Justine Vroman and Thomas Chinery explain how an understanding of climate risk can help in building a resilient global credit portfolio that also aims to support real-world change.
In March 2023, the Intergovernmental Panel on Climate Change (IPCC) published the final part of its sixth assessment report, setting out the devastation extreme weather is already causing across the world. The scientists who compiled it warned worse is to come if humanity fails to act decisively to tackle the climate crisis.
As well as being the greatest threat the planet faces, climate change poses huge risks to investment portfolios and clients’ wealth. The physical impacts of floods, wildfires and extreme temperatures create dangers for companies across a range of industries. New regulation, emerging technologies and shifting consumer and investor preferences will transform business models as the climate transition accelerates.
A climate-focused alternative to investment-grade credit
Launched in 2021, the Aviva Investors Climate Transition Global Credit strategy aims to help mitigate some of the key risks associated with climate change while delivering the benefits of a traditional investment-grade credit approach, including consistent long-term income and capital growth.
It also aims to achieve positive climate outcomes by supporting companies investing in the transition to a lower-carbon economy – even if they are not low emitters now – and those developing solutions to help the world tackle climate change and adapt to its effects. The strategy may appeal to investors who want to strike a balance between managing climate risk, fostering positive change within companies and benefiting from the green transition.
Our approach opens a much broader investment universe than is available to more specific funds – such as those tracking Paris-aligned Benchmarks (PABs) or only investing in green bonds – allowing the strategy to be a direct alternative or complementary to a core investment-grade credit portfolio.
At the same time, we look to take advantage of the untapped potential of bondholders to exert a positive influence on sustainability issues. Unlike passive investors, we engage directly with issuers to encourage them to improve not only their own climate credentials, but also those of their suppliers, supporting change across industry value chains.
Risk mitigation and resilience
As climate-aware bond investors, our main focus is on resilience and managing downside risks. We aim to mitigate the growing climate threats facing issuers and bondholders, including stranded assets and physical and decarbonisation risks.
Climate risk is often ignored or underappreciated by credit investors. It encompasses the long-term effects of climate change on a company’s operations and business model, and should play an important part in any assessment of an issuer’s creditworthiness. It may include physical hazards from extreme weather as well as transition risks such as regulatory penalties, technological advances or changes in consumer preferences.
Despite evidence of the materiality of climate-change factors, the market does not always adequately or consistently price them in. For example, balance sheets among companies in the auto industry are being challenged by the need to pivot to electric vehicles (EVs). Yet corporate bonds from carmakers that have failed to proactively make the shift towards EVs often trade broadly in line with those from climate-change leaders in the sector. We believe this is unsustainable.
We aim to mitigate the growing climate threats facing issuers and bondholders, including stranded assets and physical and decarbonisation risks
As climate-focused credit investors, we are alert to mispriced climate risk in all forms. Given corporate bonds are asymmetrically exposed to an issuer’s asset value — bondholders usually expect to receive limited upside over the risk-free rate but face a small chance of significant downside in a default scenario — climate change can adversely affect the value of a company and, by extension, its bonds.
Climate-aware companies should be better equipped to adapt their business models, shift supply chains, accommodate physical risks and address regulatory issues. If they achieve this, bondholders may benefit from smaller drawdowns, reduced volatility and lower risk of downgrades and defaults.
Backing solutions providers and promoting the transition
We use a proprietary screen to exclude the worst carbon emitters from our portfolio and reduce the kinds of risks discussed above.
However, we retain flexibility to allocate up to ten per cent of the portfolio to companies above our carbon threshold where they are helping to reduce overall emissions. Beyond this, we look to invest in solutions providers and transition-oriented companies, to further mitigate climate risk and support the shift to a lower-carbon economy.
All companies need to adjust for a warmer, lower-carbon world. Transition-ready issuers are companies from all sectors of the economy that are managing their transition risks and improving their climate resilience. In doing so, they often use the services of solutions providers (see below). We think progressive transition-oriented companies are likely to retain a first-mover advantage and be more resilient over the medium term.
