Tom Lyons, senior investment analyst and head of Allspring’s Climate Investment Research team, and Andy Hunt, head of Fixed Income Solutions, discuss climate change and how to navigate the current challenges and opportunities in climate transition investing, especially for fixed income investors.
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Andy Hunt: I’m Andy Hunt, head of Fixed Income Solutions, and you’re listening to On the Trading Desk®. Today we’re discussing climate change and, more specifically, how to navigate the current challenges and opportunities in climate transition investing, especially for fixed income investors. Joining us today is Tom Lyons, senior investment analyst and head of our Climate Investment Research team, who’ll be providing his insights on the topic. Thanks for being here. Tom, I always look forward to talking with you about this topic.
Tom Lyons: Likewise. Happy to be here, Andy.
Andy: So, why are we here today? Why should we focus on fixed income and climate?
Tom: Right. While two very important questions or one very important question when we put them together, let’s start with climate. In my view, whatever your thoughts are about the timing, and extremity of climate change, we need to accept that it’s already affecting the physical environment, technology, innovation, and regulatory responses globally. Both corporate and government policies suggest these effects are only going to grow stronger in the years to come. There’s a strong consensus that investors need to position portfolios now with these changes in mind, which takes us back to where we began, whatever your thoughts are about how climate change may evolve over time. That’s already affecting markets, and we need to make sure that we’re positioned well for that. Why fixed income? Very important question, too. Most obviously, debt is essential to fund the energy transition. Corporates like utilities use debt to fund over half their capital requirements, integrated energy transportation, other industrials, and financials have already and will release more than hundreds of billions more to fund energy transition. So, it’s self-evident on the one hand, but it’s worth reminding ourselves on the other the debt is just absolutely core and essential to decarbonization. There’s another point, Andy, that you and I have discussed in the past that you’ve raised. We want to be aware that fixed income markets in general have a much greater carbon intensity than equities. So, for example, if you look at the high-yield market, or if you look at the investment-grade, corporate bond market, which has a lot of long-dated bonds issued by high-emitting industries, these markets are around three times as carbon intense than, say, a U.S. large-cap equity index. And this has to do with a lot of factors, including the prevalence of TMT (technology, media, and telecommunications) and equities and heavy industry and credit, but bottom line, we need to be aware of that distinction if we’re trying to decarbonize our holdings. Finally, related to credit, I’d point out that subsidiary issuance that is bonds issued not by holding companies, very diversified firms, but smaller, more focused subsidiaries that issue bonds allow fixed income investors to target green activities much more precisely than we can do and holding companies that are common in the equity market. If we want to target a green subsidiary of an otherwise very diversified firm, we can do that more easily in bonds.
Andy: Yes, thanks, Tom. I think the dirty little secret is that fixed income can be quite dirty. And that’s an interesting point to remember for our investors. So, let’s take a step back and consider the big picture. Governments and companies worldwide are pledging to achieve net zero, in accordance with the Paris Accord, but there are lots of folks saying that sufficient change will not be achieved fast enough. What is your view of the task ahead? What will it take to fulfill this ambition? And what are the investment implications?
Tom: Well, first and foremost, I think we all need to make sure we fully understand the challenge. There’s no question that net zero by 2050 is a monumental task. It’s certainly a greater challenge than any that society has faced in my lifetime and, arguably, ever. We’re talking about literally restructuring the way that the world produces and consumes energy across the economy. And, by extension, given the emissions intensity of agriculture and food, we’re talking about rebuilding the way our food supply chains work. So, this is a challenge on a very grand scale. There’s nothing easy about it, and we need to attack it with the scale of that challenge in mind. I’d also say that we, as a global market, need to get better at allocating capital. As huge as the process of decarbonization is, we have sufficient capital. There are, according to different industry organizations, hundreds of trillions of dollars equivalent ready today to help fund decarbonization. The problem is, we’re investing it too slowly. And we’re concentrating our investments mainly in renewables and transportation only. We need to understand that these are actually a minority of the global emissions framework. And there are many others not least building materials, basic materials that provide the key ingredients for those building materials, and many agricultural industries that simply aren’t getting the priority that they need, as investments occur. So, allocating capital is a really important part of succeeding. And then finally, I just say we need to, as we always have, stay focused on value creation. Many of the decarbonization investments that we’re looking at making are economic, they make sense irrespective of climate change, others may not, but there are regulations evolving that will start to make them economic via taxes and other policies. So, value creation has to be the bottom line for our core equity and credit investors.
