Investors adopting decarbonization targets must consider how these targets, along with their financial objectives and constraints, alter the feasible investable universe and their portfolios over time.
We propose a systematic approach to assess the impact of imposing climate targets on corporate-bond portfolios, assuming companies may or may not adhere to their decarbonization targets.
We examined the effect of a set of decarbonization targets on hypothetical corporate-bond portfolios under different decarbonization scenarios and show the adjustments needed to meet these targets by 2030.
Institutional investors evaluating their decarbonization targets may want to consider different scenarios for projected carbon emissions of companies in their portfolios. We analyzed three scenarios by assessing the impact on hypothetical index-tracking corporate-bond portfolios aiming for different decarbonization levels by 2030. Under a scenario where issuers meet their emissions targets, the impact on portfolios might be low. Under a scenario where issuers fail to reduce emissions from their current levels, however, decarbonization may require significant shifts from sector and credit-bucket allocations in the portfolios.
How missed emissions targets could hit bond portfolios
We considered fixed-income investors interested in analyzing the changes necessary in their corporate-bond portfolios tracking USD and EUR benchmarks to meet annual decarbonization targets of 25%, 35% and 50% by 2030 under three different scenarios for future Scope 1 and 2 (S1+2) emissions. This analysis relies on a nontrivial assumption that the universe of investable bonds remains unchanged.[1]
Using data available as of June 2024, we simulated the effect of setting portfolio-level targets on our set of hypothetical portfolios for each scenario, adhering to the same constraints.[2] The goal of these constraints is to allow limited flexibility of key drivers of portfolio risk, such as effective duration and option-adjusted spreads, while allowing deviations in sector and credit-bucket allocations. Issuer weights could change but had to stay within ±50% of current levels. The same rule applied to sub-industry weights to prevent large concentrations in a few sub-industries. Changes in the portfolio resulted from buying and selling holdings.
A scenario-analysis approach
Scenario
Scenario 1
Scenario 2
Scenario 3
Assumption on S1+2 carbon emissions of issuers and companies[3]
2030 projected emissions assuming reduction targets are met. For companies without targets, constant emissions were assumed relative to the most recent data.
2030 projected emissions based on credibility assessment. For companies without targets, emissions were projected to increase by 1% annually from the latest available data.
No change in emissions by 2030 relative to the most recent data.
We used data from the MSCI Implied Temperature Rise (ITR) Model to outline scenarios 1 and 2. For bonds that are not covered by the carbon-emissions dataset, the average by sub-industry of the most recently reported or estimated data was assumed.
As shown in the interactive plot below, in scenario 1, emissions could decrease by 25% over the next five years without rebalancing the portfolios to deviate from their current compositions. The 35% and 50% targets would also be achievable with relatively small reallocations among sectors, but some turnover within high-emitting sectors like energy and utilities would be needed.
Under scenario 2, however, where we account for the credibility of issuers’ targets, larger transactions would be necessary to achieve the 50% decarbonization target, especially for high-yield portfolios. For the hypothetical USD high-yield portfolio in particular, the energy, utilities and materials sectors represented 22% of its market value, but these sectors had projected emissions reductions of only 5%, making it harder to decarbonize.
In scenario 3, where no changes in the emissions profile of the bond issuers are assumed, significant shifts in sector and rating allocations would be necessary to achieve each decarbonization target, including large turnover within each sector. To achieve the 50% target also required softening the constraint on issuer-weight changes. Portfolios with fewer issuers, such as the hypothetical EUR-denominated high-yield portfolio, would face greater challenges in meeting these targets.
Portfolio-level impact of target setting under different scenarios
Evaluating decarbonization projections
By conducting a what-if analysis based on assumptions for issuers’ future emissions, on either broad portfolios or narrower high-emitting portfolios drawn from the energy sector, investors could evaluate the impact of different decarbonization targets on their bond, equity or multi-asset-class portfolios. This kind of scenario analysis could allow managers to assess the implications of the target decarbonization rate, and adjust their decarbonization targets accordingly, or manage their expectations for turnover and tracking-error risk. It could also help in identifying a rate of decarbonization where financial mandates are not compromised (i.e., maintaining sector allocations, rating distributions and issuer concentrations).
