Approach to Responsible Investment

A focus on Environmental, Social and Governance (ESG) issues can be particularly important when investing in credit markets. Companies’ management of ESG-related issues has a direct impact on their risk profile and, in turn, the probability of default. We believe that climate-related risks are as important as any other financial risk factor. These risks have additional emphasis in a world that needs to decarbonise rapidly.

Transition risk is meaningful to our Australian Fixed Income portfolios due to the exposure to the industrials and utilities sectors. We are conscious that exposures to high emitting industries will be most affected by the transition to renewables and the reduction of emissions. Additionally, we want to avoid the risks associated with exposures to stranded assets. Our stranded assets toolkit has been in place since 2013 to assist in monitoring this. We expect the transition to a lower carbon economy to require widespread changes in how companies operate, service and manufacture. 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 believe that companies that are not adequately addressing climate-related risks will face a reduced ability to refinance. 

Our portfolios also have large exposures to sovereign and government-related debt (reflecting the underlying composition of the benchmarks and universe). These issuers are also vulnerable to climate-related financial risks. Over time, we believe that borrowing costs for climate laggards are expected to increase.

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. 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. In particular, we believe our exposures to issuers within the Industrials and Financials sector are most at risk of potential adverse financial implications due to 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 to 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, will lose their social licence to operate over time. Similarly, it will be important for our portfolios to monitor this and our exposures to issuers that are not transitioning to a low carbon economy.

Climate-related risks are identified and assessed throughout the credit research process. Analysts utilise sustainability reports published by companies and third party research providers to help inform their views. As part of the credit research process, our analysts also assess the net zero alignment of each company. This assessment uses the framework developed by the Institutional Investors Group on Climate Change (IIGCC). The analyst considers whether the company has made any short- and long-term targets, the level of ambition and quality of these targets, their capital expenditure dedicated to achieving these targets and track the company’s progress in reducing their actual emissions over time. As well as finding our own information throughout the credit research process, we also subscribe to various ESG data vendors to supplement this information and aggregate for further analysis.

While there are a selection of resources available (albeit much smaller) to analyse sovereign and government-related issuers in this regard, our main lever available to use is engagement. Unlike with corporate issuers, there are less sovereign and government-related debt issuers available to choose from, and they tend to represent much greater proportions of benchmarks.  As a result, ongoing engagement to encourage change is our most useful tool.

At the portfolio level, we are able to conduct climate scenario analysis. We can use this tool to test the alignment of our portfolios to the various International Energy Association (IEA) scenarios¹, and indicate which year the portfolio is estimated to overshoot its carbon budget. The scenario analysis data also provides insight for our portfolios with regard to physical and transition risk exposures. This can enable us to see how exposed our portfolio companies are to different natural hazards and whether these are sufficiently being managed. We plan to use this tool to monitor our portfolios at regular intervals and use the results for reporting.  As we have set net zero targets for each of our active, publicly available portfolios, the results from the scenario analysis tool will provide useful forward-looking analysis. On the historical data front, we also have access to carbon data. This data illustrates the carbon intensity and highlight which companies and sectors are contributing to our portfolio’s carbon intensity. We can also determine our exposure to fossil fuels, fossil fuel reserves as well as renewables.

¹ The International Energy Agency has developed a set of scenarios, each of which is built on a different set of underlying assumptions about how the energy system might evolve. These are not predictions, they are designed to enable users to compare different versions of the future of global energy.

A product of the credit research process is an ESG risk rating, of which climate-related risks are included. Climate related risks are identified as part of our Environment pillar, along with other environmental risks such as waste management, pollutants, water, biodiversity impact etc. As part of the climate-related risks, we assess whether the company has made long-term as well as short/medium-term decarbonisation targets, the level of emissions data disclosed, as well as the capital expenditure that the company has dedicated towards transitioning to net zero. Our analysts not only look at how management manage downside risks but also how they capitalise on the upside risks.

The portfolio managers factor climate-related opportunities as part of new product design. As part of this process, we have access to ESG data providers to which we subscribe to carbon analytics, climate scenario-analysis, physical and transition risk. In particular, the climate scenario-analysis tool can provide us with an indication of the net zero alignment of our portfolios. We can also assess the exposure of our portfolios to climate change mitigation activities, which can be useful when designing products in a world that needs to rapidly decarbonise.

Our credit analysts prioritise ESG engagement with companies that have material risks that are either not well managed or understood. Engagement on climate change issues can include seeking more information about the company’s ambitions to decarbonise, tracking and disclosing their emissions and target setting. If we felt a company was continuing to poorly manage ESG risks over a 12-24 month period – and appear unwilling to make meaningful changes despite repeated engagement – we may adjust down our ESG risk assessment. Our ESG risk ratings influence the assignment of Internal Credit Ratings, and so negative changes would guide an analyst to downgrade the Internal Credit Rating. For sovereign and government-related issuers, our portfolio managers meet with these issuers regularly. As part of these meetings, our portfolio managers engage on ESG issues including the issuer’s alignment to net zero by 2050. While individually we are likely to have less ability to drive behaviour with these issuer types, we do believe that engagement, both individually and in conjunction with other investors and investor groups, does have the potential to sway issuer behaviour over time.

The credit analysts do not cover sovereign and government-related issuers, and as such, no formal ESG risk rating is generated. It can be more challenging to navigate sovereign and government-related debt ESG issues, particularly if the issues pertain to a large government entity. While divestment is, in many cases, not viable from a performance risk management perspective (particularly if the portfolio is focussed on Australian fixed income, for example), ongoing engagement by the portfolio managers is. 

For our Australian Fixed Income portfolios, we have focussed on portfolio level targets as opposed to company level. We have set quantitative targets for our portfolios, based on thresholds of the portfolio aligned to net zero. These targets cover all of our active, publicly available portfolios. These targets focus on the proportion of the portfolios either committed, aligning or aligned to net zero by 2050. Over the short (2025), medium (by 2030) and long (by 2050) term, the targeted proportion of the portfolio aligned to net zero significantly increases. The criteria for committed to aligning, aligned and achieving net zero is based on the framework developed by the IIGCC.

Short term (by 2025)

Portfolio level

• 75% of portfolio committed to net zero
• 25% of portfolio aligning to net zero

Medium term (by 2030)

Portfolio level

• 100% of portfolio aligning to net zero
• 50% of portfolio aligned to net zero

Long term (2040-2050)

Portfolio level

• 100% of portfolio aligned to net zero by 2040
• 50% achieving net zero by 2040
• 100% of portfolio achieving net zero by 2050

For our segregated mandates, we are currently in the process of engaging with clients to incorporate the management of climate-related risks and net zero alignment within their investment management agreements. We believe over time that all of our clients will enable these changes to ensure their portfolios align to an orderly transition to net zero by 2050. Similarly, for our passive portfolios, while our mandate is to replicate certain indices, we hope that our ongoing engagement with companies, sovereign and government-related issuers will drive change across the benchmark constituents.