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Taking An Inclusive View

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The ESG investing trend, particularly with climate, is toward greater breadth, said S& P DJIs Steadman. As an example, he pointed out that the S& P 500 Carbon Efficient index contains nearly the full portfolio of the S& P 500 index. Theres a reweighting methodology that tilts the constituents toward companies that are doing better from a carbon efficiency standpoint. But rather than focusing on exclusions, as ESG investing has done in the past, the trend now is toward being as inclusive as possible. That is, capturing a broader universe of opportunity and then modifying capitalization weights to reflect ESG principles and priorities.

According to Steadman, broad, climate-centric indexes tend to reflect the general market more so than narrow, exclusionary indexes. Performance deviations from the market beta are fewer, and the composition offers diversification more in line with the market.

Through that shift, index users can seek beta exposure as well as express what one could call values alignment, he said. These indices also aim to incentivize companies to act in a way that we hope would mitigate climate change.

According to Howard, investors can no longer view climate exposure as a choice whether or not to invest in climate change, or whether or not to be exposed to climate change. Every asset class, of every type, is now to some degree impacted by climate change.

Read:Rising Climate Change risk not yet factored in markets

Sustainability At The Forefront

The global energy system is undergoing a seismic transition from one based primarily on fossil fuels to one based primarily on renewable sources, said Carlo Funk, head of ESG investment strategy for Europe, the Middle East and Africa at State Street – Global Advisors. And this is going to happen, full stop.

Funk said he believes the world is at a tipping point where ignoring climate change is no longer an acceptable option, and climate-related developments, such as increased regulation and more commitments from the private sector, are accelerating. He pointed out that a couple of decades ago, a chorus of industry experts doubted Germanys then-announced renewable energy goals, claiming that the ambitious program couldnt be supported by the countrys infrastructure. However, last year, Germany surpassed 50% renewable generation.

Right now were seeing a lot of pledges, but little has happened as yet, Funk said. Eventually those companies will have to live up to those promises and what happens then? Then we will likely see massive capital repricing and reallocation, leading to climate-centric investment risks and opportunities. Financial market participants will be held accountable, and those are fundamentally governments, corporations, pension plans and the banking and financial sectors. So, while the transition to a low-carbon economy wont happen overnight, if you dont act now to prepare, it could be too late.

Read:Are we on the road to net-zero?

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All Stakeholders Push Forward

Within the broader investment topic of environmental, social and governance, climate is right at the top in terms of impact and importance, according to Sarah Bratton Hughes, head of sustainability for -Schr-oders- in North America. For many years, it has been integral to how we think about the investment landscape. But now, increasing pressure is translating into corporate action. As a consequence, its an unavoidable issue for asset managers and asset owners. Thats not to say other areas of ESG arent also important. But climate is both imminent and pressing demanding an immediate response.

The push toward disruptive change and a net-zero economy is happening at the political level, the corporate level and the social level, she said, adding that it has gathered significant momentum over the past couple of years. About two-thirds of the worlds emissions come from countries that have made commitments to net-zero carbon emissions over the next few decades and the past 12 months have seen about a 50% increase in the number of companies making commitments to the Paris aligned-decarbonization targets.

The other important point here is that climate considerations are not just about carbon, nor even just about greenhouse gases, Drew continued. Theyre also about biodiversity and considering how companies use land and water resources, because they impact biodiversity levels and deforestation has a very big impact on climate.

Both Risk And Opportunity Are Broadening

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Climate impact isnt just about carbon, said Hari Balkrishna, portfolio manager for the Global Impact Equity Strategy at T. Rowe Price. Investors need to be focused on things like methane, and -gas type refrigerants, which in some ways are much more harmful than traditional . And the risks and opportunities stretch well beyond the energy and transportation sectors to encompass changes in sustainable agriculture, bioplastics and replacing petroleum products with green hydrogen for industrial applications and heavy transportation.

Climate factors have to include things like energy transition or the amount of physical climate risk a company has, their biodiversity impact, whether or not theyre contributing to circular economies, and how theyre using land and water resources, said T. Rowe Prices Drew. We also look at how companies handled past controversies, which can be a good indicator of how well theyre managing environmental issues. We consider climate and ESG issues very broadly across every single portfolio because these issues, to some degree, are going to affect the financial outcomes of all of our investments.

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The Power Of Engagement

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To have an impact on climate, or to attempt to mitigate climate risk in an investment portfolio, the first thing that asset owners and investment managers need to do is engage in the issue on multiple levels.