Andy: Very cool. Very well said, given the energy is a critical component, as you’ve noted in this transition to a lower carbon economy. What do you see as the implications of the current energy crisis and geopolitical environment in the context of net-zero investing?
Tom: As well as being a grave humanitarian crisis, the unprovoked war in Ukraine has effectively disrupted both the global energy supply chain and the food supply chain, and as a result of this, emissions, at least in the near term, may rise in Europe. Right now, we are switching back to coal from natural-gas-fired power stations, mainly due to bottlenecks and supply of natural gas from Russia and other places. Europe, as has been well publicized, is working hard to end its reliance both on Russian oil and natural gas. And our attempts at the same time to scale up renewables more quickly is being restricted by bottlenecks in the China-controlled supply chains of key parts for wind and solar. So, we are looking at what could be higher emissions in 2023 and 2024. This isn’t necessarily bad. Firms with very secure supplies of energy tend to be more stable, more successful, and, ultimately, as a result of that may be able to decarbonize even more efficiently if we take a long-term view. But we have to understand that the importance of energy security in the near term is going to cause us to divert a little bit from the decarbonization path that we originally conceived. Finally, I just say that we need to be careful in thinking about the implications of the decarbonization choices we’re making. It’s wonderful to avoid dependence on geopolitically risky sources of fossil fuels. However, we are now talking about relying on wind, solar electric vehicle battery technologies, whose key parts come from comparably complicated parts of the world. And here we’re talking not only about China but about many other emerging markets that are producers of the primary battery metals that we need for transportation. We just want to be sure that we don’t get rid of one problem and take on others that are comparably challenging.
Andy: Indeed, the interesting sort of second-order effects always need to be considered. Moving on, as more and more investors start to take action in their portfolios, what do they see? What do you think they see as the driving motivations in making this consideration this change? Why should investors care?
Tom: I think there are a couple of reasons. And I think they differ slightly from geography to geography. When we talk to European investors, decarbonizing their own portfolios to best align themselves with the Paris Accord is a very high priority. I think that’s also the case in Japan. I think in the United States the focus is more fundamental, and in some ways, more traditional. And I think there are three main elements to the U.S. perspective. The first is, as we always have, we want to identify opportunities and generate alpha on the back of what is a monumental trend in markets that is decarbonization. We need to understand that there are going to be winners and losers as a result of climate change— both its physical effects and, as a result of decarbonization, through new technology innovations and new regulations and choosing the right securities. And managing portfolio risk is going to depend on our ability to identify those opportunities and generate alpha, by extension. Overlapping with this, we need to understand and manage unwanted risks. These might be more extreme temperatures, rising seas, and extreme weather affecting densely populated coastal cities and towns. And, by extension, negative effects on the value of real estate and negative effects on the tax base for various municipalities. Or they might be transition risks—you know, how well positioned is a coal producer in the United States as carbon prices take effect? How well positioned is an auto parts supplier that’s entirely reliant on internal combustion engine markets? We just want to be thoughtful about direct and indirect exposures. We have two declining industries in our portfolios. And then finally, I’d say especially for core equity and credit managers, as opposed to say, impact investors. Ideally, we would bring the full momentum and large scale of the trillions of dollars that these investors manage to the most worthy and attractive firms from a decarbonization perspective. That is, if we want to gain exposure to any industry in the economy, let’s make sure that we’re properly assessing the value of the decarbonization solutions that the leaders in each of these sectors bring and use that to our advantage and, by extension, bring that advantage to the real economy and its quest to decarbonize.
Andy: So, yes, alpha risk mitigation and creating a more sustainable economy, a more reliable economy—three good reasons. I will note that I think that some investors will resonate with one, two, or three of those and different priorities will be set, but decision-makers will come to the realization that this is a good way to invest as well as a worthy way to invest. So, with that in mind, how would you recommend investors implement a climate transition strategy?
