Climate Glidepaths for Energy Portfolios
Key findings
- Achieving net-zero goals is challenging for fixed-income investors in high-emitting sectors, especially energy, who have the intent to remain invested and support companies in their transition to a low-carbon economy.
- Climate glidepaths could offer fixed-income investors a portfolio-construction approach to guide their portfolios toward medium- and long-term emissions-reduction objectives.
- Simulations of glidepath solutions for USD investment-grade corporate bonds in the energy sector highlight the trade-offs between emission reduction and financial targets.
For some investors, sustainable investing necessitates reducing portfolio emissions. Adding this new set of targets to the investment objectives — i.e., emission-reduction targets — requires a careful navigation of market complexities and risk considerations alongside sustainability metrics and objectives. A "climate glidepath" may help by mapping out a plan and keeping investors on course.
In our previous paper, Net-Zero Glidepaths for Fixed-Income Portfolios, we showed how bondholders could devise portfolios to meet emission-reduction goals while aligning with their core security-selection processes and financial-mandate constraints.[1]
In this blog post, we used the framework to simulate portfolios for index-tracking and buy-and-hold investors in USD investment-grade (IG) corporate bonds issued by companies from the Global Industry Classification Standard (GICS®) energy sector.[2] All portfolios were backtested from September 2019 to December 2023, with monthly rebalancing.[3] At each rebalancing, portfolio turnover was restricted to reinvesting cash generated by the portfolio.[4] The climate glidepath shaped the portfolio-construction approach by integrating decarbonization as a constraint in the security-selection process over time. This approach entails establishing emission constraints relative to the baseline levels of the initial portfolio as of the fourth quarter of 2019.[5]
Climate glidepaths for index-tracking investors
Index-tracking investors represent a significant cohort among corporate bondholders. These investors generally aim to deliver returns close to their broad-market peer (indexed strategies) or some premium (active or total-return funds). We simulated two climate glidepaths, both controlling for active risk versus the USD IG energy market.[6] The portfolios adhered to constraints on credit-bucket allocation and sub-industry and issuer concentration.[7] One aimed to minimize active risk while reducing emissions by 3.5% annually (relative to the levels as of September 2019).[8] The other prioritized minimizing emissions while managing for active risk.
During the analysis period, market emissions remained elevated compared to September 2019. Even so, the climate glidepaths continued to trend toward decarbonization. The degree of decarbonization achieved was significantly impacted by the active risk, however. While the first glidepath simulation kept active risk below 35 basis points (bps), this approach failed in reducing emissions during periods of market-emissions increases or when cash flows were limited.
By experimenting with different levels of active risk for the second glidepath setting, we found that to closely adhere to their decarbonization objectives, investors would have needed to allow for at least 70 to 80 bps of active risk. In this setting, the portfolio maintained its decarbonization objectives at the expense of a difference between the portfolio's effective duration and the market. This setup provides an example of flexibilities required to maintain both climate and financial objectives of the portfolio while the decarbonization of the portfolio is slow due to natural speed of change in this high-emitting sector.
How index-tracking climate glidepaths reduced portfolio emissions
The outperformance of the climate glidepaths compared to the market primarily stemmed from differences in sub-industry allocation, particularly the underweighting of integrated oil and gas, a sub-industry with high average emissions that underperformed throughout most of the analysis period.
Climate glidepaths for buy-and-hold investors
Buy-and-hold corporate-bond investors may have liability-driven mandates — e.g., insurers and defined-benefit pension funds. We simulated three hypothetical energy portfolios, each invested in five sub-industries representing over 95% of the USD IG energy sector.[9] All simulated portfolios adhered to the same financial constraints.[10] The base buy-and-hold portfolio had no decarbonization constraint, while the two glidepath portfolios aimed to reduce their carbon emissions by 3.5% annually, relative to the levels of September 2019. Additionally, the second glidepath portfolio allowed sales of bonds up to 1% of the portfolio market value.
Our analysis demonstrated that the glidepath portfolios were able to meet the expected emission-reduction targets over the backtested period. In instances where cash flows and reinvestment were insufficient to reduce portfolio emissions adequately, the glidepath portfolio without sales carried forward the emission-reduction budget to the next rebalance. However, permitting the small 1% sale enabled the second glidepath portfolio to achieve the targeted emissions reduction across nearly all rebalance dates.
