28 Jun 2024
Authors | Samuel Grantham, Investment Director | Thomas Leys, Investment Director
We built our climate transition bond team four years ago, ahead of a fund launch in June 2021. Over this time, we’ve helped our clients invest in transition opportunities, while contributing towards real-world decarbonisation and climate change adaptation.
Although our aims have stayed constant, we’ve seen plenty of developments in the investment landscape. Here, we share seven of our key learnings – and look at what lies ahead.
1. The rise of greenwashing
One of the most important developments we’ve seen in sustainable investing is greenwashing. This is an area no investor takes lightly.
The challenge begins with a company’s sustainability reports. These lengthy documents often aim to present the business in its most favourable light. And they usually do – to much fanfare. However, a deeper examination can reveal inaccuracies in reporting and measurement. Thorough analysis of a company’s spending or how it incentivises management can also reveal a less rosy picture. In other words, businesses often overstate their green credentials.
Over the past four years, we’ve developed the processes and frameworks to help us better understand the true impact of a company’s products and services on the real world. We don’t just interrogate sustainability reports. We seek to understand and quantify how a business enables the climate transition.
2. The pros and cons of labels
This brings us to the dangerous appeal of labels. Sustainable investing is awash with terms like ‘green’ bonds, ‘low carbon’, ‘science-based target’, and ‘Article 9’. These stem from attempts to simplify and understand a complex world. However, we’ve found there’s no straightforward label for ‘good’ and ‘bad’ when it comes to sustainable investment. This is especially the case for climate-change investing. Investments labelled ‘green’ or ‘low carbon’ often don’t meet expectations. Similarly, owning a portfolio with 'science-based targets' does not guarantee a positive, tangible environmental impact.
3. It's not easy being green
‘Green’ bonds are a great way to direct capital to environmental projects. These include renewable energy initiatives, pollution prevention measures and water management schemes.
‘Green’ bonds are a growing sector. Around US$250 billion ‘green’ bonds were sold in 2023. That said, numerous companies with environmentally harmful practices issued these bonds. This highlights the importance of evaluating ‘green’ bonds not just on their label but also within the context of the company’s overall operations, business activities and supply chains.
Furthermore, many metrics investors use to identify ‘green’ companies exclude important pieces of the climate puzzle. Typically, investors focus on Scope 1 and 2 emissions (the direct emissions from the company’s operations and energy use) and neglect Scope 3 emissions (the indirect emissions in a company’s value chain). In our experience, Scope 3 emissions can account for as much as three-quarters of a company’s total emissions.
4. Climate transition: a different approach
For many in the market, climate investing means focusing on 'green' or low-emitting companies. Others, meanwhile, steer clear of high-emitting businesses and sectors. Both approaches aim to build climate funds that have a low-carbon footprint.
Our process is different. We identify the primary sources of emissions across critical sectors – energy, transport, material, real estate, and industrials. We then pinpoint companies with ambitious and credible plans to slash those emissions. We believe investors won’t be able to address climate change by only investing in companies with small carbon footprints. We need to find businesses with credible decarbonisation plans that deliver tangible results.
Utility or bank?
Here are two examples to illustrate our point. One is a Portuguese utility that’s investing tens of billions of euros in renewable power. It also has concrete plans to phase out coal within the next few years. Then there’s a US bank that’s lending billions to fossil fuel companies. Its emission intensity stands at one tonne of CO2 per one million dollars of revenue, a stark contrast to the utility's 260 tonnes of CO2 for the same revenue amount.
At first glance, the banks may seem to boast a lower carbon footprint than the utility. But more comprehensive analysis reveals that the utility is actively contributing to a significant reduction in its emissions, far outweighing the bank’s carbon footprint metrics. It‘s the utility’s initiatives that will, in our view, have a more substantial impact on mitigating climate change.
That’s why our strategy extends beyond merely assembling a low-carbon portfolio. We believe practical results are achieved by directing investments towards companies with meaningful decarbonisation strategies in high-emitting sectors.
5. Don’t avoid avoided emissions
It’s also important to focus on companies helping others transition to a low-carbon future. Examples include firms producing batteries, electric vehicles, building insulation materials, recycling solutions, and public transport. While these companies may not boast low carbon footprints, their products and services play a vital role in the global effort to combat climate change.
Insulation and transportation
Take, for example, a company producing building insulation. Its operations and supply chains will have associated emissions. However, in lowering a building’s carbon footprint, the firm is having a material impact that far exceeds the negative effects of its own emissions.
Then there’s a rail company that links the UK and France. Its Scope 1 emissions, while flat over the last five years, might deter some environmentally focused investors. Dig deeper, however, and we see that by offering electrified rail services as an alternative to fossil-fuel-powered ships or planes, the company helps avoid approximately two million tonnes of CO2 emissions annually.
6. ESG: behind the numbers
We can’t talk about climate investing without addressing environmental, social and governance (ESG) data and regulation. In Europe, SFDR (Sustainable Finance Disclosure Regulation) and the EU Taxonomy for green classifications represent a significant step forward in the regulatory landscape. These developments have led to marked improvements in both the quantity and quality of ESG data. However, they’ve also resulted in some unintended consequences.
Let’s return to our Portuguese utility. Approximately 5% of its revenue still comes from coal generation. As a result, investors relying on strict exclusion metrics might overlook the company. Yet, it’s a leader in Europe's net zero transition and the world's largest developer of renewable energy. The company is also committed to phasing out coal by 2025. Blindly avoiding it would be a missed opportunity.
7. The high-yield opportunity
Producing detailed ESG data is time-consuming and costly. Most investment-grade bond issuers have dedicated sustainability teams to create and analyse this data. By contrast, many high-yield issuers are younger and smaller companies. Most don’t have the resources, framework or experience to deliver detailed sustainability reports.
But the absence of detailed reports does not diminish the importance of high-yield companies to the climate transition. We've encountered numerous companies whose disclosures might be limited but whose operations significantly contribute to the climate economy. This, though, presents an opportunity for asset managers adept at identifying companies with less robust disclosure but strong ESG practices. Investments in such enterprises have the potential to outperform, as and when the market recognises a firm’s inherent value.
Final thoughts…
The world is heading for a temperature rise far above Paris Agreement goals. With devastating floods and fires becoming increasingly prevalent, the need to decarbonise and build up climate change resilience is more important than ever. We believe fixed income investors can tap into compelling opportunities, while contributing towards the net zero transition and helping economies adapt to a warmer world.
You can listen to Samuel Grantham and Thomas Leys talk more on climate transition bond investing on the Sustainability inspires podcast.
Disclaimer
This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for informational purposes only and should not be considered a is an offer investment recommendation or solicitation to deal in any of the investments or products mentioned herein and does not constitute investment research. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of abrdn. The companies discussed in this podcast have been selected for illustrative purposes only ought to demonstrate our investment management style and not as an investment recommendation or indication of their future performance. The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested. Past performance is not a guide to future returns, return projections or estimates and provide no guarantee of future results.
Companies are selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance. Past performance is not a guide to future results.
Risk warning
The value of investments, and the income from them, can go down as well as up and an investor may get back less than the amount invested. Past performance is not a guide to future results.