By Jonathan Davis, Client Portfolio Manager, Emerging Markets Fixed Income at PineBridge Investments

When it comes to combatting climate change, the Paris Agreement of 2016 is clearly vital. This important framework aligns nearly 200 countries in pursuit of a critically important long-term climate goal: limiting the rise in global average temperature to 1.5 °C above pre-industrial levels. However, while the scope of the agreement is important, its terms also pose limitations on its ability to generate real progress toward its climate goals from the ground up. Actual change that delivers a meaningful reduction of greenhouse gases requires a shift in incentives for both governments and corporations to transform their operations toward the goal of carbon neutrality.

Here’s where we – and you – come in. As providers and stewards of global capital, asset owners and asset managers can take an active role in creating the incentives needed to realize the Paris Agreement’s objectives, as well as newer ones.

Another, more recent, important thrust against climate change came in May 2021, when all G7 economies committed to reach net-zero emissions by 2050.1 That meeting also yielded the G7 Industrial Decarbonization Agenda, an initiative to reduce greenhouse gas emissions from heavy industries such as steel, cement, and chemicals. In addition, the G7 ministers agreed to stop direct funding of coal-fired power stations in developing nations and instead focus on investing in clean-technology power.The decarbonization of our planet is vital to its sustainability, and the coordinated commitment of governments, financiers, and corporate entities toward that goal is essential to its success. Asset managers have a responsibility both to contribute to environmental sustainability efforts and to ensure that our clients’ portfolios are positioned for financial sustainability.

At PineBridge, we have a history of focusing on alpha generation through bottom-up credit analysis and security selection. And when seeking to tap decarbonization-related alpha, we find that the most compelling opportunities are often within sectors that currently contribute significantly to global carbon emissions – but what sets these companies apart is their potential to be early adopters in the adjustment to a carbon-neutral reality, and thus to generate the outperformance that can accrue to first movers. 

With so much of this story yet to be written, we have identified three must-have attributes within our ESG framework that we believe will enable our investments both to promote decarbonization and to profit from it.

First, determining a company’s forward-looking ESG trajectory must be an integral part of ESG risk analysis.

There is a strong link between ESG-related risk and the cost of capital, particularly among corporate issuers in emerging markets – and that link should only increase as investors become more focused on sustainability risks and more capital is allocated to ESG-related investment strategies. We see this reality playing out in our Emerging Market Corporate Bond strategy, among others. As such, we find it critical to evaluate not only the current state of a company’s ESG-related risks, but also the six-month-forward trajectory of those risks. Issuers that are genuinely committed to improving their sustainability risk profiles should benefit from a declining cost of capital and enhance investment returns for our actively managed portfolios. Identifying these companies is paramount.

Second, with an eye toward an issuer’s improvement on ESG measures, we must be prepared to include exposure to entities with less-attractive starting points but that are moving toward lower-carbon processes.

Historically, many ESG investment strategies have aimed to deliver a more sustainable portfolio by excluding issuers and industries that featured a higher ESG risk profile –often referred to in fixed income markets as “voting with your feet.” Our Emerging Market Corporate Bond strategy works differently. While exclusionary approaches certainly contributed to the higher cost of capital for higher-risk ESG issuers and thus played a role in spurring management teams to pay more attention to investors’ ESG concerns, they overlooked another key role that investors can play in decarbonization and other ESG initiatives. By excluding industries such as those with higher carbon emissions, investors forfeit their ability to provide the financial incentives corporations may need to adopt greener operations, which are often higher-cost — and thus to offset higher operating costs in areas that could make the greatest contribution to key initiatives like carbon neutrality.

Third, it’s critical to maintain an engagement framework that encourages issuers to make investments in green technology – investments that will make their business models not only more sustainable, but also more profitable in the carbon-neutral world of the future. 

We believe it’s vital for investment managers to maintain a formal engagement framework that not only sets a standard for the way in which we engage management teams on ESG issues across industries, but also provides for a way to measure the impact of those engagements on corporate behavior. Management teams today are far less likely to avoid discussing material ESG issues on earnings calls, which underscores the progress asset owners and managers have made in pushing ESG risks to the fore. The next step toward ensuring a more sustainable future – both for our planet and for the financial profiles of the companies in which we invest – is to adopt a standard set of issues to promote coordinated improvements across sectors and hold management teams accountable for their progress toward those goals.

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