A couple of years ago we wrote an article about
preparing Buy & Maintain (B&M) portfolios
for Net Zero. That used portfolio statistics
from a B&M fund many of our clients hold to
demonstrate the pitfalls and opportunities in
making an (increasingly larger) part of their
portfolio aligned with Net Zero targets.
This article reviews the progress the portfolio
has made towards Net Zero and discusses
how further progress can be achieved.
Engagement remains key to success.
Important fund changes
While the fund objectives always considered ESG in a
broad sense, the manager is now explicitly required to
manage the portfolio in line with the principles of the
Net Zero Investment Framework, where this does not
conflict with the other objectives of the portfolio.
Quarterly reporting now includes enhanced climate
metrics, including alignment, and engagement
reporting to assist client review, in addition to
biodiversity metrics that are interlinked with
assessing climate risks.
We suggest these improvements could also be
implemented by clients with segregated mandates.
Emissions monitoring — the denominator
problem
We used a range of metrics in the previous article to
assess the future emissions pathways. These were:
- Weighted Average Carbon Intensity (WACI) using Enterprise Value as the denominator
- WACI using debt outstanding as the denominator
- WACI using $m of revenues or $m of GDP as the denominator
- Carbon footprint per £m invested
All metrics have flaws but some are more subject to sharp
market changes than others, notably Enterprise Value and
£m invested, which will move due to changes in equity
prices and interest rates even if emissions stay constant,
and therefore were affected by the market background in
2022. While revenues could also have been affected by a
weaker economy, high inflation or idiosyncratic reasons,
we have used WACI with revenues as the denominator for
this analysis as revenues are reported as at the end of each
issuer’s fiscal year, which may be part way through 2022,
and changes since our last review will be easier to attribute.
We intend to revisit WACI using Enterprise Value and £m in
a couple of years’ time when we will be better able to put
the movements due to market changes in context.
That having been said, market changes will have indirect
impacts. For example, the non-gilts index has a large
weight of (generally high-emitting) utilities at the long
end. Over 2022 the market-cap weight of these in the
index decreased and the average emissions of the index
fell (although GazProm being removed from the index and
a number of maturing bonds issued by utilities each had
a similar effect).
Clients should use a range of metrics to
measure climate characteristics of the
portfolio but recognise these are only
point in time figures. Data will change
and external factors, such as market moves, can
affect the year-on-year figures, making short-term
moves less relevant. We recommend clients take
the time to understand the potential drivers of
changes in emissions for a given metric outside
of outright emissions reduction in the short term.
However it is more useful for clients to focus
on the long-term target and temporarily deemphasise metrics if necessary.
Changes in WACI since the last review
The manager has obtained more granular information
on the issuers in the May 2021 portfolio since our last
review. Using this more complete data, the emissions
of the May 21 portfolio have risen since our last paper,
as shown in the graphs below. This is another example
of how reported metrics will change over time. In spite
of starting from this higher base, the absolute emissions
of the portfolio and its WACI have fallen from the number
we calculated in our last paper.
Some of this is due to a few high-emitting issuers
introducing emissions targets and cutting emissions.
We welcome this as a step on the path to Net Zero.
The portfolio has grown materially since the last review
and changes in asset allocation, including diversifying
allocations to high emitters at the long end, have been
the most significant contributors to the fall in WACI.
However, we expect the fund to grow less explosively
in future so future falls in WACI are more likely to come
from falls in absolute emissions.
Changes in revenues have slightly increased the WACI
number, as discussed above.
Buy & Maintain managers should be striving to be able
to provide this level of granularity to clients, particularly
as institutional investors are coming under increased
scrutiny to demonstrate their progress towards Net Zero
Changes in the projected pathway,
assuming the portfolio is unchanged
The change in emissions today is one thing, but the
future pathway is more important to judge whether the
portfolio is on target for Net Zero.
The projected emissions of the December 2022 portfolio
are lower than May 2021’s (using data available then and
data available now) and are expected to continue to
fall more steeply throughout the life of the portfolio.