Tom: I would start with some of the ideas that have come from our work with Willis Towers Watson’s thinking ahead institute on climate, one of the first things we discuss with asset owners that are a part of that group is the importance of themselves articulating their own organizational beliefs and objectives. What do they think will be the result of the physical effects of climate change? What are their own institutional objectives with the contribution they’d like to make to solutions? What are the relative strengths that these organizations have to achieve these things? How can Allspring help you answer these questions? Having established what your true climate beliefs are and what your relative strengths are to address the challenges created by climate change. What are going to be your priorities? And having done that with an asset owner or a client investor, we then start to consider different ways to express financial and climate objectives through a choice of investment strategy. For example, we have dedicated strategies that use very well-defined and robust investment processes to choose firms with clear and measurable objectives, both related to climate and financial performance. We have exclusions, which a lot of the market relies on to avoid exposure to some of the most problematic sectors like coal extraction. And we have engagement where especially those firms, with the largest assets under management or ownership, use direct dialogue with companies to communicate what sorts of climate objectives that those investors need to see from the companies to remain invested. Depending on which investor we’re talking about, all or maybe just one or two of these strategies may be most effective. But, suffice it to say that we partner with our clients to put all of them to work in what we hope will be the optimal fashion.
Andy: Yes, indeed. I particularly like the narrative around exclusion as a slightly blunt instrument, but inclusion as being a means to identify and invest in tomorrow’s winners. As even if today, they are not necessarily firing on all cylinders, it’s a good investment unlock by being able to identify tomorrow’s winners and investing in them today. So moving on to your perspective, as an active manager, what are some of the challenges in getting this right in portfolios in actually picking the portfolios and the securities within them?
Tom: I would say, first of all, quality data and systems are prerequisite. They’re not the whole story to be sure, but they need to be in place in order to engage in a decarbonization strategy or a transition strategy. We’ve spent the last few years not only procuring but refining and fine-tuning our carbon data. We purchased it several years ago; it was pretty good, but we needed to make it better to achieve some of the more nuanced climate objectives that we seek to achieve through our investments. We also needed to make sure that information could flow seamlessly from our databases into our portfolio management models and to our reporting systems. So, this data and systems, these needs are not the whole answer, but they are essential to have in place before we begin. The second and arguably more important is the investment process. Many firms in the market, ourselves included, have time-tested value-creation strategies that continue to be the primary focus of our business plans. Let’s not throw these away. Let’s stay focused on those competitive advantages that brought us to where we are today. And that continues to allow us to succeed. But let’s do that with the full benefit of the new climate data that we have, which has become fairly prolific, and with the benefit of the fundamental insights that our analysis of that data gives us. So, in other words, keep the special sauce, keep those successful, multi-decade-long investment processes that are proven effective, but give them the benefit of applying the climate analysis on a forward-looking basis to understand how best to position in response to climate change.
Andy: Yeah, it does seem to me to be an area where there’s a lot in the data that you can readily access. But there’s a lot that’s not, and the trajectory, the forward-looking view, is really the realm of good active management. I think that’s a key aspect. So, Tom, would you wish to leave us with any parting thoughts?
Tom: Absolutely. Yes, I would. While it’s clear that there is a broad range of sometimes-conflicting views on the materiality of climate change in the market, that is the extent to which it affects the value of assets. I think it’s absolutely clear that climate change, broadly defined, including its physical effects, including technology responses, including new regulations and investor responses, and the trillions of dollars of capital that we expect to be invested in response, represent maybe the most important market trend of the next few decades. There’s no doubt that climate change will produce both winners and losers. And we should be working together to get our portfolios on the right side of this change.
Andy: Thank you, Tom. As I said at the beginning, I always like talking to you about this topic. I learn something and appreciate something new every time I speak with you. So, thank you very much again.
Tom: I do, as well, and thanks for having me.
Andy: That wraps up this episode of On the Trading Desk®. If you’d like to read more market insights and investment perspectives from Allspring Global Investments, you can find them at our firm’s website, allspringglobal.com. To stay connected to On the Trading Desk® and listen to past and future episodes of the program, you can subscribe to the podcast on Apple Podcasts, Spotify, or whatever podcast subscription service you use. Until next time, I’m Andy Hunt. Thanks for listening.
Disclosure: Investment strategies that are not ESG-focused strategies may consider ESG related factors when evaluating a security for purchase but are not prohibited from purchasing or continuing to hold securities that do not meet specified ESG criteria.