 to endure and believe an opportunity has opened for investors to structure their portfolios on pace with changes across the corporate world and in credit markets.

To do this successfully, investors must take great care. We hold that every Buy and Maintain investor could potentially benefit from applying a climate-aware lens to their portfolios using these five principles:

Complement Financial Objectives

This is the first priority. Investors should use climate integration, such as risk mitigation and net zero alignment, to improve, or at the very least maintain, financial performance. In our view, the integration of climate takes into greater account emerging and material risks – including consumer trends and regulatory penalties – and that these risks could increase the potential for defaults and downgrades.

We favor a process where scenario analysis helps build our framework of understanding and a team of fundamental credit research analysts integrates climate into the research process for both financial and ESG (environmental, social, and governance) factors. Meanwhile, portfolio managers structure portfolios to minimize climate risks at longer maturities. The goal is to deliver an improved climate risk profile that minimizes forced sales while wider environment-related benefits can feed through over time.

It is not about being “green at any price.” This is a low-turnover approach to Buy and Maintain investing that seeks to reduce costs and skew climate risks toward shorter maturities where reinvestments can potentially reshape portfolios steadily toward net zero alignment and reward transition leaders.

Investment in the Transition

Many portfolios, even if entirely net zero-aligned, may feel the effects of climate change’s physical risks. By financing the transition, we believe asset owners can potentially retain a wider opportunity set, maintain better spread levels, and reduce turnover. In addition, they may help drive high-emitting companies towards net zero – which could mitigate those wider physical risks from climate change and build more sustainable economies.

For example, this can work when Climate Buy and Maintain strategies range from issuers already aligned with net zero to those in the process of aligning and those offering climate solutions – such as green bonds. This provides direct financing to companies and projects aiming to mitigate or adapt to climate change.

Reducing carbon intensity within portfolios can be simple. A fire sale of the most high-emitting names would cause emissions to drop sharply. An example from our standard portfolio shows selling the worst 5% of emitters can potentially lead to a 40% cut in emissions. However, investors may want to avoid wholesale exclusions that sideline carbon-intensive companies progressing towards net zero alignment but perhaps have further to travel. Too exacting a policy could sharply reduce the investable universe, increase concentration risk, and deny capital to businesses that may be on a genuine transition pathway. 

Of course, excluding or divesting from climate laggards if they have shown insufficient progress or willingness to commit to a net zero strategy – or at a client’s request – remains an option, especially if they are exposed to an increasing degree of climate-related risks.

Every wider sector can play its part in the transition. Best-in-class utility companies will be as essential in the future as they are now – and their successful transition will be an essential part of the road to net zero.

We also believe it will be crucial to support a ‘Just Transition’ sensitive to the social effects of declining industries and changes in our energy mix. Violent swings in where and how people are employed could leave communities adrift and sharpen inequalities. Investors may be able to soften the impacts, and possibly mitigate against social risks to long-term holdings, by broadening their analysis of the transition in this way.

Alignment to Net Zero

Our Climate Buy and Maintain credit strategies all target net zero by 2050 or earlier – but the nature of this alignment is crucial.

By making climate-focused changes to investment strategy, we believe trustees can potentially benefit their plans, irrespective of their end-game. Those targeting self-sufficiency may have greater resilience to climate change over the longer term, while those seeking a risk transfer might have portfolios  more closely aligned to those of the insurance companies taking on their assets. This could potentially reduce the cost of any transfer while also reducing near-term portfolio risks from regulatory regime changes and the impact on asset prices.

Engagement at All Levels

Focused dialogue with company management is an essential part of the Climate Buy and Maintain process. We think engagement can help to shape company strategy and allow businesses to become more resilient to the impacts of climate change – and we are convinced that it must be a key component for transitioning companies, and therefore portfolios, to meet their climate objectives.  

Voting at company meetings where we own equity holdings is only one tool at our disposal. In fact, fixed income investors have an equally wide range of tools at their disposal to enact meaningful engagement initiatives.

We believe the most effective engagement is ongoing and takes place at multiple levels – from credit analysts engaging with issuing companies, to quantitative teams liaising with data providers, and engagement at the corporate level with industry bodies and regulators. In the climate space, each of these interactions, in addition to industry partnerships with our peers, is designed to help create more sustainable and net zero-aligned businesses.

In addition to the wider environmental and social benefits of contributing to net zero through engagement, we believe that over the medium to long term, engagement should help make the first three principles more achievable while acting as a risk mitigation tool. Companies with a strong sustainability mindset could be quicker to respond to a more demanding consumer base, less likely to face regulatory or labor issues such as strikes, and less likely to be shunned by investors. That can potentially mean these issuers experience lower drawdown or downgrade risks.

From a portfolio perspective, if more companies are chaperoned towards alignment and then to net zero, then this could potentially retain a wider and fully diversified investment universe.

Transparency through Reporting

Asset owners are faced with an increasingly heavy reporting burden and will continue to need clear and timely data from their asset managers to manage this burden. We believe progress related to each of the above principles should be clearly reported to clients, alongside traditional financial metrics. That way, clients can see how a strategy may be improving outcomes and delivering real-world impact.

But which metrics should asset owners consider and request from asset managers? Right now, there is no single measure that adequately captures net zero alignment, and therefore a dashboard of different data is required, together with clear explanations. We believe, at a minimum, reporting should include a range of carbon emissions, degree of net zero alignment, and a measure of climate-related risk.

Further, these metrics should be:

  • Simple to understand, so investors and end-stakeholders can understand and appreciate their meaning
  • Time-consistent, so progress against the metrics can be monitored over a long period of time
  • Aggregable across mandates and asset classes so clients can report at a total portfolio - and most importantly:
  • Relevant to the clients’ regulatory requirements and investment objectives

Using this framework, we believe investors should be able to see in full the actual and potential impacts of climate change on their portfolio – and set climate-related objectives accordingly – all while aiming to deliver sustainable long-term returns.

    Disclaimer

    This document is for informational purposes only and does not constitute investment research or financial analysis relating to transactions in financial instruments as per MIF Directive (2014/65/EU), nor does it constitute on the part of AXA Investment Managers or its affiliated companies an offer to buy or sell any investments, products or services, and should not be considered as solicitation or investment, legal or tax advice, a recommendation for an investment strategy or a personalized recommendation to buy or sell securities.

    Due to its simplification, this document is partial and opinions, estimates and forecasts herein are subjective and subject to change without notice. There is no guarantee forecasts made will come to pass. Data, figures, declarations, analysis, predictions and other information in this document is provided based on our state of knowledge at the time of creation of this document. Whilst every care is taken, no representation or warranty (including liability towards third parties), express or implied, is made as to the accuracy, reliability or completeness of the information contained herein. Reliance upon information in this material is at the sole discretion of the recipient. This material does not contain sufficient information to support an investment decision.

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