Low-carbon investing in credit markets

Use a range of metrics

There are a variety of metrics that you could use to build a picture of an issuers relative carbon performance. Firstly, we can use ‘weighted average carbon intensity’, or WACI, which compares a company’s carbon emissions to its revenues – however revenues can fluctuate, which skews results. We also use the ‘financed emissions’ metric, calculated by comparing a company’s emissions to the proportion of its enterprise value (EV) that an investor owns: If a company has issued £50m of debt and £50m of equity, for example, its enterprise value is £100m – an investor holding £1m of equity, for example, would therefore be responsible for 1% of the company’s overall emissions.

But EV-based measures are not perfect either and can be much more difficult to calculate for private companies, where the equity part of the calculation is more difficult to ascertain. For public companies their market capitalisation represents a market assessment of value, but for private companies we have to take the equity value of the business from its balance sheet – this value often diverges materially from a company’s true market value. As a result, private companies are often penalised significantly by EV measures. Given around 60% of sterling bonds are issued by private companies this can have a material impact across an entire portfolio.

We should perhaps be moving towards forward-looking measures instead, such as ‘implied temperature rise’. The measure considers the total emissions a company will generate from now until reaching ‘Net Zero’, and then estimates the potential for global warming should the company’s carbon reductions be replicated worldwide. But while conceptually elegant, the measure is based on the promises of management and an array of subjective assumptions, using potentially low quality and highly inconsistent data. This gives us little confidence in the accuracy and analytical value of these measures. Hopefully, quality will improve over time, but in the meantime, a full bottom-up analysis of a company’s ability and willingness to transition remains essential.

Widen the scope beyond carbon

Building a credit portfolio solely focused on carbon will risk skewing funds towards certain sectors. This might see them favour financial services, which historically have been more volatile, and avoid areas such as utilities companies, which not only have stable cashflows, but may also be 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 opportunities. A great example of this is a bond issued by the Thames Tideway Tunnel, a £3bn super sewer being constructed under the River Thames. The bond is secured on the project, benefits from highly regulated cashflows, and offers an attractive credit spread for the fundamental credit risks. The WACI of this bond is very high, at around 15x the average for the index. However, not only do we have good visibility on emissions falling following construction, but the tunnel provides a fantastic environmental benefit beyond carbon. Currently, London’s Victorian sewer system cannot cope with heavy rainfall, which sees excess rainfall, together with sewage, pumped directly into the river. The tunnel will remove this last significant source of pollution for the Thames – a fantastic environmental and credit opportunity that a carbon-only approach may have missed.

Keep tabs on the evolution of markets

There are other solutions to low-carbon investing in credit markets too. Green bonds, for example, which are ‘use of proceeds’ (i.e., the funds raised are earmarked specifically for green projects), are a principle we are very supportive of. But we often see shortcomings in this market, something we at RLAM have written on extensively. An area potentially more credible is sustainability-linked bonds, which don’t look at inputs, but rather at a company’s outputs. Borrowers set clear ESG targets, which if not met, trigger a modest increase in coupon.

While the sustainability-linked bond market is still very small compared with ‘use of proceeds’ bonds, we need to be careful to ensure targets are meaningful. However, a focus on delivering outcomes has to be a far more credible proposition.

The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested.

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This is a financial promotion and is not investment advice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and are not investment advice.

Issued in April 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.