Investors underestimate the role of the bond market in the fight against climate change, according to Ana Victoria Quaas, chief investment officer at Fidelity International. “Not only is the bond market much larger than the stock market, but bond investors can also use their capital in a more targeted way.”
“Almost everyone is now aware of the devastating effects of climate change. It is quite clear that climate change is one of the biggest risks – if not the biggest risk – to the long-term profitability and sustainability of businesses. But much less is said. about the crucial role fixed-income investors should play in the transition to net-zero emissions by 2050.
The global bond market is traded for approx. USD 1 trillion daily, showing enormous potential to support the transformation to a carbon-neutral world. According to McKinsey, capital expenditures on physical assets for the transition to net-zero between 2021 and 2050 are estimated to require an additional $3.5 trillion annually.
Not only does the bond market play a central role in closing the funding gap, but this market also has some specific advantages if investors want to influence companies in how they do business. In that sense, the bond market offers investors a unique opportunity to tackle the climate problem. Equity markets are often thought to play the most important role in driving issuers to become more sustainable. The opposite is true. Fixed income investors are sometimes better positioned to put pressure on companies than equity investors.
Bond investors have more to say
First, the bond market is larger than the stock market. The Securities Industry and Financial Markets Association (SIFMA) estimates that global bond markets will be worth $123.5 trillion by the end of 2020, compared to $105.8 billion for the stock market. In addition, companies rely on bond markets for new issuance much more regularly and on a larger scale than equity markets, fostering a close relationship between fixed-income investors and corporate managers.
The bond markets include both listed and unlisted companies. In addition, governments, local authorities and supranational institutions issue debt securities, not shares. This is important as unlisted entities are responsible for significantly more CO2 emissions than public companies.
Finally, interest rate markets allow investors to use capital in a more targeted way. They can finance specific projects (via green bonds, for example) or follow their clients’ interests via sustainability-linked bonds.
Limitations of the passive approach
The entire economy needs to make the transition to a low-carbon world – all sectors, asset classes and regions. In that sense, it can be tempting to invest in a climate strategy through systematic data filters or through a passive low-carbon index composed of the issuers with the lowest CO2 footprint. This is a relatively simple way to invest sustainably and is sufficient for many investors.
However, this passively managed approach has its limitations. For example, this approach allows you to invest in companies with low carbon emissions or in companies with a range of superior ESG scores, but it does not support efforts to reduce carbon emissions, nor does it weigh risk and return. This approach also does not look at the direction a company is heading. Instead, you use historical data to get an idea of future results.
This approach can also slow down diversification if you exclude certain types of businesses or industries. For example, a benchmark adapted to Paris excludes companies that generate more than half of their revenue from electricity generation with fossil fuels. If we ignore whole groups of companies and sectors, non-climate oriented investors will continue to finance them and the ultimate emissions will never be reduced.
More return potential
An effective strategy to decarbonise the economy should therefore be based on allocating capital to companies that demonstrate best climate practices today or are on the way to it. Australian mining company Fortescue Metals, for example, would be overlooked in any foreclosure strategy. Still, it has a credible plan for its transition and offers an attractive investment profile. Fortescue is the fourth largest iron ore producer in the world and aims to be carbon neutral by 2030. The company allocates 10% of net profit to a dedicated green energy and industrial subsidiary, has strong credit quality and zero net leverage.
Active climate investing is time-consuming and research-intensive, but this is offset by the potential for greater sustainability impact and long-term alpha. Companies that are at the forefront of the transition to a climate-neutral economy should be rewarded with more capital resources. Companies operating in sectors with high emissions or backlogs should be tackled – after all, asset managers have a duty to encourage issuers to be ambitious and set targets to combat climate change.
“Companies that are at the forefront of the transition to a climate-neutral economy should be rewarded with more capital resources”
Investors who integrate a net-zero emissions strategy, supported by a forward-looking framework and positive engagement, will not only create value for stakeholders, but also improve sustainable returns in their portfolios. Capital markets will not thrive when climate change leads to default. The bond market is in a privileged position to drive change and investors are increasingly aware of the potential of this sleeping giant.”