Carbon is ubiquitous, yet overlooked. It’s present in the ink we use to write a book, a glass of sparkling wine, your daily dose of caffeine and even in the soles of our shoes. Carbon emissions are also caused by the companies in the corporate bond portfolios that insurers and pension funds manage on behalf of their policyholders.

It seems rather obvious that in a world transitioning towards “Net-Zero” carbon emissions in less than the 30-year tenor of a U.S. Treasury bond, bonds should incorporate some sort of “carbon risk premium”, yet only a fraction of the fixed income universe explicitly mentions its carbon-reduction credentials in labels like “green bond”, “sustainability-linked bond”, or “transition bond”.

In this blog, we identify two examples of carbon risk premium at play in the “non-green”, general fixed income universe, and explain how these can be captured by adopting an inclusive, integrated, forward-looking approach.

• Policy Risk Premium: emission trading schemes and outright carbon taxes are meant to put a price on the negative consequences of carbon to society. Many companies have started to reflect this via an “internal carbon price” (see Exhibit 1). Nevertheless, the distance between a Net-Zero carbon price and internal metrics is wide.

Some high carbon-emitting sectors, like utilities, energy and basic materials (~30% of the investment grade corporate universe) feature a huge price dispersion across issuers. Others, like financials (~25% of investment grade bond issuance), underestimate the quantity - of their indirect CO2 emissions (e.g. generated through non-green, or “brown” infrastructure project financing). Both represent investment opportunities. Issuers more closely aligned with a Net-Zero carbon pricing model are less vulnerable to climate policy changes, and those that finance greener projects could see increasing profitability from government incentives. Recently, S&P provided an example of these trends, by lowering the required Funds from Operations / Net Debt thresholds of six European utilities (Iberdrola, Enel, EDP, Orsted and EnBW) that it considers best positioned to benefit from reinforced energy transition policies in Europe.

• Technology risk premium: the increased importance of “Net Zero” technologies, such as electric cars, are causing old intellectual (e.g. patents) assets to become “stranded”, i.e. less economically viable in the future. The average carmaker bond tenor is seven years, a timespan that is forecast to yield a substantial decline in combustion engine car sales. A similar 5-year horizon is often necessary for capital expenditure (capex) cycles to yield fruit. In this new environment, not all automotive players are transition-ready (see Exhibit 2), and their current capex intentions may provide visibility over the future viability of their business model. Issuers that plan to tap bond markets to finance carbon-reduction capex could see increased revenue and cash-flow sustainability from future sales of hybrid and electric vehicles, while others could fall behind.

EIOPA (the European Insurance and Pension Regulator), UK’s Department for Work and Pensions and the Bank of England are establishing 2021–2022 frameworks to assess the impact of climate stresses on insurers and pension funds. Both must adapt their investment policies to avoid falling behind the curve.

Actively-run, carbon-transition portfolios can help unlock the value of Carbon Risk Premia in fixed income, and help to manage downside risks. For example, the generalized drift from “A” to “BBB”-rated investment grade issuance was felt across the board in the past five years, but an active selection process tilted towards top carbon-quartile companies (i.e. those that had more ambitious carbon-reduction objectives) would have resulted in better rating resilience (see Exhibit 3).

Exhibit 3 2015 - 2020 % bond issuance change across IG corporate issuers

Source: J.P. Morgan Asset Management, BofA ML, MSCI

In conclusion, a “Net Zero” world is likely to translate in fixed income winners and losers. This blog proposes three portfolio dimensions that pension funds and insurers can act upon in order to benefit from the upcoming carbon-transition:

1. Be Inclusive: do not blindly blacklist high-emitting sectors like energy, there might be value in issuers with Net Zero-aligned internal carbon pricing;
2. Be Integrated: look at both quantitative and qualitative/indirect carbon footprint. Some low-emitting banks may be vulnerable to the deteriorating fundamentals of the “brown” projects they finance;
3. Be Forward-looking: consider future carbon reduction plans and clean-tech capex. The business viability of similarly rated car manufacturers could translate in different rating dynamics in the future.

Carbon is everywhere, but some may turn out to be a diamond.