Climate transition: looking beyond a low-carbon portfolio

We built our climate transition investment team four years ago. Fionna Ross invites Samuel Grantham and Thomas Leys, Investment Directors in the abrdn Fixed Income team, to share their learnings and to discuss what lies ahead. 

Transcript

Fionna Ross 

Hello and welcome. I am Fionna Ross, Senior Sustainability Investing Specialist in abrdn’s Sustainability Group, and I'm your host for today's Sustainability Inspires podcast. 

My guests today are Samuel Grantham, who is an investment director in the abrdn fixed income team. Hi, Sam.

Samuel Grantham 

Hi, Fionna. Thanks for having us. Great to be here. 

Fionna Ross 

It's great to have you. We're also joined by Thomas Leys, an investment director on the abrdn fixed income team. And you're also both climate transition bond fund portfolio managers. Hi, Tom.

Thomas Leys

Likewise, great to be here. Thanks, Fionna. 

Fionna Ross 

Okay, so today we're discussing climate transition within the context of sustainability. And for those listening in, we really hope that this is going to leave you inspired to help with your joint efforts as we build towards a more sustainable future. 

So, let's get into exploring this topic, Sam and Tom, you built a climate transition investment team at abrdn four years ago now.  In that time, the landscape really has undergone some quite considerable changes. 

In your opinion, what are some of the key takeaways from this experience? And have you encountered any notable lessons along the journey that you could maybe share to some of our listeners? 

Samuel Grantham 

Yeah, thanks. Thanks, Fionna. And like you said, I mean, yeah, we developed the framework and the approach about four years ago now, and there's actually been some huge lessons learned over that time period. 

In terms of some of the key takeaways before we kind of get into kind of more detail in terms of the transition, how we're thinking about it, and some of the evolutions in the space, I think one of the most important things is around greenwashing. It's something that all investors are concerned about. And at the end of the day, if you go through a company's sustainability report, nine times out of ten, you're going to think the company's looking fantastic. 

But in reality, you know, that's not necessarily the case. So that's an important takeaway for us. And over the last four years, we think we've been much better in terms of how we assess and how we measure, not just greenwashing, but also how companies are making an impact on the transition. 

I think another key takeaway is, you've got to be interested in what you do. And from a personal perspective, I studied chemical and environmental engineering at university. So, you know, thinking about it, kind of more than ten years ago now. 

But also, even at high school, I was studying and very interested in kind of environmental engineering and design. And I've really tried to keep that momentum up in terms of my day job as well.

Thomas Leys 

So, I mean, from my side, some of the lessons that I think that are really key, and that we've learned over the last few years is the dangerous appeal of labels.  You know, within the sustainable investment world you're bombarded with things like green bonds, article nines, science-based targets, low carbon, and, you know, part of this stems from people's need to simplify things. 

You know, it would be great if we had a label that told us what was good, and what was bad in this in this world because it can be quite difficult to distinguish that within sustainability, probably more so than within just traditional investing. 

So, I think, you know, we've learned over the last four years that there's a huge range of quality when it comes to these labels. And just because something is called a green bond or low-carbon or, you know, or has a science-based target, doesn't necessarily mean that it's that it's doing good things.  

You know, what we've learned is that you really need to scratch below the surface in this when you're doing climate change investing.  And really that actions speak louder than words. You know, there's so many companies we've seen with excellent sounding targets, or as Sam said, excellent sounding sustainability reports. 

But it's really when you see what you know how the company is actually spending its money, how the management is really incentivised, what they've done in the past few years. You know, that's, that's really what it comes down to. So that's been a key takeaway for me.

Fionna Ross 

So clearly an area that you're both very passionate about, I think that really shows and also some of the challenges that you've highlighted are issues that I'm sure most of us in the field have had to grapple with at some time or another. So, it's great to get your kind of insights and thoughts here. 

So, let's move on, and expanding on your actual climate transition investment process. Often, when many people think about climate investing, we think about investing in green companies or those companies that perhaps have low emissions. 

