- We looked at the financed emissions of selected corporate-bond indexes and found that 90% or more of the financed emissions came from less than 20% of the indexes' market values.
- Reallocating from high to low emitters may quickly reduce emissions, but could also create large deviations in sector allocations for portfolios using the indexes as benchmarks.
- We created hypothetical decarbonized portfolios that track the indexes by following a reallocation-based approach that preserves sector allocations without significantly impacting the portfolios’ main risk characteristics.
When developing their climate-transition strategies,1 some investors might be considering the implementation of reallocation approaches — shifting capital from high to low emitters to reduce their portfolios’ carbon footprint. We used financed emissions, as defined by the Partnership for Carbon Accounting Financials (PCAF), to construct bond portfolios following such emission-reduction approaches. Based on our analysis, a reallocation approach that preserves sector exposures did not significantly change the main portfolio risk characteristics while decarbonizing.
Where are financed emissions coming from?
We compared the cumulative contribution to PCAF-aligned financed emissions of bonds in the USD- and EUR-denominated MSCI Investment Grade Corporate Bond Index and MSCI High Yield Corporate Bond Index.2 We found that 90% or more of Scope 1 and 2 financed emissions came from less than 20% of the indexes’ market values.
Energy, utilities and materials — three sectors traditionally associated with high carbon emissions — contributed more than 80% to the financed emissions in the investment-grade indexes, even though they represented less than 15% of their market values. These three sectors also contributed the most to the USD high-yield index’s emissions. One notable difference for the EUR high-yield index was the larger contribution of the industrials sector, which was mainly driven by a higher contribution of the airlines segment.
90% or more of financed emissions came from less than 20% of the indexes
Based on data as of Aug. 31, 2022. Index constituents were sorted by financed-emissions intensity.
Reallocating from high to low emitters
We considered a hypothetical fixed-income portfolio manager interested in building decarbonized corporate-bond portfolios tracking USD and EUR benchmarks. The portfolio manager was considering the implementation of a reallocation approach. A tilt toward bonds classified as green was desirable.3 We used MSCI Total Portfolio Footprinting metrics to compare the possible reductions in financed emissions.
We first tested a portfolio-level approach.4 This approach resulted in a sharp decrease in carbon emissions, but quickly led to skewed sector allocations. There were other disadvantages (see interactive plot below): certain sectors with large concentrations in just a few issuers and important deviations in relevant portfolio- and sector-level characteristics, such as the duration times spread (DTS) for the energy sector.
This approach could also pose some difficult decisions, such as: Energy — one of the sectors with the highest emissions — has outperformed this year, but can portfolios be decarbonized while staying invested in this sector?
We found that a sector-level approach, on the other hand, could have kept sector allocations unchanged while reducing carbon emissions, preventing large concentrations in just a few issuers and without drastically impacting the portfolios’ main risk characteristics.5
This approach tilted increasingly toward each sector’s emissions leaders. Lower-emission segments like oil and gas equipment and services in the energy sector, and renewable energy in the utilities sector, became overweighted. Similarly, high-emission segments like airlines in the industrials sector were underweighted.
As shown in the interactive plot below, a reallocation of 20% market-value weight within sectors resulted in financed-emission reductions of between 40% and 70%, depending on the benchmark. In contrast with the portfolio-level approach, changes in portfolios’ characteristics such as durations, option-adjusted spreads and DTS were relatively small at both the portfolio and sector levels.
The trade-offs in decarbonizing bond portfolios
Based on data as of Aug. 31, 2022.
Decarbonizing? Mind the impact.
On the journey to align fixed-income portfolios with the goal of a net-zero economy, investors may wish to keep an eye on the impact of the selected portfolio-construction approach on the portfolio’s characteristics. We found that a nuanced reallocation approach that preserves sector exposures resulted in significant reductions in financed emissions and kept the portfolio’s main risk characteristics close to those of the benchmark.
1Holistic climate-transition strategies would incorporate multiple dimensions to minimize the transition and physical risk of the portfolios, while also capturing green opportunities and ensuring alignment with 1.5°C pathways. For more information, refer to: “Implementing Net-Zero: A Guide for Asset Owners.” MSCI ESG Research, July 19, 2022.
2In accordance with the Paris Agreement’s goal of limiting absolute emissions, the PCAF standard suggests accounting for generated emissions the portfolio finances. “The Global GHG Accounting and Reporting Standard for the Financial Industry.” Partnership for Carbon Accounting Financials, Nov. 18, 2020.
3We used MSCI ESG Research’s “Green Bond and Green Loan Assessment Methodology” to identify bonds classified as green.
4We start from the benchmark constituents and weights. Bonds not classified as green are sorted based on their financed-emission intensities. Then an increasing market-value weight is reallocated proportionally from high- to low-intensity emitters.
5We start from the benchmark constituents and weights. For each sector, bonds not classified as green are sorted based on their financed-emission intensities. Then an increasing market-value weight of the sector is reallocated proportionally from high- to low-intensity emitters.