Climate-aware companies should be better equipped to adapt their business models
We assess issuers using our proprietary transition risk (T-risk) model. This model identifies climate-change risk at a sector or industry level, ranking the risk as high, medium or low. We combine this with a score that provides a measure of the quality of climate-risk management processes at individual companies.
The combination of these two elements determines whether a company satisfies our transition criteria. For example, companies operating in high T-risk sub-industries will need market-leading approaches to climate change to be assessed as eligible for investment.
Solutions providers are companies mitigating the risk of climate change or helping communities adapt to adverse physical impacts. We initially assess companies as offering solutions depending on whether they derive at least 20 per cent of their revenue from these themes. Issuers that meet this threshold are then assessed using proprietary analysis. We further examine revenue sources by business segment to determine whether the issuer’s business activities satisfy our eligibility criteria.
In the credit universe, solutions providers are tilted towards more mature and large-cap companies. Many of the companies that meet the 20-per cent threshold enjoy growing and resilient sources of revenue and have long-term support from major government incentives.
The US Inflation Reduction Act is reducing costs for clean-energy technology and could provide tailwinds to whole sectors
These incentives are becoming more powerful. For example, the US Inflation Reduction Act (IRA) is reducing costs for clean-energy technology and could provide tailwinds to whole sectors, such as battery manufacturing. With Europe pressing ahead with its own subsidies for green technologies, large caps in specific sectors could be major beneficiaries of these trends and prove resilient in market downturns.
As the solutions-provider universe is relatively small and concentrated on a narrow range of sectors (typically industrials, utilities and technology), diversification is potentially an issue. However, our additional transition lens gives our portfolio the diversification and opportunity set needed for any global credit portfolio.
We believe our holistic approach, combining solutions providers, transition-oriented companies and carbon-intensive companies with genuine green strategies, is unique among climate-focused credit funds. As such, it may interest clients looking for a strategy that offers the potential to achieve both positive climate outcomes and investment performance.
Active investment: Science-based targets (SBTs) and engagement
The opportunity for engagement in the credit markets is considerable. Given companies will often issue bonds many times a year, credit investors can frequently apply influence through their capital-allocation decisions and associated dialogue with issuers. Additionally, many issuers are owned privately; there is no pressure from public equity holders to improve governance. This gives bondholders a real opportunity to drive meaningful change in an important part of the capital markets beyond the reach of equity investors.
Bondholders have a real opportunity to drive meaningful change
Focused dialogue with company management is essential to meet our climate objectives. A well-structured and targeted engagement programme can help shape investee company strategy and allow businesses to become more resilient to the impacts of climate change.
When we engage with companies, we encourage them to adopt SBTs. While some competitors have net-zero targets, based on relative carbon-emissions reductions or a percentage of green revenues, we believe SBTs are currently the best way to align to the 1.5⁰C global warming goal established by the 2015 Paris Agreement.
This is because they are more practical, specifying by how much and how quickly firms reduce emissions. Because they often include “Scope 3” emissions associated with companies’ customers and suppliers, setting SBTs can also have positive effects across value chains. We target 90 per cent portfolio exposure to companies with SBTs by 2030.
Estimates of the capital required to drive the climate transition vary from $3.5 trillion to $9.2 trillion a year. Whatever the exact figure, much of this capital will be in the form of debt. Given the stress on government balance sheets, a lot of investment will come from exactly the kind of companies we invest in. Engagement is paramount to drive that change.
Download Building resilient portfolios while supporting positive climate outcomes to understand:
- Why climate risks are often widely ignored, misunderstood or inconsistently addressed by credit markets.
- How integration of climate factors into an actively managed credit portfolio can enhance long-term returns and help create resilience for investors.
- How investing in and engaging with companies that incorporate SBTs can help promote positive steps to combat climate change across entire industry value chains.