How buy-and-hold climate glidepaths reduced portfolio emissions
Both glidepath portfolios maintained compliance with required financial constraints (i.e., duration target, credit allocations and issuer and sub-industry concentrations). Yield differences relative to the base portfolio were low; the differences in excess returns may be primarily attributed to the underweight of companies from integrated oil and gas in the glidepath simulations.
Climate-glidepath solutions could help in attaining impact-investment goals
Climate glidepaths solutions could provide useful tools to help investors align their investment objectives with their impact goals of decarbonization of their high-emitting portfolios, especially energy-sector portfolios. However, the success of a climate-glidepath approach relies on the assumption that enough companies and issuers will reduce their emissions with the aim of reducing economy-wide emissions to net-zero. If the emissions of issuers in the investable universe are not adequately reduced, it is likely, as in our analysis, that the portfolio will diverge over time from the investment objectives.
Decarbonization entails costs and may pose challenges within existing financial frameworks. When faced with such scenarios, investors are compelled to make strategic decisions, whether they involve adjusting decarbonization rates, allowing divergence from market neutrality (i.e., different duration targets or sector/industry allocation), reconsidering positions (potentially through sales) or permitting portfolio shifts away from other aspects of their investment mandates).
The authors would like to thank Ray Wang and Akhil Kappagantula for their contributions to this blog post.
1 This approach consists of reinvesting the cash flows generated by the portfolio into eligible securities, which gradually reduced emissions toward a target of net-zero. This includes coupon payments, bonds reaching maturity and the sale of ineligible securities (e.g., due to downgrades).2 GICS is the industry-classification standard jointly developed by S&P Global Market Intelligence and MSCI. The USD investment-grade energy market is represented by the energy-sector bonds in the MSCI USD Investment Grade Corporate Bond Index.3 The period is consistent with the simulation period for portfolios in Net-Zero Glidepaths for Fixed-Income Portfolios.4 On average, cash flows representing approximately 1.5% of the portfolio's market value were generated monthly before rebalancing. However, there were periods with low cash flows, dipping below 0.5%, which constrained the portfolios' decarbonization capabilities.5 This mechanism adds to the model's flexibility by allowing an emission-reduction budget to roll forward in periods where cash flow generated by the portfolio and reinvestment in lower-emitting issuers do not sufficiently reduce the portfolio's emissions.6 Active portfolio risk is measured by forecast tracking error: the forecast of annualized volatility of active returns according to the MAC.S model.7 We used MSCI's Barra® Open Optimizer, the long-term variant of the MSCI Multi-Asset Class Factor Model and MSCI climate metrics for this analysis. Portfolios were constrained to maintain weights within each GICS sub-industry within ±5% of the market, credit ratings within ±5% of the market, a maximum 7% issuer weight and (for each bond) a maximum weight of 1.5% and a minimum of 5 basis points. The investable universe comprised investment-grade USD-denominated energy-sector bonds that had a minimum size of USD 300 million, were issued by companies domiciled in developed markets and were constituents of the MSCI USD IG Corporate Bond Index at the time of rebalancing.8 Here emissions associated with a security is the total direct emissions (Scopes 1 and 2) of the issuer. Portfolio-level emissions are the weighted-average emissions of the securities.9 The sub-industries allowed in these simulated portfolios included integrated oil and gas, oil and gas storage and transportation, oil and gas refining and marketing, oil and gas exploration and production and oil and gas equipment and services.10 We used MSCI's Barra® Open Optimizer, the long-term variant of the MSCI Multi-Asset Class Factor Model and MSCI climate metrics. The optimization objective for each portfolio aimed to enhance diversification by minimizing idiosyncratic risk. Additionally, all portfolios were constrained to a maximum one-year difference relative to the initial portfolio in their effective duration, weights within the allowed sub-industries within ±5% of the market, credit ratings within ±5% of the market, a maximum 7% issuer weight and (for each bond) a maximum weight of 1.5% and a minimum of 5 basis points. Furthermore, all bonds in the investable universe were required to have been issued in the last year.
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