23 Mar 2022
Matthew Franklin, Fund Manager at Royal London Asset Management, discusses the growing interest in carbon within investment portfolios and how he sees the market evolving over time.
There is an enormous focus from financial markets on decarbonisation and we see three key forces driving this. The first is societal – the massive shift that we have seen building over time as people become increasingly aware of the impact we have on the planet and are demanding change as a result. The second is more formal – through legislative changes, such as requirements on pension funds to give greater focus and disclosure around carbon emissions, which then feeds through to asset managers. And third, interestingly, I think there is also growing decarbonisation interest even amongst investors not explicitly concerned with the climate. As the yield of a bond increasingly reflects perceived environmental performance, these investors are keen to be the right side of future market moves.
Together, these three forces are driving a huge shift in how capital markets think about environmental impact of investments.
That is a very interesting question, and the reality is that there is no single answer. Each measure has its strengths and drawbacks. So, a bit like using credit metrics, we need to use several if we want to build a more complete picture of a business.
First, we have ‘weighted average carbon intensity’, or WACI, which we calculate by comparing a company’s carbon emissions to its revenues, allowing us to compare between companies to see who is more environmentally efficient. A clear problem here is that revenue isn’t a perfect way to provide scale comparison across companies, and revenues can easily fluctuate from year to year, which can skew this measure.
Another measure is ‘financed emissions’, which is calculated by comparing a company’s emissions to the proportion of its enterprise value (EV) ie the sum of its debt and equity that you own. If you have £1m of bonds of a company with debt of £50m and equity of £50m, you will be responsible for 1% of the company’s overall emissions.
What this allows us to do is see the emissions that asset owners are responsible for, as it can easily be aggregated across an entire portfolio.
Yet there is a big problem with EVbased measures. If a company is public, you can easily get the equity part of the calculation from its market cap, but for a private business these calculations will look at the balance sheet equity value of a business from the annual accounts – even though balance sheet equity can often diverge materially from a company’s market value. As a result, private companies will often be penalised significantly by these measures, just because they aren’t listed. Not great when around 60% of sterling bonds are issued by private companies!
A good example of this critical flaw in practice is the housing association London and Quadrant (L&Q). As it is a charity, it doesn’t have listed equity, so we must use its book equity for calculating financed emissions. However, because the balance sheet value of social housing properties is typically recorded at historic cost, L&Q’s ‘equity’ is significantly underestimated. If we were to estimate a market value for those properties, comparable financed emissions could be as much as 40% lower. Which is quite a steep penalty for financing a business with such a positive social impact!
What we should perhaps be moving towards are forward-looking measures such as ‘implied temperature rise’. This considers the sum of all emissions a company is expected to generate from now until ‘Net Zero’ is achieved and calculates the global warming potential this would have if it were replicated all over the planet. This is conceptually elegant but practically impossible to ascertain without a vast array of increasingly subjective assumptions. Trying to predict the future over 30 years, using data that is of potentially low quality and high inconsistency, and based on management promises, gives us very little confidence in the accuracy and analytical value of these measures. I’m hopeful the quality will improve over time, but we aren’t there yet. In the meantime, a bottom-up analysis of a company’s ability and willingness to transition remains essential.
Once you have chosen your preferred carbon measure, getting good quality data on your portfolios holdings is incredibly challenging. Using thirdparty systems to get carbon data works wonders for equity investments; but we often find for credit investments they miss the nuance of exactly how and where we are lending our clients’ money, often giving us meaningless data as a result.
An interesting example of this is the regulated UK water company, Wessex Water. We can lend to Wessex and benefit from its highly regulated cashflows and regulatory ringfence. Third party systems tell us that the carbon intensity of Wessex Water is around 9,500 tonnes Co2 per million dollars of revenue. Now this figure is enormous, and despite good results in all other categories, weighs down Wessex Water’s overall ESG score.
But when we dig into the data to try to understand what’s going on, we find the tool isn’t actually reporting the carbon intensity of Wessex. With Wessex not having listed equity, it defaults to Wessex’s owner, YTL. This may be a convenient move, but it then presents a massively distorted picture. YTL is a Malaysian conglomerate, and as well as owning Wessex water, also owns a variety of other businesses, many of which, as you can see, are hugely carbon intensive. So, we end up with a meaningless figure for Wessex’s carbon intensity. The right approach is to go directly into Wessex Water’s accounts, getting the true figures for the actual entity that we are lending to. Done properly, we discover that carbon intensity is actually about 50x lower than third-party reporting.
Third-party systems have limitations
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One risk of solely focusing on carbon data when building a credit portfolio is that it will skew your fund towards certain sectors.