But from what I understand this isn't necessarily the case for the climate transition investment process as you take a more forward-looking view.  Can you expand more on this idea of delivering positive change and your thinking around this?

Thomas Leys 

Thanks, Fionna, that's a very good question and it sort of follows on from what I was saying before.  

You know, when we look in the market, a lot of climate funds today are avoiding high-emitting companies in order to create low carbon footprints. And what we like to do is, you know, change the thinking slightly, we like to step back and think what are the biggest sources of emissions today on Earth, and you know, what companies can we invest in, that will do the most to address those. 

So, when you think, you know, emissions coming from energy, transport, materials, real estate, industrials, we'd rather pick companies within those sectors that have got ambitious incredible decarbonisation plans to make a difference in the real world rather than just lowering the emissions of a portfolio. 

For example, if you take, you know, if you take a Portuguese utility, that's investing 10s of billions of euros in renewable power, phasing out coal in the next few years, or investing in a US bank that still lending billions to fossil fuel companies, you know, the bank actually has an emissions intensity of one tonne of CO2 per million dollar of revenue, whereas the utility has got one of 260 tonnes per million dollar of revenue. 

So, one sounds 260 times as carbon intensive on that metric. But actually, you know, we think lending to that Portuguese utility, that's bringing down emissions in the real world, you know, is much more impactful. 

So, you know, we're shifting the thinking a little bit from trying to create low-carbon portfolios to actually trying to create a low-carbon world. And then sort of almost counterintuitively, we think the highest potential climate impact comes from the highest emitting sectors. So, rather than avoiding those, we've been actively investing in them. But you really need to do your research and take that forward-looking view. 

We also need to be careful when we talk about low-carbon. I mean, you mentioned there, you know that historically, people have been investing in those green companies, with a lot of the metrics we use to measure green often excludes key parts of, you know, key pieces of the puzzle. 

A lot of people only look at scope one and two emissions, i.e., the direct emissions of a company, they're not necessarily looking at the supply chain emissions.  We think that misses a critical part of the picture because supply chain emissions are often over three-quarters of a company's emissions. So again, coming back to that point about using labels and how difficult it can be to rely on them. 

And also, in addition to investing in companies that are transitioning themselves, so those brown companies that are on that, on that positive journey, we think it's important to look for companies that are helping others transition. 

If you think about companies that are producing batteries, electric vehicles, building insulation, recycling companies, or even things like public transport. You know, here again, we're less focused on these companies having low emissions footprints. And we're more taking a forward view, you know, and thinking, how do these companies have a positive impact when it comes to bringing down emissions in the real world through avoided emissions instead.

Fionna Ross 

Can you maybe expand a bit more on that, you know, why are these also important to consider? 

Thomas Leys 

When we typically look at the carbon footprint of a company, we're looking at the emissions from their direct operations, and even their supply chains. But if you think about a company's entire impact on emissions, you also need to think about the products and services they have, and how they influence others. 

So, if you think about a company that's producing, building insulation, they might have emissions associated with their operations and their supply chain. But the impact of their product can help others reduce their emissions footprint materially. 

So, it's important to think beyond just the company's own supply chain and operations and think about what the products actually do. And there's a real missing piece of the investment opportunity set, and also a missing piece of the puzzle when it comes to assessing impact of climate investments. 

So you're moving away from just focusing on the scope one and two emissions of a company and thinking broader about, you know, what the impact is of the business, and then that way you can help reduce emissions in the real world.

Fionna Ross 

Thanks, Tom. That's really insightful.  I think also the idea of reducing carbon emissions in the real economy as opposed to just at portfolio level, it's such an important point. 

Okay, so when we talk about climate investing, it's hard to avoid the topic of regulation, ESG data and also new instruments such as green bonds, for example. What do you think investors should be aware of when they're looking into green bonds? And also, if I can throw another question on, how reliable would you say that ESG data actually is today? 

Samuel Grantham 

That's, that's a big question. But I'll have a go at tackling it. 