Caveat: this calculation assumes that companies and
sovereigns in the portfolio meet their stated emissions
targets (as sourced from MSCI or SBTi). The fund
manager will be monitoring this, adjusting projections
and engaging with issuers as necessary in future.
The reasons for the fall are:
- Reductions in WACI over the last 18m, as mentioned
on the previous page
- Better pathways for some issuers. For example,
a large utility company has moved from no emissions
reduction target to a 66% emissions reduction
target by 2050. With a high WACI this has a material
impact on the current portfolio pathway, even with a
relatively small portfolio weight, demonstrating the
benefits of investor engagement with issuers and
the handicaps of blanket exclusions. Other holdings
have made similar commitments
Changes in the projected pathway, taking
into account the run-off characteristics of
the portfolio
The previous emissions analysis, while more detailed
than most managers are able to provide at the moment,
is fairly standard in scope and all that is relevant for a
high-turnover portfolio. However, this portfolio is Buy
& Maintain and pays all maturities and coupon cashflows
to clients rather than reinvesting them. Therefore it is
both possible and relevant to consider how its emissions
might change as the portfolio runs off over time.
Today’s run-off emissions pathway is also lower and
much less ‘lumpy’ at the longer end than it was in 2021.
This is because of:
- Emissions reduction and improved targets
- Portfolio inflows making it possible to diversify
high-emitting issuers or those with no reduction
pathway.
Other indicators of the path to Net Zero
We recommend clients use a balanced scorecard that
does not look solely at emissions. 39% of the fund
portfolio now has SBTi targets, compared to 23% in
May 2021, and 68% of the portfolio is aligned or aligning
to a Net Zero pathway. That having been said, the
allocation to green bonds is only 2%. We do not feel
this is a weakness, given the proportion of the portfolio
that is aligning to Net Zero.
The manager has begun to include biodiversity in their
reporting, although the Taskforce on Nature-related
Financial Disclosures (TNFD) is not yet fully defined
so some metrics may change. Nevertheless all best in
class managers should be forward thinking in this area.
Portfolio coverage for this is 63% and shows land use
is by far the greatest pressure on biodiversity.
Overall, we believe this portfolio is well constructed
to provide secure cashflows and also well constructed
to assist in a client’s transition to Net Zero.
Engage, engage, engage
All this is very reassuring and we are pleased many
issuers in the portfolio have set ambitious emissions
targets in the last couple of years. However, setting
targets is easy — achieving them will be difficult and
managers should be reviewing progress continuously
and escalating engagement as necessary.
Many managers are still not able to produce
mandate-level engagement reports routinely,
although most should by the end of this year.
This is a minimum standard of ours and managers
that fail to do so will be at risk of being downgraded.
We encourage clients to ask for this reporting,
to evidence that managers are engaging with issuers
of all types, as required by the regulator, and to
cross-check engagement activity and outcomes across
all their portfolios. Managers have been able to report
many engagement ‘successes’ in the last few years as
issuers set targets. We expect a higher proportion of
engagement ‘failures’ in future, as those targets are
missed and it is important managers are reporting
on these.
We feel such engagement and escalation will become
as important to the successful management of a
low-turnover B&M portfolio as best in class credit
analysis, and managers should see engagement
as a source of risk reduction and, where relevant,
alpha generation. We are not sure all B&M managers
yet appreciate this.
Best in class managers should be able
to analyse the portfolio’s emissions
pathway and demonstrate it is on the
path to Net Zero. They should also be
engaging with all issuers to ensure targets are
met and reporting regularly on that engagement,
including on issuers where escalation has been
or will be necessary.
Next steps
We suggest clients review managers’ regular
reporting for their B&M portfolios and:
- Check TCFD and emissions reporting of the
current and future portfolio is providing the
necessary information.
- Check engagement reporting covers issuers of
all types, not just corporates with listed equity,
and includes details of issuers that are lagging on
ESG commitments or failing to meet milestones.
The manager should have a clear escalation policy
for those failing to meet milestones.
- Check managers are thinking about biodiversity
(the partner issue to climate) and are making plans
to include TNFD reporting in their future reporting,
as we suspect this will be a regulatory requirement
in time.
- Engage with managers who are unable to do the
above and have no clear route to achieving this.
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