SHARPENING THE LENS
As businesses across nearly every industry engage in the transition to green and sustainable operations, institutional investors are seeing expanded opportunities to allocate capital with environmentally conscious targets. Under the umbrella of environmental, social and governance investing, the imperative of climate change — and the need to achieve the global commitment to net-zero greenhouse gas emissions by 2050 — is presenting more nuanced and more numerous investment opportunities for asset managers and their clients.
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Investor commitments to climate-related investing will only continue to accelerate. “Given both the government and corporate decarbonization pledges that we’re seeing, and public awareness of the issue, our expectation is that huge quantities of capital are going to be withdrawn from sectors that emit carbon and reinvested in those that aid the transition,” said Marina Severinovsky, head of sustainability, North America for Schroders. Another major underpinning for this shift is from next-gen investors — millennials and Generation Z — who are increasingly part of the investor community and more likely to demand that their portfolios reflect their values while meeting return objectives. “They see sustainable investments as a way to contribute to the change they’re looking to see in the world,” she said.
Emerging sectors
As institutional investors continue to explore ways to move further along the decarbonization pathway for their portfolios, T. Rowe Price sees many climate-related investment opportunities in 2022 and beyond, said Christopher Whitehouse, head of ESG at T. Rowe Price Investment Management. In some of the “obvious” opportunities like solar or wind energy, investors have already priced in a lot of the potential in their performance, he pointed out. The firm is looking further down the value chain to opportunities in battery-storage technology and renewable diesel. T. Rowe Price uses a proprietary impact investment structure that aligns with the United Nations Sustainable Development Goals to help guide its approach (see chart).
Much of the focus at Pictet Asset Management is on finding the leaders in the momentum created by the net-zero transition. “Tomorrow’s picture will be different from today’s picture because the world is changing. Economic agents are changing their business models, and countries are changing the composition of their [gross domestic product] over time. So it’s absolutely essential to not only look at how things are today, but also what they might look like in five, 10 or 15 years,” said Eric Borremans, head of ESG at Pictet Asset Management.
Schroders’ climate-focused investing comprises several different approaches, ranging from sustainable strategies which actively aim to do better than the index in terms of carbon intensity to thematic strategies, Severinovsky said. Examples of the firm’s thematic approach include the Global Energy Transition fund, which considers long-term investments in companies involved in the transition to clean energy, and the Global Climate Leaders fund, which focuses on companies that gain a competitive advantage by leading on climate change commitments.
Interest in passive ESG strategies is growing significantly as well. S&P Dow Jones Indices offers several strategies, from core ESG indexes and low-carbon and net-zero approaches to more thematic and fixed-income strategies, said Margaret Dorn, senior director and head of ESG indexes, North America, at the firm. These indexes rely on data sets that consider industry-specific, financially material ESG and climate opportunities and risks.
Looking ahead
The green economy — companies and initiatives committed to meeting environmental goals and resource conservation — comprises just 5% to 10% of the global economy, and it has a lot of room to grow, Borremans said. “It’s not insignificant, but it’s not a lot.” However, he said, “it’s growing fast: probably at least twice the rate of the global economy. It’s a growth story and a very profitable one. But because it’s still relatively small, you’re bound to have supply-and-demand shocks and valuation bubbles.”
Investors need to carefully consider how they identify opportunities that can benefit from the green transition. For instance, some energy companies that are carbon-intensive today may continue to be penalized by investors, even though they have committed to reducing their emissions but are still early in the transition, Borremans said. These companies may benefit from a higher rating in the future, after they have moved further down the path to net-zero emissions.
Borremans compared investments in these types of transitioning companies to investing in distressed debt companies with the expectation that they will move up in credit quality to become high-yield or even investment-grade assets. “We’re looking to be a catalyst for change and benefit from that rerating,” he said.
Such an approach emphasizes the importance of forward-looking analysis when it comes to climate-related investing. “We have never had an economy that has been faced with a situation like this, so you can’t really do back tests because it hasn’t happened before,” Borremans said.
A BALANCING ACT
With the heightened focus on climate-related investments in institutional portfolios, asset managers are more engaged in helping asset owners understand the unique risks involved in companies and issuers undergoing the transition to a net-zero economy — and the need for consistent monitoring to keep up with changing conditions.
Read: Legislation Supporting Clean Energy Would Impact Key Sectors
The Task Force on Climate-Related Financial Disclosures, or TCFD, has defined climate-related risk in terms of two main categories: transition risks and physical risks, said Margaret Dorn, senior director and head of ESG indexes, North America, at S&P Dow Jones Indices. She added that she characterizes these risks as a seesaw: If you focus too heavily on one and ignore the other, one side could rise to unacceptable levels. “You may want to look at climate change more holistically and address all key elements, including transition risks and physical risks, as well as opportunities available for investors to finance industries and activities that lead to a lower-carbon economy.”
