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 Global Credit portfolios due to the exposure to the energy sector. We are conscious of the need for energy sources to transition from fossil to renewable sources and consider it important to support companies in this process, for an orderly transition. Across our portfolios, 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.

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 in the Utilities and Financials sectors are most at risk of potential adverse 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, will lose their social licence to operate over time. Similarly, it is and will continue to be important to our portfolios for us 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 data from 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 Investor 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. In addition to 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.

At the portfolio level, we are able to conduct climate scenario analysis. We use this tool to test the alignment of our portfolios to the various International Energy Association scenarios¹, and indicate which year the portfolio is estimated to overshoot its carbon budget. The scenario analysis data also provides insight into the portfolios with regard to physical and transition risk exposures. This enables us to see how exposed our portfolio companies are to different natural hazards and whether these are sufficiently being managed. Going forward, we plan to use this tool more systematically 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, which includes climate-related risks.. 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 this risk identification process, 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 consider climate-related opportunities as part of any new product design process. As part of this process, we have access to ESG data providers to access carbon analytics, climate scenario-analysis, physical and transition risk tools. In particular, the climate scenario-analysis tool provides us with an indication of the net zero alignment of our portfolios. It also allows us to 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 will reflect this in our ESG risk assessment with a higher risk designation and/or a weaker ESG risk trajectory. 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 our Global Credit 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

• 75-100% of portfolio committed to net zero
• 25-50% of portfolio aligning to net zero
• 0-25% of portfolio aligned to net zero

Medium term (by 2030)

Portfolio level

• 100% of portfolio committed to net zero
• 75-100% of portfolio aligning to net zero
• 50% of portfolio aligned to net zero
• 0-25% of portfolio achieving net zero

Long term (2040-2050)

Portfolio level

• 100% of portfolio aligned to net zero by 2040.
• 50% of portfolio achieving net zero by 2040, with 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 are aligned to an orderly transition to net zero by 2050 and presumably to stand a chance of retaining any value/minimising stranded asset-risk.

Over the long term, we would expect to see the exposure to brown assets to decline, while the exposure to climate solutions and green assets is expected to increase. This will be particularly evident as our exposures to the energy sector transition from fossil fuels to renewables.