Steadman said he believes that momentum toward climate engagement is likely to accelerate in the U.S., particularly in the second half of this year, and that climate indexes, particularly the S& P 500 Paris-Aligned Climate index, will be major benchmarks and a standard in their own right.

As we build our different products, we very much have in mind that there will be certain asset owners that are expressing their worldview through the prism of an index, said Steadman. Theyre perhaps using an index as a tool for investing in line with their institutions values. Climate-focused indices offer a comprehensive vehicle that institutional investors can use with passive management, thereby potentially rewarding companies for positive progress on ESG generally, and climate specifically.

For us, the question is, how can we use our influence as active managers to facilitate change in companies, and help those companies transition toward more sustainable businesses and business models? said Howard. Thats really the role of engagement and ownership, and using our voice and our leverage to achieve that.

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Demand For Green Bonds

Lawton sees two areas of opportunity. The first is green bonds, which grew to $136 billion in issuance in the first quarter of 2021, a 100% increase over the first quarter last year, and he expects that growth to continue at a healthy rate.

There are also pockets of value among hybrid capital securities from issuers at the forefront of the renewable-energy movement, Lawton said. These securities typically offer attractive valuation relative to senior unsecured bonds from the same company. Capturing incremental yield while directing capital to long-term climate winners is an appealing proposition.

However, he offers a cautionary note on green bonds: The market is wrestling with high sector concentration, price distortions and greenwashing the risk that investments presented as green really arent, once you look under the hood. About 80% of corporate green bonds originate from just three sectors: utilities, banks and real estate. Over time, Lawton said, diversification should improve as new issuers enter the market. In addition, investors may have to navigate price distortions given increasing demand from climate-focused bond funds. Lastly, he noted, its important to go beyond the green label to research the underlying projects being financed. Not all green bonds are created equal. Investors need to understand relative climate benefit varies by bond, said Lawton.

Layer In Fiduciary Duty

Going beyond influence, asset owners and investment managers also need to think about engagement through the research and portfolio-construction process.

No company is going to escape climate impacts, said Howard. So from an investment perspective, we need to engage in the issue from the point of view of risk, opportunity and fiduciary duty. Our aim is to identify those companies with strong business models that will not only survive, but thrive, because management has taken steps to ensure the organizations sustainability.

Read:Transition to a 1.5°C World

The thing with climate is that a completely holistic ESG approach is not going to have much of a climate impact, said Funk. For example, a broad-based ESG portfolio will never be Paris-aligned. To reach that goal, the investment methodology needs to be refined with additional data points, metrics, overlays and other approaches. ESG and climate principles are not mutually exclusive, but if you want to really move the dial when it comes to climate and climate change, you need to engage specifically with the climate issue, and climate should be embedded as the dominant analytical factor.

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Structural Disruption: Who Will Win

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Big Energy incumbents have an advantage because they understand the entire infrastructure and how to bring a unit of energy to the end consumer, Funk said. But within that universe, there will be winners and losers. The winners will be those that adapt more quickly and drive the bulk of innovation.

He likened the coming energy shakeout to the trajectory of digital technologies. Innovation will come from large incumbents, but new emerging players will also tap into the value chain to help bring the world to net-zero emissions. That value chain stretches beyond energy to include steel, cement, fertilizer, plastics, pure thermal energy, thermal storage, agribusiness, construction materials and textiles. Funk argued that winners are likely to be those that have a favorable carbon footprint or those than can rapidly reduce their exposure to climate-related costs.

Read:Fundamental Active Equities: Climate debate

These will be the biggest structural changes since the industrial revolution, and there will be no shortage of very, very interesting companies and opportunities out there for investors to consider, Funk said.

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Data Gets More Granular

Underlying that work is a commitment to comprehensive, transparent data that has a wide range of uses. For example, Steadman pointed out that low-volatility strategies can be concentrated in carbon-intensive industries and good data helps asset owners put a climate lens on a strategy that is not precisely ESG or climate. Data is essential in addressing the question of greenwashing, he noted, and it is also critical in measuring risk in specific industries and in comparing companies within their peer groups.

In 2016, S& P Global acquired a company called Trucost, a recognized leader in the field of environmental metrics, Steadman said. We combined Trucosts capabilities with ESG scoring and analytical tools from a Swiss company S& P Global acquired called SAM, which is now also part of S& P Global, to create Sustainable1, an S& P Global ESG research, data and analytics hub. When it comes to environmental data that Sustainable1 produces, theres a checking that takes place, where we start with public disclosures and then model our own estimates for climate impact. That validation step is critical because there can be widely different levels of reporting rigor when it comes to emissions and other environmental metrics. So its important to publish indices based on consistent, sound data.

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