Aligning financial performance and climate in active fixed income

The following blog is an extract from our article: Moving toward future-proof portfolios: Aligning financial performance and climate in active fixed income.

2023 was the hottest year on record[1], with extreme weather events becoming far more frequent. We believe investors have a crucial role to play in driving the transition to a low-carbon economy and mitigating climate-related risks.

How should an investor balance a focus on reducing the negative climate impacts of their investments with a desire for financial returns?

This negative framing of the climate question is evident to many investors, who see balancing carbon and returns as an increasing challenge. However, it is our firm belief that instead of framing the challenges and opportunities of the energy transition in these terms, investors could be asking a different, more positive question: how can these opportunities and risks be addressed simultaneously?

In fact, we believe that addressing the opportunities and risks created by the energy transition to help target positive impacts on climate outcomes can be closely aligned with a focus on long-term returns. However, far from maximising the potential value created by the transition, in our view many companies are still failing to transition at an optimal pace.

It’s the combination of the negative framing of the climate question and the slow transition progress of many companies that, in our view, create such a significant opportunity for active investors to have both a positive impact on climate outcomes and also target returns. On the one hand, many still misunderstand the fundamentally economic nature of decarbonisation – leading to the possibility of material mispricing for investors to take advantage of as they seek to reduce their climate impact; on the other hand, there is a window of opportunity for investors to engage with and positively influence those companies who continue to underperform their real climate potential.

Net zero or SDGs?

Recently, we have observed that many investors with sustainability priorities have been coalescing their efforts around one of two approaches - investments which focus on a climate-focussed ambition of reaching net zero carbon emissions by 2050, and the multi-faceted UN Sustainable Development Goals (SDGs) that include climate but also extend to many other environmental, social, and governance (ESG) considerations.

Our net zero framework primarily focuses on carbon in the value chains of its constituent companies, especially coal extraction or power generation, and alignment with LGIM’s Climate Impact Pledge. Underpinning our net zero framework is LGIM's Destination@Risk model, which we will explore in more detail later in this document. This model enables us to robustly measure the climate risk embedded in the portfolio and its climate alignment. It combines decarbonisation objectives based on backward-looking data and an objective based on forward-looking data (temperature alignment). This allows us to assess climate and transition risk in a way which overlays additional, independent insight to the data which is most commonly available from third-party agencies. Drawing on the energy scenario insights of this framework, the relevant strategies target a 1.5C alignment by 2030.

Read the full article: Moving toward future-proof portfolios: Aligning financial performance and climate in active fixed income

[1] Source: Climate.gov