Will new climate legislation accelerate the transition, or will the energy crisis hamper it? Thomas Chinery and Justine Vroman assess the implications for strategically positioned bondholders.
Read this article to understand:
- The legislative changes expected to speed the flow of capital into transition-oriented companies
- How debt issued by climate solutions providers and transitions leaders has performed relative to the wider market
- The role bondholder engagement can play in accelerating climate action
A global energy crisis is focusing minds on the transition. Packages of legislation worth many billions of dollars have been proposed on both sides of the Atlantic to speed the shift to renewables. Simultaneously, there have also been regressive steps taken with more coal creeping back on the power mix.
So, how should investors view these complex drivers of transition strategies in volatile markets?
AIQ spoke to Thomas Chinery (TC) and Justine Vroman (JV), co-managers of the Aviva Investors Climate Transition Credit strategy, for their insights.
This year has seen key data points breached relating to climate and changes on the legislative front. How could this impact the impetus for climate action?
TC: Within the energy mix, we are moving from coal and oil producers towards gas in the interim and then onwards to renewables. The conflict between Russia and Ukraine means the shift from coal to gas has been delayed, particularly in Europe. Coal power plants are being brought back onstream and usage is increasing, whereas gas power plants look less appealing from a capex and investment perspective.
The conflict may have temporarily made things worse because the need to address climate change is becoming more pressing. Think of what we've seen: there are suggestions swathes of companies and homes in countries like Australia will be uninsurable within a decade or two. It’s serious.
The new legislation in the US and EU is symptomatic of what's going on more broadly. Globally, there is a push for action and regulatory changes are coming that will help the drive to net zero.
What does that mean? It means you must be much more cognisant of what you are doing if you are a company director and where you are positioned as an investor. As regulatory change picks up, stranded asset risk will rise, as things that were previously seen as acceptable become less so. Companies that have not changed their balance sheets and operating models will face greater pressure to make that adjustment if they come to them later.
We often talk about first-mover advantage. In most contexts, what this means is you pay the R&D and others copy you. But in a world of finite resources, which is the world we find ourselves in with the energy transition, first movers will be the ones that see the greatest beneficial price impacts.
JV: Legislative action is accelerating: the US Inflation Reduction Act is likely to play a significant role bringing change about. It is basically an industrial policy that conceals climate policy behind the primary goal of incentivising growth in US manufacturing. There will be around $69 billion of climate-related spending and tax incentives, and another $290 billion in loan guarantees. It’s intended to deliver emissions reductions of around 40 per cent by 2030.
We already see climate change having a major impact on every large company around the globe
We already see climate change having a major impact on every large company around the globe. Many are expensing physical impacts and the effects of government actions, such as fines. Banks are facing increasing pressure on their loan books, and ratings agencies are starting to adjust assessments depending on climate transition performance. This is probably going to result in price tiering between decarbonisation leaders and laggards, much as external pressure led to higher costs of capital for tobacco companies in the past.
What’s the difference between your strategy and the wider market in terms of the carbon intensity of emissions?
JV: The carbon footprint of our portfolio is below 100 tonnes of carbon dioxide (CO2) per $1,000,000 revenues versus over 200 for the global credit universe. Exposure will vary but, considering our restrictions on fossil fuel investments, we expect the portfolio to run a significantly lower carbon footprint on an ongoing basis.
Companies that generate revenues from fossil fuels are largely excluded from our universe. We have a carbon fossil fuel filter defined by the climate pillar team. However, we can allocate up to ten per cent of the strategy in companies that in theory fail to meet it providing they have clear transition strategies in practice. For instance, most utilities get excluded by the filter, but it is important to decarbonise power generation, so we focus on companies that invest largely in renewables and electric grid investments.
We have a lower exposure to energy and utilities overall
Our low carbon footprint versus global credit is driven by allocation and selection effects. We have a lower exposure to energy and utilities overall, but we also aim to identify the best opportunities on the energy transition journey.
