Decarbonising Fixed Income Portfolios – The Heart of the Matter

    Based on Research by Zarina Nasib, Senior Product Manager, Sustainable Investment & Alan Meng, Sustainable Fixed Income Research Lead, FTSE Russell

    While it is nowadays a well-accepted fact investors must manage their exposure to fossil fuels and carbon-intensive assets, opinions might still vary as to the degree of carbon cleansing that portfolios need to undergo. Whether they want to exclude, reduce, or simply calibrate their exposure to fossil fuels, asset owners and asset managers need access to the right tools. Environmentally aware equity investors have plenty of alternatives to choose from. Finding the right solutions in the fixed-income space, meanwhile, can still present a challenge.

    To help investors meet their net-zero greenhouse gas emissions targets, FTSE Russell has developed the FTSE Fixed Income ex Fossil Fuels Enhanced Index Series. By employing a transparent, rules-based exclusion policy, the architects of the index series attempt to meet the rising demand for fixed-income benchmarks that efficiently screen out a wide range of fossil-fuel-related activities such as generation, refining, transportation, storage, distribution, ownership and sales.

    Many roads to net zero

    Alan Meng, Sustainable Fixed Income Research Lead, FTSE Russell

    Asset owners and asset managers differ considerably regarding their investment philosophy and ethical positions. Consequently, they tend to adopt different strategies even when pursuing a net-zero strategy. Some investors might choose to simply ‘tilt’ their portfolios away from carbon-intensive assets, i.e., invest less than the relevant benchmark in such issuers and securities. Others might opt for maintaining their exposure to carbon-intensive assets while seeking to invest only in those companies that can demonstrate that they are making a significant effort to transition away from fossil fuels.

    Perhaps the most common practice for investors determined to decarbonise their portfolios, however, is to exclude securities directly linked to fossil fuels. Despite being a relatively straightforward approach, exclusion, too, implies a variety of considerations and different practices. Some investors might, for example, define their exclusions relatively narrowly, focusing only on companies that produce the most carbon-intensive fossil fuels, such as coal or tar sands.

    Others look more broadly, excluding all types of fossil fuels ranging from conventional oil to gas production. Still others might choose to go further, wishing to exclude even the whole fossil-fuel-enabling value chain. Such investors would stay away from fossil-fuel dedicated transport infrastructure such as pipelines, oilfield services companies or refineries.

    Once they have decided on the exclusion approach best suited to their investment philosophy, investors still need to calibrate the degree to which they intend to apply it. Should they categorically exclude any exposure to the fossil-fuel categories that they want to avoid? Or should they perhaps apply a materiality threshold by defining, for instance, a minimum revenue exposure to an excluded activity?

    When it comes to decarbonising a fixed-income portfolio, there are some additional complications to consider. Investors need to identify the links between the issuer of a bond and its parent corporate entity, for instance. And mapping entities within corporate issuer trees is far from a trivial task.

    Screening out fossil fuel

    Zarina Nasib, Senior Product Manager,
    Sustainable Investment,
    FTSE Russell

    Given the multiple choices and considerations that fixed-income investors determined to decarbonise their portfolios need to make, it is clear that creating a suitable index that is both robust and flexible is challenging. Acknowledging the complexity of the task at hand is a good start.

    “In the design of the FTSE Fixed Income ex Fossil Fuels Enhanced Index Series, we have started from the premise that there is no single right way to approach the sustainability and fossil-fuel exposure challenge in fixed income,” explains Zarina Nasib, Senior Product Manager for Sustainable Investment Product at FTSE Russell.

    Choosing a relatively conservative approach, the designers of the index series have opted to exclude issuers exposed to the fossil-fuel sector either through direct involvement or through company ownership. Achieving this ambitious goal requires robust, granular datasets that can ensure the accurate representation of companies by their business activity and ownership. Recognising that there is no single sustainability source that fits the purpose, FTSE Russell uses a combination of three datasets: Product Involvement Research, a proprietary Corporate Bond Sector database, and The Refinitiv Business Classifications.

    Product-related exclusions

    Applying the primary filter of product involvement research helps to screen out companies involved in the production of fossil fuels and related products or services, as well as their distribution, retail, power generation, etc. The screening process removes companies that have any involvement in the following categories: oil and gas, oil sands, Arctic oil and gas, shale energy, and thermal coal. In addition, in accordance with FTSE Russell’s Baseline Exclusions Consultation, the index excludes companies involved in tobacco production, controversial weapons and those violating the UN Global Compact through controversial conduct.

    Product-related exclusions are determined by calculating companies’ involvement in controversial activities and then excluding those bond issuers whose revenues in a particular product category exceed a maximum permissible revenue threshold. This threshold is set at zero per cent in all fossil fuel categories, effectively ruling out issuer involvement. The product categories and exclusion thresholds are set out in the index ground rules.

    Adding on extra filters

    Using two more datasets adds further robustness to the screening process. One of these is the proprietary FTSE Russell Corporate Bond Sector (COBS) scheme, which is maintained for all bonds tracked by FTSE fixed-income indices. FTSE Fixed Income ex Fossil Fuels Enhanced Index Series use the subsectors defined by the COBS to screen the constituents of the underlying universe and identify fossil-fuel issuers.

    The other additional dataset is the Refinitiv Business Classification (TRBC), a global, comprehensive industry classification system owned and operated by Refinitiv. In the index series, TRBC is one of the sources for identifying bond issuers’ product involvement.

    “While no dataset is perfect, these three screens help filter out bond issuers with involvement in fossil fuel-related activities and provide additional assurances to index users,” says Nasib.

    Ownership matters

    The FTSE Fixed Income ex Fossil Fuels Enhanced Index Series recognises that decarbonising fixed income portfolios means excluding not just those issuers directly involved in the production or distribution of fossil-fuel-related products or services but also companies with indirect involvement, exposed to fossil fuels through ownership. Mapping corporate issuer trees and sifting through opaque structures, such as special purpose vehicles classified as financials, adds an extra layer of complexity to the exclusion process.

    FTSE Russell follows some simple principles to help inform the additional exclusions based on indirect involvement. Suppose an issuer owns a majority stake, i.e., more than 10%, in a company involved in fossil-fuel-related activities. In that case, it is considered part of the same category and thus excluded from the index. In the case of a minority stake, however, the revenues of the subsidiary are not attributed to the parent company. Still, the percentage of the ownership stake is captured in order to signal the level of control present in the relationship.

    This enhanced granularity and comprehensiveness of the index series, capturing both direct and indirect involvement in fossil-fuel-related activities, is part of the index design. It aims at reassuring even investors with ambitious decarbonisation targets.

    Developing a transparent and robust solution to meet the increasing needs of fixed-income investors to decarbonise their portfolios is undoubtedly a daunting task. There are many details to keep in mind and complex relationships to consider.

    The FTSE Fixed Income ex Fossil Fuels Enhanced Index Series rises to the challenge, offering a tool that both asset owners and asset managers can use to manage their carbon exposure in an efficient way. Ultimately, adopting the enhanced index series should support the global push toward net-zero greenhouse gas emissions.

    Julia Axelsson, CAIA
    Julia Axelsson, CAIA
    Julia has accumulated experience in asset management for more than 20 years in Stockholm and Beijing, in portfolio management, asset allocation, fund selection and risk management. In December 2020, she completed a program in Sustainability Studies at the University of Linköping. Julia speaks Mandarin, Bulgarian, Hindi, Russian, Swedish, Urdu and English. She holds a Master in Indology from Sofia University and has completed studies in Economics at both Stockholm University and Stockholm School of Economics.

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