“We are now seeing increased interest and awareness from investors about the risks that climate change poses to their portfolios, because the productive assets and business models of underlying companies are at stake,” said Eric Borremans, head of ESG at Pictet Asset Management.
Physical risks
Physical risks directly impact a company’s operations and are caused by climate events, such as natural disasters, or climate shifts, such as rising sea levels or drought. As investors continue to learn about the nature of these risks, the research into exactly how they might materially impact a company now, and in the future, continues to grow, Dorn said.
“We want to map out the physical risks of, say, a company’s property, plant and equipment in various climate scenarios, and the associated risks to those assets,” said Christopher Whitehouse, head of ESG at T. Rowe Price Investment Management.
The need to better understand physical risks has also boosted investor calls for more data and transparency from companies themselves. T. Rowe Price is encouraging its portfolio companies to report emissions within the TCFD framework as part of that process, Whitehouse added.
Transition risks
Transition risks are often considered less tangible but could have an impact on potential losses or reputational risks due to policy, legal and technology changes, or shifts in culture and the market perception of companies.
Dorn used the example of carbon pricing to illustrate how S&P DJI thinks about transition risk. While there seems to be market agreement that the global price of carbon will rise in the future, there’s uncertainty around how much it will increase. “So, there’s a financial risk implication that companies will either have to absorb the additional costs of carbon emissions or, ultimately, pass it on to their customers,” she said. “Either way, you know that carbon could have direct financial implications for companies.”
The materiality impacts
Growing numbers of institutional investors are recognizing the materiality of physical and transition risks, with the need to build portfolios capable of withstanding both, Dorn noted.
While it’s often easier for investors to understand physical risk, since they can visibly see climate changes in their own environment, transition risks cannot be overlooked, particularly with increased regulatory focus on carbon-emissions disclosure and other areas.
At the same time, the availability of more and better data has deepened investors’ understanding of climate risks. “As the data gets more granular, so do the investment strategies that can apply the data,” Dorn said.
S&P DJI’s climate indexes offer investors tools to address different values, objectives and opinions on how to respond to the risks and opportunities of climate change. For example, the S&P Paris-Aligned and Climate Transition indexes, or PACT, provide a science-based approach to climate investing aligned with 1.5 degrees Celsius, while they stay as close as possible to the benchmark index, offering broad, diversified exposure. Back-tested data for both the S&P 500 Net Zero 2050 Paris-Aligned index and the S&P 500 Net Zero Climate Transition index have exhibited outperformance over their S&P 500 counterpart, Dorn said (see chart).
Find your North Star
Aside from financially material risks to companies, investors recognize the wider societal impact of climate change.
“My viewpoint on climate change is that it’s an existential threat,” said Hari Balkrishna, portfolio manager of the Global Impact Equity Strategy at T. Rowe Price. “If we don’t actually solve for it, a few trillion dollars lost from the global economy is going to be the least of our problems. We’re going to be wrought with devastation and social issues.”
That viewpoint helps provide a North Star for Balkrishna when evaluating companies. “There are many companies that are delivering positive environmental and social impact,” he said. “And they have better bottom-line and top-line growth prospects than the index. I correlate impact investing with smart finance.”
The lack of standardization on climate-related metrics for evaluating companies has led asset managers to commit more resources to develop proprietary models and seek out more granular approaches to addressing climate risk.
“Data and materiality give us a common language to discuss climate issues, make comparisons across companies and [evaluate opportunities] with internal managers,” said Christopher Whitehouse, head of ESG at T. Rowe Price Investment Management. Data underpins the firm’s active-management approach and informs its due diligence with companies, he said. It also indicates the climate-related metrics that it believes each of its portfolio companies should disclose and follows up on how companies are progressing on meeting those disclosures, he said.
Schroders relies on its in-house metrics while building climate-related investment strategies. “It’s quite challenging to compare companies using external data and draw conclusions that you can really have faith in,” said Catherine Macaulay, sustainable investing analyst at Schroders. “So we place a high value on developing our own methodologies that we trust and invest heavily in a number of proprietary tools that look at climate risk as well as the broader environmental and social impact of companies.”
For example, Schroders’ SustainEx tool measures companies’ Scope 1, Scope 2 and Scope 3 emissions, as well as potential benefits from avoided emissions, and quantifies these in dollars, Macaulay said. It takes a similar approach to other environmental and social indicators. “We find that measuring the impact in dollar terms is more tangible when compared to external scores that have little meaning in isolation, and it allows you to compare a diverse range of impacts on a like-for-like basis.”