Nevertheless, we prefer not to focus on carbon intensity as a metric overall but to align with a 1.5 degrees of warming scenario. We also focus on engagement, encouraging companies to establish science-based targets (SBTs); that's in line with our approach that looks holistically at company strategy. We do not just look at a carbon footprint or whether the debt being issued is classified as a green bond.
We look to invest in companies pivoting towards net zero. Interestingly, the European Central Bank (ECB) is going to tilt its corporate sector purchase programme towards issues with better climate performance.1
It is looking at climate performance through a greenhouse gas emissions lens, but also seeking more ambitious carbon reduction targets and better climate-related disclosures. It's an issuer approach rather than a product approach, focusing on energy transition rather than emissions alone. This is aligned with our vision and involves moving away from simplistic assessments.
TC: We are not averse to increasing the carbon intensity of the portfolio to back the transition. But we are also cognisant of helping our investors meet their net-zero interim targets. Many have targets to achieve in 2025 and 2030, so we are looking at the emissions trajectories carefully.
How has performance held up in a difficult period?
TC: We are underperforming the benchmark by around 50 basis points now, but performance has held up well relative to peers. Obviously, we would prefer to be above benchmark, but there are certain complexities that flow from the exclusions and nature of our positions.
Our portfolio construction is heavily focused on supporting the transition but it is also broader
The way we have sought to structure our strategy - using a climate-solutions sleeve and climate-transitions sleeve - gives a different opportunity set. Our portfolio construction is heavily focused on supporting the transition, but it is also broader, which allows for a more diversified level of risk.
Is performance differentiated between the two sleeves?
JV: That's a very interesting question, but it would be better to judge this later in the cycle as we are experiencing untested conditions. It’s still early, but in contrast to equities solutions providers, the opportunity set in fixed income tends to be made up of more mature, larger cap companies in sectors like capital goods, technology, telecoms, and rail. These are lower beta exposures that would tend to outperform in a credit selloff.
With this composition effect, solutions providers have outperformed transition leaders year-to-date. In the transitions sleeve, the banking sector has not held up well despite fundamentally benefiting from higher rates and a steeper yield curve. We also find real estate and industrials have underperformed versus solutions providers. They are likely to bear greater economic pain from higher energy prices and potentially face energy rationing.
Real estate and industrials are likely to bear greater economic pain from higher energy prices
To meet the dual objective of impact and performance, we've been retargeting an allocation to solutions providers of about 30 to 40 per cent versus a benchmark weighting of around 20 per cent. That’s quite a strong weight, to maximise impact.
From a portfolio construction standpoint, we think many solutions providers are sitting on growing and resilient sources of revenue and are likely to be comparatively resilient in downturns.
Underpinning this are some important legislative changes: in addition to the US Inflation Reduction Act, we also have RePowerEU.2 It’s a €300 billion plan to reduce EU dependency on Russian gas by 2027, boosting renewables and energy efficient investments.
What are the some of the core thematics you look at within the strategy?
TC: What’s interesting is how interlinked solutions and transition players are. Take a popular climate thematic like electric vehicles (EVs). We have original equipment manufacturers (OEMs) switching from traditional internal combustion engines to EVs or hybrids in the interim. There is a huge upstream vertical element to consider.
The cars run on electricity, but we need to be sure where it is coming from. We need to achieve the greenification of the generation market, to address the stability of grid infrastructure and capacity losses. If you have ‘dirty’ production at the top feeding into an EV and you have lost load on the way, that's not a strong ‘solution’. Based on this increased demand, grid infrastructure for the electric transmission must be materially improved and made much smarter, which means moving away from centralised generation hubs.
The applications and technologies associated with EVs are areas we see opportunities to invest in
Then look at the way an EV is structured versus an internal combustion engine; it has thousands fewer parts per car. The technology and data that go into running the vehicle are more important than the traditional moving cogs. The associated applications and technologies are areas we see opportunities to invest in, particularly as the market evolves towards autonomous driving.