I think you're absolutely right. I mean, you've seen a huge growth in in green bonds over the last few years, and though this has clearly been positive in terms of kind of tracking positive environmental impact, ensuring companies that issue green bonds are, you know, allocating to eligible projects, investors need to be aware of potential risks as well. 

So, when we go back to, for example, 2022.  It was a very difficult year for fixed income from a performance perspective. But actually, green bonds were one of the worst performing parts of the fixed income market as well. 

You know, why was that the case? Well, when we think about green bonds, they tend to be issued by certain or essentially a handful of sectors.  So predominately from real estate, from banks, and kind of from utilities. 

So, first of all, not ideal from a diversification perspective. You know, if you were running, for example, a pure green bond fixed income strategy. But also, if you go back to 2022, you had huge banking stress, you had high-interest rates, which put pressure on property valuations. So that impacted the real estate sector and obviously, the banking sector as well. 

And then you had the energy security crisis in Europe impacting utility valuations as well. So, it was almost a perfect storm for the green bond market. I mean, away from this, it's really important to point out, you know, green bonds are an excellent way to allocate investments to specific projects. But actually, there are many green bonds issued by environmentally harmful companies.  And actually green bonds issued with weak frameworks underpinning that. So, you know, this really raises again, one of the kind of key takeaways for us around greenwashing risks.

So, in terms of our philosophy, you know, I think we've always been of the view, look at the entire issue as operations and business activities, and decide whether we think the business supports our objectives or not, that's really, really important. We would rather, and we say this a lot, invest in unlabelled bonds from a green company than a green bond from a harmful company. 

In terms of ESG data, again, you know, lots of developments here, especially with sustainable investing regulations, such as SFDR, and the EU taxonomy. We've seen huge improvements in the quantity and quality of ESG data, which obviously, is great. But there's also been some potential unintended consequences from this as well. 

You know, Tom touched on a really good example, this Portuguese utility, you know, a lot of investors actually would be excluded from owning the company, because it still has around 5% of revenues from coal generation, which tends to be the threshold for some investors. 

However, as Tom mentioned, this is a company in our view, at the forefront of the energy transition in Europe.  They are one of the largest developers of renewables globally, and they're looking to phase out all coal by 2025. 

So, we think these are exactly the types of companies you should be supporting. And yet a lot of the sustainable investment landscape is actually suggesting you should sell out of this type of company.

So, you know, should the same ESG standards be applied to all issuers, I guess it's another point to flag here. You know, the difference between a high-yield and investment-grade issuer, I think it's actually really important. And it's something we don't discuss enough.  High-yield issues, which are often smaller or younger companies, they may lack dedicated ESG teams, they might not have green bond frameworks or the resources to produce that sustainability report. 

But this doesn't mean they're having less impact on, for example, the transition, which is obviously what we're talking about today. In some cases, they actually could have more positive impact. And we're finding some really interesting companies in the high-yield market, for example, where the disclosure might not be strong today, but the underlying business is supporting the transition in some way. 

So ultimately, you know, there are risks with purely relying on label bonds or relying on ESG data. We feel, you know, sustainable regulation, and ESG data is definitely going in the right direction. But it is at times causing unintended consequences, RE the transition. 

But for us, I mean, it's not all doom and gloom that also creates investment opportunity, right? In our view, if investors who can uncover companies with good ESG practices, but limited disclosure, actually, that's an opportunity to outperform by investing before improved disclosure eventually attracts greater market attention.

Fionna Ross 

And I think you highlighted some really important points there.  It’s interesting, especially to hear about the differences between high-yield and investment-grade issuers. I think, from my equities background, it makes me think of comparing, you know, smaller cap companies to larger cap companies and the similar kind of challenges that exist there. 

Okay, so I think we have time for one last question. I believe that this is something that you are both often asked in meetings.  As bond investors, can you actually have a meaningful impact on the transition say in comparison to, for example, equity investors?

Samuel Grantham 

Yes, that's definitely a question we get asked a lot.  I mean, there's a number of reasons why potentially, you could argue they have less impact from a fixed income perspective. I mean, equity investors typically hold ownership stakes and companies giving them potentially, I guess, greater influence over corporate governance, strategic decisions, etc. 

