As climate change takes centre stage in global economic discussions, a new investment approach is gaining traction, that of transition investing.
Instead of divesting from carbon-heavy industries, investors, both retail and institutional, are choosing to engage directly with companies to help them adopt sustainable transition strategies.
“Today, one of the key themes is around transition-focused investing, which is really about sort of adapting your portfolio in a sort of quite nuanced sophisticated way to try and look ahead to how companies, in particular, are navigating the transition or plan to navigate the transition to a low-carbon economy. What that means in practice is a focus on engagement and broad diversification as opposed to divestment and exclusion,” said Tony Campos, head of sustainable investment at FTSE Russell, on a recent episode of the Relative Return podcast.
This approach takes a cross-asset class strategy, unifying equities, fixed income and other areas, Campos explained.
“A lot of investors will have a meaningful allocation to index-based investment for cost-effective diversification. And rather than using the sort of traditional market cap-weighted benchmarks that often form the basis for those passive allocations, we’re finding more and more, both institutional and retail investors looking to transition money out of those traditional indexes into climate transition-aligned benchmarks,” he said.
Last month, global asset manager Insight Investment issued a paper looking at transition investing as a new pillar in sustainable finance.
“Transition investing, in our view, should target companies with a higher carbon footprint operating in sectors crucial for decarbonisation. Regulators and standard-setters increasingly acknowledge the need for such an approach,” the asset manager wrote.
This approach, it clarified, allows investment in highly carbon-intensive companies and also companies involved in the extraction, processing and distribution of so-called “enabling materials” such as lithium, copper and aluminium, which are crucial for technologies that will be central to achieving net zero.
In a broader sense, Insight Investment noted regulators, too, are shifting towards supporting transition-focused investing, having also recognised that the exclusion of high-carbon sectors could hinder long-term innovation.
The asset manager highlighted improvements in Europe, where the UK’s Financial Conduct Authority has introduced an “Improvers” label as part of its sustainability ratings, while the EU market regulator European Securities and Markets Authority has set guidelines for transition portfolios.
“Even some companies and banks issuing debt on behalf of issuers have taken on board this concept and we believe that transition-focused green bonds might become more popular in the short term,” the asset manager said.
Insight Investment cautioned that investing in companies with greater potential for net zero transition may lead to portfolios with fewer companies on track to net zero by 2050 initially but could unlock larger-scale decarbonisation.
“Investors need to be aware that this approach means a higher carbon intensity level in a portfolio in the short term in exchange for more progress on absolute decarbonisation in the medium to long term," it said, adding that transition portfolios may outperform traditional ones by boosting sustainability metrics through decarbonising carbon-intensive sectors.
To hear more from Tony Campos, click here.