From that point, you can start to think about transport as a service, using fleet vehicles rather than individuals owning their own cars. Privately owned vehicles spend around 95 per cent of the time on the drive, so it's an inefficient way of locking up capital. By contrast, if you were to sign up to an autonomous fleet and get sufficient people to join, you can always access the vehicle you need to take you to where you need to be.
What does that mean? That means significantly lower sales of automobiles, and these automobiles are more resilient because they have fewer moving parts. The expectation is the new EVs will do hundreds of thousands of miles in a lifetime rather than 100 or 150 thousand for an internal combustion engine.
This is all about integrated thematics: solutions names and transition names that connect. As an investor, it is very important to be aware of where they interlink and understand the relationships from a risk perspective.
How are the long-term thematics holding up in the face of broader credit market challenges around inflation and rate increases?
TC: Our strategy is only 18 months old. When we have been through the recessionary stages of the cycle, we will be able to give a more comprehensive answer. The way we look at climate resilience gives us an opportunity to look in depth at the fundamentals of the company, while paying greater attention to the climate view.
We do the same amount of work on credit fundamentals and think carefully about positioning. There are names we like that we have reduced exposure to because we see them as higher risk or not well placed in the current environment. It does not mean we cannot support them in the medium term.
We can bring risk down by investing in different parts of the capital structure
We are still trying to be dynamic and making sure we underpin the first pillar of this - investor returns. The second pillar - supporting climate transition – we seek to achieve in how we shape our opportunity set and engage with investee companies. We believe we can achieve both goals whilst also positioning for current market dynamics.
It's not like an equity portfolio where you might seek to hold a position for five years. We can invest in multiple currencies and at different points on the maturity scale. We might historically have held a name at the 15-year or the 20-year point in US dollars. If we see the dollar overvalued relative to the euro, we can switch that dollar position or bring the maturity down. That's one way of adjusting for volatility within different markets.
We can also bring risk down by investing in different parts of the capital structure. We were carrying a lot of hybrids but have reduced that exposure over time into more senior positions, because hybrids are exhibiting a negative correlation to rates volatility.
Are any attractive opportunities presenting themselves due to the market dislocation?
JV: We are seizing opportunities where it makes sense at relatively attractive valuations. For instance, we have been adding front-end bank exposure in US dollars. We are seeing a lot of new issues coming to the market and sometimes in rare sectors such as the European electric grid. That's an opportunity to add names we like at attractive valuations, with a three-to-five-year horizon in mind.
TC: Major exogenous shocks can bring market views forward or backward; we are currently experiencing a backward step with the war in Ukraine. But what we saw with the COVID pandemic was how significant these shifts can be and how rapidly things can move from a market perspective.
Within our framework we have a smaller opportunity set
Within our framework, we have a smaller opportunity set, and the nature of the strategy means turnover is lower, but that does not mean we cannot be dynamic. We can position in relation to currency, maturity, and within the capital structure: all these allow us to manage risk in a dynamic way.
What are your engagement priorities?
TC: Engagement is a key tenet of our strategy. Our view is simple: every company we look to invest in should have or be working towards a SBT that covers Scope 1, Scope 2, and Scope 3 emissions.
Most of the market looks at Scope 1 (direct emissions from company-owned and controlled resources) and 2 (indirect emissions, for example, through production processes) but does not include Scope 3 (emissions up and down the value chain).
Bondholder engagement is powerful. Every time a company brings a bond to the market, which could be multiple times a year involving different points in the capital structure and different currencies, it gives us the opportunity to discuss issues. It’s not like equities, where a company will tap markets infrequently in addition to holding shareholders meetings with engagement and voting.
Bondholder engagement is powerful and much more targeted
Bondholder engagement is much more targeted. The issuer needs the money there and then; if they do not give the right answers, they won’t get the money. It’s that simple. This is not to say we choose to discuss issues every single time, because that would be excessively onerous. It does give us opportunities to express opinions and ask questions. When a company is bringing a bond to market, the responses to questions we pose appear incredibly fast. It’s a real moment of opportunity.
There is one final point. The data produced by the UN suggests a real funding need to drive the transition, but the transition will not be primarily funded by equity. It will be predominantly funded by 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.