I guess another argument is equity investors interests are more closely aligned with long-term objectives and sustainability of the companies they invest in. I mean, clearly, me and Tom have a fixed income background. So, with we're biased and probably think the opposite. 

Maybe I'll touch on a few examples. And then Tom can as well. But if we specifically think about the transition, what needs to take place, but also recent developments, such as what we've already touched on in terms of labelled bonds. You know, we think, actually, you could argue fixed income plays an absolutely crucial role in terms of impact, with respect to the transition. 

First of all, we're not just focused on public companies, unlike on the equity side, and actually, as bond investors, we have the flexibility to invest across the corporate and sovereign landscape. So maybe, you know, in terms of examples to bring this to life, government-sponsored rail network investment in Chile. 

So, from a climate perspective, we really like it.  Rail transport reduces emissions by providing essentially a more efficient alternative to personal cars and therefore reduces greenhouse gas emissions as a result. This particular investment is government-owned and operated, so around two-thirds financed by government capital contributions, and the remaining via the public debt market, which is where we got involved. 

So as bond investors, you're supporting a key part of the Chilean economy, helping provide financing for low-carbon transport to a large part of the Santiago population. And as a result, you're reducing air pollution and greenhouse gas emissions, you know, that wouldn't be possible in an equity fund.

 I think another point to mention is if we think about some of the more vulnerable regions, with respect to the climate transition, you know, India is one of the largest consumers of coal globally. That's resulted in environmental degradation, including deforestation and habitat destruction. 

But also, as we all know, coal combustion is a major contributor to air pollution as well. So therefore, you know, moving towards a low-carbon economy is essential for mitigating the impacts of climate change and reducing pollution in India. 

There's a number of investable, Indian renewables in the public bond space, however, these companies are not invested in the equity space. Now, given that private companies, but again, issue in that public debt market. 

So really, it's another example where bond investors can direct capital to where essentially, it's most needed, you know, reducing the cost of capital for companies driving the energy transition in a region over reliant, still on fossil fuels.

Thomas Leys 

Another way in which fixed income investors can cause impact or support impact in ways equity investors can’t is something that's been mentioned obviously, on this on this podcast a few times, which is the use of labelled bonds. 

So obviously, through green bonds, social bond, sustainable bonds, you know, when done properly, these can be very, very effective, you know, you're investing in, directly in projects, and you can track the use of proceeds, you can see, you know, you can see your money within a few years going towards, you know, renewable power, energy efficiency measures, social projects, and so on. So, that can be quite powerful, whether, you know, you're really tying the money, you're investing to those, those impact projects. 

Similarly, with sustainability-linked bonds, obviously, there's been various controversial examples of this. But when done properly, you know, you can really incentivise the company through, you know, a legal document, and through increased cost of finance, you can really incentivise them to stick to sustainability targets. And another thing that's often not talked about is the primary markets, you know, one of the main ways in which fixed income investors invest is through new issuances. 

So, you know, in that instance, you're actually giving the money direct cash, you know, there's a real transaction there with the companies. And so that sort of bilateral transaction between you and the company is much more frequent compared to equity investing, where you're often buying shares from another shareholder and sort of the actual transaction with the company is less frequent. 

So, we think that that gives an opportunity for investors to actually have, you know, it gives a very strong reason for them to have a sort of say on where that money goes, we think. 

Samuel Grantham 

Yeah, I think that's a really good point, Tom. I mean, actually, just on that labelled bond point, I think, you know, if we're already on a, essentially a 2.4, 2.6-degree warming trajectory at the moment, which means an urgent need, not just to focus on bringing down emissions with respect to the transition, but actually focus on adaptation, you know, building resilience into economies, which are impacted by climate change. 

Fionna Ross 

Well, unfortunately, that’s us come to the end of our time. So, thank you, Sam, and Tom, and also all our listeners for being with us today. We look forward to joining with you again soon. 

Samuel Grantham

Thanks Fionna. 

Thomas Leys

Thanks Fionna. 

Fionna Ross 

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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.