Simply focusing through a carbon lens, your portfolio will have a bias towards financial sectors, which historically have been more volatile, and away from areas such as utilities, which not only have more stable cashflows, but many of which are key enablers of the energy transition.
Another risk of simply focusing on carbon is that you can miss other important environmental, social and governance (ESG) risks and, just as importantly, opportunities. A great example of this is a bond issued by the Thames Tideway Tunnel, a £3bn super sewer currently being constructed under the river Thames. The bond is secured on the project, benefits from its highly regulated cashflows, and offers an attractive credit spread for the fundamental credit risks.
When we look at the WACI of this bond, it is very high, at around 15x the average bond in the index. But this tunnel provides a fantastic environmental benefit away from carbon. Currently, whenever there is heavy rainfall in London, our Victorian sewer system cannot cope. Excess rainfall, together with sewage, is pumped directly into the Thames. But once the tunnel is complete, this will remove this last significant source of pollution for the Thames. So it’s a fantastic environmental and credit opportunity that could well have been missed with a more blinkered carbon only approach.
Another ‘solution’ offered by the credit market in building a low carbon fund is green bonds. These are bonds where the proceeds from a new bond issue are earmarked against environmental projects, and it’s an area that has grown enormously in the last few years.
Now we are very supportive of the principle of green bonds – we think they have raised awareness of environmental issues for both issuers and investors – but whilst they sound like an easy and convenient way to build a low carbon credit fund, we often see shortcomings between theory and practice, something we have written on extensively here. In the same way that you wouldn’t just rely on a credit rating, we don’t think you should just rely on bond labels, and instead believe it’s essential to go beneath the surface and look at fundamentals.
Almost all green bonds are unsecured lending into a corporate’s general treasury pot, alongside the company’s vanilla non green bonds. Whilst a borrower will talk at length about their lovely green projects, you often won’t actually be secured on those assets, but rather providing funding to the overall business. Lending in this way also means that green assets could potentially be sold in the future, and we would retain exposure to a less environmentally attractive business.
And we believe you shouldn’t just think about the use of a bond’s proceeds on day one when money is lent, but also how you are repaid over the entire bond’s life. The coupons paid out over time won’t just come from a company’s green assets, but from the entire business, not all of which may be as climate friendly.
Yet the market, as a whole, remains very fond of green bonds – we see many cases where green bonds trade at a lower credit spread than unlabelled bonds from the same company, despite them being structurally and fundamentally identical.
Whilst we see some pretty significant weaknesses in labelled bonds, one area that has the potential to be more credible are sustainability linked bonds. These bonds don’t look at inputs, but rather a company’s outputs – borrowers will set out clear ESG targets, such as emissions reductions. The bond’s legal documentation will then require a modest increase in coupon if these targets are not met. This market is still very small compared with ‘use of proceeds’ bonds, and we need to be careful to ensure the targets are meaningful, but a focus on delivering outcomes has to be a far more credible proposition.
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WACI: Portfolio’s exposure to carbonintensive companies, expressed in tCO2e / $M revenue. Scope 1 and Scope 2 GHG emissions are divided by companies revenues, then multiplied based on portfolio weights (the current value of the investment relative to the current portfolio value). This follows the recommended methodology by the Taskforce for climate-related Financial Disclosures. E09 - Carbon footprinting - metrics.pdf (tcfdhub. org). The WACI is calculated as a weighted average sum of the holdings with carbon intensity coverage. For the portion of the fund where carbon data is not available, the holdings are removed and the remainder of the fund is re-weighted to 100%. The portion not covered by carbon intensity values are assumed to behave as the holdings with data available. The % of coverage by market value of the portfolio is based on all of the portfolio holdings including cash. Our equity data comes wholly from MSCI. For fixed income securities, RLAM has developed its own carbon intensity tool. The report uses RLAM data for the fixed income securities as a first port of call, supplementing with MSCI estimates where no reported or better estimate exists. RLAM’s data for the emissions includes a combination of company disclosures through annual reporting, sustainability supplements and filings to the carbon disclosure project and primary research by our RI team. Where we lend to ring-fenced subsidiaries we have tried to source carbon data and revenues specific to those subsidiaries.
For more information on the risks of investing, please refer to the Prospectus and Key Investor Information Document (KIID), available on the relevant Fund Information page at www.rlam.co.uk.
Issued in March 2022 by Royal London Asset Management Limited, 55 Gracechurch Street, London, EC3V 0RL. Authorised and regulated by the Financial Conduct Authority, firm reference number 141665. A subsidiary of The Royal London Mutual Insurance Society Limited. AL RLAM PD 0126