The in-house models form a key part of Schroders’ climate escalation framework — which sets out how it will help drive the transition to a low-carbon economy — and enable the firm to monitor company performance and progress against expectations. “Through working with portfolio companies and encouraging them both to commit to and deliver change, we can drive real-world emissions reductions that actually move the needle,” Macaulay said.
Despite the challenges in comparing climate-related investments across companies and issuers, the metrics to measure specific climate risks are getting more granular.
“We’re looking at implied temperature rise and decarbonizing a portfolio,” said Holly Turner, sustainable investment analyst at Schroders. “What does the portfolio look like in 2030 or further into the future, based on implied temperature rise?” It is particularly important to look at these types of implied metrics when investing with a decarbonization theme and thinking about a portfolio’s impact in the future, she noted.
Asset managers also use metrics to identify greenwashing — a form of deceptive marketing in which a company’s actions on sustainability don’t align with its public stance. “There are a lot of oil and gas companies that have renewable investments and green websites that will try to convince [investors] that they are turning green,” said Balkrishna at T. Rowe Price. “But if you run the math, you can see that few of them have even 15% of revenues from renewables in 10 or 15 years. Materiality using accounting data is really a simple smell test.”
Read: Schroders Climate Transition Action Plan
On the other hand, some power utilities — among the biggest carbon emitters — are driving a truly meaningful transition toward renewable energy, Balkrishna said. “These are some very interesting investment opportunities, where the market hasn’t given [these companies] full credit for the extent of their renewable energy generation [and their efforts] to actually move in that direction, he said. “There is a huge decarbonization journey happening” in this sector.
“We go through a very rigorous process to measure material alignment to one of our impact pillars, effectively building an impact model on every company we invest in” Balkrishna added. “That requires a lot of measurement where we, as an active manager, get involved in measuring the ex-ante and ex-post impact of our clients’ investments, from a bottom-up perspective.”
Across the asset spectrum
Due diligence is important not only to investors evaluating equities, but also across the other asset classes. S&P Dow Jones Indices is increasingly working on climate-related investments in fixed income and alternatives, such as infrastructure and commodities. “We’re coming into a maturation stage of ESG, in which investors are looking to diversify their ESG application into many different asset classes,” said Margaret Dorn, senior director and head of ESG indexes, North America, at the firm. “We approach that mandate with the same due diligence and research process that we would any index strategy.”
Schroders uses climate-related metrics when evaluating sovereign issuers. “Sovereign ESG can get less airtime than corporate ESG, but we don’t think it’s any less important” in terms of materiality, Macaulay said. Schroders’ proprietary tool measures sustainability at a country level for more than 150 governments and considers indicators such as carbon emissions, biodiversity losses, forestry and investments in clean energy.
Pictet Asset Management seeks opportunities in sovereigns via its impact-driven strategy and it is working on a climate sovereign bond strategy, said Ella Hoxha, senior investment manager, global bonds, at the firm. For the latter, it is scoring sovereigns based on their emissions levels over a period of time per unit of GDP, as well as measuring their progress on the policy front as determined by experts. “We’ve been working to come up with a way of allocating to sovereigns on the basis of how they’re performing on their decarbonization agenda,” Hoxha said. “The focus has been on solutions to address that problem. It’s very eagerly anticipated by clients.” (See chart on global net-zero coverage by country level)
More interest by investors in a climate-related lens on sovereigns is one way to create lasting impact over time, Hoxha said. “The idea is that the more investors come on board, the more the pressure increases on sovereigns. But it hasn’t really been tackled yet in the markets.”
Green bonds remain an important part of the ESG universe, and as the universe grows, asset managers caution that investors need to watch out for greenwashing.
“The volume and flows of green bond issuance are rising very quickly. It makes perfect sense when they are bonds issued by specialized companies that will use the proceeds to finance green assets,” said Eric Borremans, head of ESG at Pictet Asset Management. “But it’s a mixed bag out there. There’s dark and very light green, and even some brown,” he said, referencing the different levels of environmental quality of green bonds.
As the green bond sector continues to mature, asset managers expect increased regulation and transparency, as well as more standardization of data, said Hoxha, which will make it easier for investors to evaluate these bonds.
Investors need to conduct their due diligence to learn about the wide range of indexed strategies that can help them accomplish their goals, Dorn said. The rules-based approach of an index can bring greater transparency to sustainable investing. Investors can learn about the datasets being used, the criteria for security selection and weighting, and have full transparency into the composition of the index.
