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.
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.
We used a range of metrics in the previous article to assess the future emissions pathways. These were:
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.
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
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:
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:
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.
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.
We suggest clients review managers’ regular reporting for their B&M portfolios and:
|Preparing Buy & Maintain portfolios for Net Zero
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