Approach to Responsible Investment

Climate-related risks are a large consideration in the design of the objective-based portfolios¹. As part of the Multi-Asset Solutions team’s approach to Responsible Investment, exposure to fossil fuels is excluded from the universe of our objective-based portfolios. There is a 0% revenue exposure from the below activities:

• Extract thermal coal, generate power or have the capacity to generate power from thermal coal
• Companies in the Coal & Consumable Fuels or Oil & Gas Exploration & Production Global Industry Classification Standard (GICS) subindustries
• Conduct Oil Sands extraction or have the capacity for extraction

Despite the low exposure to fossil fuels, transition risk (financial risk rising from changing strategies, policies or market behaviours as society and industry transitions to a low carbon economy) is still an important consideration to avoid exposure to stranded asset risk. These risks will continue to be prominent, particularly over the next decade as businesses plan and implement their transition. We expect the transition to a lower carbon economy to require widespread changes in how companies operate, service and manufacture. We believe companies that do not transition in an orderly manner are at risk of being left behind, subjected to penalties and with stranded assets. Market pricing for climate risk is already starting to increase. We expect this to grow exponentially as we approach 2030 and beyond. As it pertains to default risk, we view that companies that are not adequately addressing climate-related risks will face a reduced ability to refinance. 

If climate change continues to evolve without sufficient mitigation, we would expect company financial performance to be negatively impacted by growing physical risks including natural disasters, supply chain disruptions, extreme temperature changes, employee safety and disruptions to operations. If not mitigated, we would expect the physical impact to worsen as we approach 2050, with instability rising until then. Alongside these risks however, we see opportunities for companies to try to mitigate the impact of these disruptions by developing resilient assets and supply chains. Our objective-based portfolios invest in assets across a broad range of regions and therefore a diverse range of geographies, all facing varying environmental conditions. Using third party data service, we have analysed sector contribution to the portfolio’s physical risks and which companies are most at risk of potential financial implications as a result of fires, floods and other extreme weather events worsened by climate change.

While many of these risks may impact a company’s day-to-day operations, the regulatory environment surrounding climate-related financial risks is rapidly evolving. These regulations will continue to try and discourage companies from participating in activities that adversely affect climate change. Companies that do not comply could be open to litigation, which could pose negative implications for portfolios that hold such companies. The changing regulatory environment accompanies the prospect of reputational risk. Companies that continue to exacerbate climate change, due to their connections to fossil fuels and other high emitting activities, we believe will lose their social licence to operate over time. Similarly, it will be important for our portfolios to monitor this and our exposures to companies that are not transitioning to a low carbon economy.

In the Multi-Asset Solutions team, our Responsible Investment approach is integrated in the investment process of our objective-based portfolios and can be incorporated into bespoke solutions. We use ethical (values-based) screens to divest from companies that do not align with our purpose and beliefs, as well as investment screens (exclusions) which focus on revenue derived from activities in excluded industries.

In 2020, we underwent a process to divest from fossil fuel assets in our objective-based portfolios. We undertook robust analysis to ensure this exclusion would fit within our portfolio construction process. This process analysed the MSCI All Country World Index with and without the high carbon-emitting sectors. Overall, our analyses concluded that the removal of high carbon-emitting companies significantly reduced the carbon footprint and potential emissions while only generating a small level of tracking error². The decision to exclude fossil fuel companies involved robust analysis to ensure this exclusion would fit within our portfolio construction process. These findings led to the development of our fossil fuel divestment policy, which can be found in our website.  By excluding companies directly involved in exploration and production of fossil fuels, we avoid exposures to companies with a high level of transition and stranded asset risk.

Beyond fossil fuel companies, we determine which companies to exclude by looking at which subindustry they operate in as well as the level of carbon risk. To complement our research, we also have access to a variety of ESG data providers to which we subscribe for data on carbon analytics, climate scenario-analysis³, physical and transition risk exposures, global compact screening and controversy. Each year, our objective-based portfolios are reviewed and rebalanced based on the asset allocation and screening processes in place, and climate-related risks and insights we get from several ESG data providers are taken into account.

Our investment process focusses on what we believe is the optimal balance of asset allocation to diversify the portfolio across asset types, regions and currencies. As a result we hold numerous companies for diversification and typically don’t engage directly with the companies. For this reason, we believe a divestment policy is most appropriate for our objective-based portfolios. We typically hold a large number of securities for diversification benefits. Due to the large number of companies the portfolio has exposure to, it can be unfeasible to engage with each directly. Additionally, the allocations can often be quite small, relative to the company’s total market capitalisation or debt outstanding, making it challenging to obtain a meeting.

As it is challenging for our portfolio managers to engage and influence companies directly, we employ engagement services from reputable providers, typically on select relevant topics. Over time, we will continue to consider using such engagement services on other topics, including climate change. We do use voting as a tool to drive change on climate-related issues. While we maintain full control of our voting decisions, we subscribe to Glass Lewis’ ESG guidelines⁴ as a reference and for research, and climate-related issues are captured as part of this.

We have set net zero targets for our objective-based portfolios focussing on portfolio-level targets as opposed to company level and we plan for 100% of these portfolios to be achieving net zero by 2040. As multi-asset investors, we believe that portfolio level targets as opposed to company level are more appropriate as the composition of the portfolios can change frequently. These targets are based on the net zero alignment maturity scale defined by the Paris Alignment Investment Initiative Net Zero Investment Framework Implementation Guide.
 

Net Zero Targets for the objective-based portfolios 

In monitoring our portfolio’s progress towards these targets, we will look at the ambition and quality of the net zero targets made by portfolio companies, their emissions performance, disclosure and capital allocation towards decarbonisation. We also have access to tools to calculate the carbon intensity of our portfolios and climate scenario analysis, to determine if the portfolio is on the right trajectory to be net zero by 2040.