S&P DJI’s data approach has evolved to include forward-looking analyses, as opposed to just using more traditional models, which tend to be more backward looking, like carbon-footprint analysis, Dorn said. For example, S&P Global’s Trucost Transition Pathway approach seeks to identify companies that are on track to being aligned with a 1.5 degrees Celsius scenario over the coming years.
DISTANCE ACROSS THE POND NARROWS
Climate-related investing has reached the mainstream in Europe, underpinned by aggressive regulation that was adopted earlier than the ongoing regulatory efforts in the U.S. But the U.S. is moving more decisively, working on several climate-related initiatives at regulatory agencies, including the Securities and Exchange Commission, which is creating rules for public companies to disclose greenhouse gas emissions.
The 26th Conference of Parties summit, or COP26, in Glasgow last November focused global attention on climate change. It reinforced the need for investors to continue to address climate risks in their portfolios and for better sustainability disclosures by companies. In the U.S., some asset owners have joined the United Nations-convened Net-Zero Asset Owner Alliance, while others have announced portfolio targets toward net-zero emissions.
Read: An Indexed Approach to Net Zero
European investors have committed to Paris Agreement-aligned benchmark targets with portfolios that meet annual targets on decarbonization and limiting global warming to 1.5 degrees Celsius. Europe’s recent activity reflects new regulations that require European investors to report the climate-related impact of their portfolios, starting in January 2023, under the Sustainable Finance Disclosure Regulation, or SFDR taxonomy, including carbon emissions of their overall portfolio, said Eric Borremans, head of environmental, social and governance at Pictet Asset Management.
“In Europe, we’re looking at overlapping components of climate action to achieve a fund goal,” said Holly Turner, sustainable investment analyst at Schroders. “We have funds that have developed a decarbonization commitment over time; as well as those that define universal climate parameters — such as an assessment of low-carbon transition — by using proprietary tools — such as avoided emissions — to identify climate solutions; and a net-zero dashboard to track corporate climate commitments.”
“Our avoided-emissions framework provides an additional lens by capturing a corporate’s contribution to emissions savings through offering low-carbon products and services that allow for the substitution of high-carbon activities. These savings are generally not reflected within conventional scope 1, 2, and 3 emissions,” she noted.
“Europe is where we’re getting the most interest” on climate-related investments, said Ella Hoxha, senior investment manager, global bonds, at Pictet Asset Management. “Most, if not all, of our clients are sending us questionnaires and asking what we’re doing on climate, what we’re doing on the emissions side and how we are managing performance.” That’s likely a good sign for the ESG industry as whole, she added. “It’s still early days, but there’s a lot of attention — and where attention goes, solutions come,” Hoxha said.
Read: Sovereign bond investing: a climate-focused approach
Investors are increasingly interested in specific metrics and outcomes for their climate focus. The index products at S&P Dow Jones Indices that are aligned with the Paris Agreement provide for those very specific objectives. “We’re looking at areas like greenhouse gas-intensity reduction, brown-to-green share revenue improvement, high-impact sector exposure, physical risk improvement and fossil fuel reserves reduction,” said Margaret Dorn, senior director and head of ESG indexes, North America, at the firm.
Schroders has seen increasing recognition by investors and governments that forests and other aspects of nature are critical in delivering the ambition to limit global warming to 1.5 degrees Celsius, said Catherine Macaulay, sustainable investing analyst at the firm. “COP26 really brought this to light. We saw a pledge from more than 120 countries to end deforestation by 2030, and a second commitment from more than 30 financial institutions — including Schroders — to eliminate agricultural, commodity-driven deforestation within our portfolios.”
She noted that Schroders’ partnership with Natural Capital Research allows the firm to “explore possibilities to allocate directly to projects that establish, protect and enhance nature and maximize natural carbon sinks.” Natural carbon sinks include, for instance, plants and oceans that take in and store carbon dioxide from the atmosphere. One example of Schroders’ focus on nature is a sector view of direct and supply-chain gross value-add for varying levels of nature dependency (see chart).
Whether they take an active or passive strategy, global investors are paying closer attention to metrics across ESG investments. “With increased focus on reporting, more and more clients want to understand their current emissions from their portfolio,” said Christopher Whitehouse, head of ESG at T. Rowe Price Investment Management. “That’s something that the whole asset management industry is grappling with, both in terms of the products needed and how to service the shifting needs around carbon-neutral portfolios.”
Meanwhile, all aspects of ESG appear poised to continue growing across geographies and asset classes. “A focus on ESG began in Europe but is now transitioning to investors in the United States,” Whitehouse said. “That pace has accelerated and is informing investment decisions across asset classes, both in equity and fixed income.”
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