Building Climate-Aware Portfolios to Deliver Alpha

Return expectations for fixed-income investments, as with other assets, increasingly include environmental, social and governance factors — particularly those related to the impacts of climate change. The strong momentum from economic, regulatory and social forces toward a more sustainable future will continue to affect asset pricing, making climate-aware portfolios a necessity for institutional investors. Brian Funk, head of global credit research at MetLife Investment Management, explains how identifying issuers who can transition to a climate-aware and sustainable business more quickly than their peers leads to numerous alpha opportunities.

Pensions & Investments: What investment opportunities do ESG and sustainability present?

BRIAN FUNK: First and foremost, our focus is to find strategically well-positioned companies, whatever they do, whatever world they exist in and wherever they do it. But all else being equal, companies that are being more thoughtful around the transition to clean energy — and reflect that in how they deploy capital and invest in their future operations — are more likely to trade at higher multiples five to 10 years from now.

We believe that factoring in ESG and accounting for sustainability are positive influences on relative credit spreads — especially for issuers that are in what we like to call the “hard-to-abate sectors,” such as power generation, steel, cement and commodities that are dug out of the ground. There are a lot of interesting opportunities for value creation and alpha generation among those companies that are proactively retrofitting and positioning their businesses for an impending different environment.

Asset owners, asset allocators and asset managers are in a unique position to assess and understand that climate transition is happening and that navigating it is influencing the way capital is allocated. We’re mindful of both risk and opportunity as they pertain to climate transition. As fixed-income investors, our immediate response is to evaluate and manage risk, but in that process we see opportunity over the coming decades.

P&I: What is a climate-aware portfolio?

FUNK: A climate-aware portfolio is focused as much on a sustainable future as it is on alpha generation. They are by no means mutually exclusive. It is constructed with issuers that are what we call “changing forward faster” and more effectively. We find them across all industries, but we navigate the hard-to-abate sectors carefully to discover those that are redeploying capital with a view toward sustainability.

It isn’t an easy process. You need really strong discipline around credit selection, trading and research that’s backed by data that verifies companies’ sustainable investments in their businesses.

Some investors are concerned that by factoring sustainability into portfolios, specifically around climate change, you take alpha-generation tools out of the toolkit, or that by viewing ESG through the lens of negative or exclusionary screening means, you’ll forgo opportunities. But we believe that there is great promise in companies that are aligned with the transition to clean energy and are making investments to get there. While they currently may be in an incubation period, they could be valuable in terms of cash flow generation in the future.

We also construct the portfolio on a longer-dated basis: for example, through the clean energy transition and into the next decade and based on how we can harvest the credit profile and cash flow improvements.

P&I: How do you view transition risk?

FUNK: There’s a great deal of credit intensity around the transition to clean energy that highlights our focus across every sector, specifically those in the dirtier or hard-to-abate industries. In addition to aligning corporate, government and investment policies, when you consider transition risk, you need an understanding of technological change.

For example, traditional internal-combustion-engine auto manufacturers have invested heavily in electric vehicles. They need to be thoughtful around the potential market share of their EVs as we transition; the capital needed to build assembly plants; per-vehicle costs; what consumers are willing to pay; and the ultimate cash flow when the business has fully transitioned to EVs.

Investor sentiment and valuation are also critical factors. If a company is valued at five times cash flow, and this company is being more thoughtful around transition, it might trade higher: say, six or seven times cash flow.

P&I: Which sectors look most promising?

FUNK: In developing parts of the world, companies that are building out natural gas supply have a lot of potential. Some investors might exclude natural gas, but we see it as a necessary bridge. If you can replace diesel generation, take carbon out of the atmosphere and make power cheaper, you can grow that infrastructure to provide more power at a lower price to more of the population.

A unified global view of climate change is very important. For the world to get transition right, emerging market economies have to be part of the conversation as well. The sovereign remit is massive. There is tremendous alpha generation opportunity in providing capital to an entire country. Applying an exclusionary screen, perhaps because of a low ESG rating, deprives those countries of capital to invest in their transitions.

Another example is dual-fuel maritime shipping vessels. They run on traditional fuel, but they can also run on clean power sources, some not yet commercially available. Ships are long-lived assets, and in 10 years we expect these types of vessels to be worth more. When we consider importers and exporters that use those ships, what will they be willing to pay when they go on their own sustainability journeys? We see opportunities there because exporters and importers care about their own emissions as well as those associated with their supply chains and consumers of their goods. There are a lot of opportunities within that whole ecosystem.

P&I: What is MetLife IM’s engagement process?

FUNK: One of our biggest initiatives has been engagement with issuers. Our philosophical approach to credit selection is security specific from a bottom-up perspective. We talk to companies daily, and our objective is to get a clear and transparent understanding of their thought processes and framework toward their own sustainable goals and objectives. We look closely at disclosures, relative to their peers in the same industry, and the quality and integrity of their data. We also look closely at how much of their free cash flow they reinvest in their businesses and what component of that reinvestment is dedicated to addressing what the world will look like a decade from now.

Over the last 18 months, we’ve built our own proprietary engagement database that’s shareable globally among our various research teams, portfolio managers and trading desks. It makes us more institutionally astute around greenhouse gas emissions, air quality, waste-water management, energy management. It helps to direct our analysis within each sector and gives insight into the specific areas that management teams are most focused on.

The best part of our engagement process is not the first outgoing call we make to a given issuer. It’s the follow-up conversations we have six or 12 months down the road, when we can see a result. That result, or a lack of a result, makes our judgment sharper.

Once we’ve reviewed a company’s disclosures, capital allocations and financial policies, we can get a full view of its sustainable framework through engagement. We then put the pieces together as one and apply our judgment. You can’t outsource the judgment component of security selection — and in everything we do, it’s the most critical step. ■

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