26 September 2022
Jean-François Coppenolle, head of SRI at Abeille Assurances, explains the French insurer's approach to transition risk and the tool it has developed which works both as an investment and risk management tool
Why consider transition risk in investment portfolios, is just to avoid stranded assets, or are there other considerations?
There is obviously the risk aspect to identify the potential stranded assets. But it is also about identifying the companies whose business model could be at risk, without necessarily becoming a stranded asset, through the introduction of a carbon tax, or the carbon border adjustment mechanism proposed by the EU. Also understanding changes in consumer preferences and how they could impact companies' profitability.
So, transition risk is quite a broad category with many different types of potential impacts.
And there is a flip side, which is the transition opportunities, understanding where the investment opportunities lie in relation to climate change and invest in the companies who will riapp the benefit of the transition.
And how do you asses transition risk in your credit and equity portfolio?
We are looking at a new way to deal with transition risk, which basically mixes a top-down and a bottom-up approach.
The top-down approach really is to align the portfolio with a net-zero trajectory using the recommendations and scenarios from the IPCC and to apply the scenarios by using carbon intensity and other climate metrics.
The bottom-up approach consists of an issuer by issuer analysis, scoring each as they are now and from a forward looking perspective, taking into account the investments they are making in climate solutions and the processes they are putting in place to address the challenges of climate change.
And when you mix the two approaches the benefit is that you align your portfolio to a net-zero trajectory but doing it in a way that avoids greenwashing. Because you could reduce the emissions in the portfolio by divesting from the heavy CO2 emitters but that doesn't have any real-world impact.
The way to do it is to really to identify the climate champions and invest in these companies to support them and avoid the companies that are likely to remain brown and which could be subject to a sudden and negative repricing.
How do you identify the climate champions?
We've constructed a decision tree that applies four levels of verification that reflect our confidence in the chosen annual reduction (from SBTI, MSCI, internal research, industry average, or TPI), we apply a discount factor to the metric in line with our confidence in the reduction commitments made by the issuer.
The portfolio is projected using an annual time step and each asset is revalued using forward-looking market assumptions, such as forward interest rates and sector spreads.
In addition to this approach we created a unique metric, the Transition Risk Indicator, a combination of static and forward-looking approaches to transition for the issuer the more in need of transition. This indicator allows us to identify the leaders and laggers in each sector.
It's basically like an ALM tool, but with some ESG and climate integration.
I'm currently trying to push to create a global asset and ESG datamart, which would have two subcomponents: the modelling tool which is made of the top-down approach and the bottom-up approach, and then reporting to be ready for SFDR, article 29 in France and CSRD...
Is it correct to say that the bottom-up approach feeds into the top down one, or are they separate?
They are two separate tools, but they need to talk to each other. For example, if you have to decrease the amount of the carbon emission intensity of your portfolio by 20% from now to 2030, first you need to assess what is the natural decarbonisation path of the portfolio, based on the he projections you make at issuer level.
Let's say that you find that the portfolio will naturally decarbonise by 15%, you now need to find that extra 5% to get to 20%. There are several ways you can do it. You certainly need to understand what will happen in the portfolio between now and 2030: what bonds will come to maturity, how much you will have to reinvest, look at projected cashflows on your portfolio.
Maybe through that reinvestment you can find the 5% you are missing to reach 20%, and maybe you can't, and you only get an extra 3%, so then you can look at divestment strategies from a sector allocation perspective and also at an issuer level and it is where the bottom approach comes into play. It is very akin to the deployment of an investment strategy.
In your example the 15% assessment is reached through the bottom-up approach, that is where the two tools talk to each other?
Yes, basically the two tools talk to each other where you have to take decision at issuer level. We look at the issuer plans going forward which helps us ascertain whether they are champions or laggards, and so the tool is really as much an investment tool as a risk management tool, because it gives you a good understanding of the risk in your portfolio.
And again, in your example if you can't find the extra 2%, the only option is divestment?
Yes, but there is also the option to engage as much as possible with companies.
And in the bottom-up approach, how do you get to a score for individual issuers?
We basically pull together all the indicators from all our data providers and lump them in buckets such as the carbon measurement performance, the carbon intensity of the business model and the future carbon management performance, and weighting the indicators in those buckets we pull out a score.
And how do you then integrate the financial considerations, i.e., making sure the investment is not only sustainable but brings in the necessary returns?
That is definitely taken into account, but as an insurance portfolio what matters is the yield to maturity and not so much market value changes.
I do a lot of simulation, but for example when I look at sector specific data and simulating selling the worst decile in the sector and buying the best decile in the sector, the two indicators I'm looking at are the carbon intensity of the portfolio (or the total portfolio emissions) and the yield to maturity of the portfolio.
And the objective is really to reduce the carbon intensity while maintaining the same level of returns or maybe even increasing it.
Going back to the datamart, you mentioned a reporting component, what is the thinking there?
The thinking is, at the moment most assets owners are reliant on the asset managers to provide them with non-financial reporting and therefore they rely on the controls of these asset managers to make sure that this data is accurate and robust.
There is now a change in paradigm in so far that ESG data will now have to be audited in Europe so they really need to be robust and transparent, and I don't think you can really outsource this reporting task to a third party as you need to understand how the data was prepared, what controls are applied and ultimately, you need to take decisions based on the data. There are so many data dimensions that having a single glossy report is not good enough. AS an investor, you need to be able to deep dive in the data, playing with the different dimensions (sectors for example) and ultimately own the data as it can give you a market advantage
That's why I'm building this datamart to be able to report on ESG data with the same level of transparency checks and controls than we have with financial reporting.