How Direct Line is tackling climate change in its bond portfolio
Jim Hardie, Director of Investment Management & Treasury at Direct Line Group explains how the insurer has developed a climate agreement framework to tackle carbon emissions
Sara Benwellposted on Monday, January 04, 2021
Sara Benwell: How is Direct Line’s investment strategy evolving to try and reduce carbon emissions and tackle climate change?
Jim Hardie: We’ve focused previously on starting to integrate ESG thinking into corporate bond buying decisions by setting average ESG ratings that our bond portfolios must achieve. In 2020, we wanted to build on this by starting to examine what we could do as responsible investors to support the global climate agenda to reduce greenhouse gas emissions.
"We’re starting with our bond portfolios, which currently represent 75% of all the assets held in DLG’s portfolio."
We’ll start our journey early next year having obtained internal agreement on the first steps regarding a more focused climate initiative framework to be applied across our investment portfolio. We’re starting with our bond portfolios, which currently represent 75% of all the assets held in DLG’s portfolio.
The framework involves two key pledges. The first is a broader target to ensure that the DLG investment portfolio will be net carbon neutral by 2050 - that's our overarching objective.
Within that we also have introduced a shorter-term objective. Across the corporate bond portfolios we will achieve a 50% reduction in our weighted average greenhouse gas emissions intensity by 2030, benchmarked against our end 2020 levels.
Sara: How are you planning to achieve these targets?
Jim: In order to measure progress, we’ll use data from one of the major vendors in the marketplace. Our objective is to use that data to identify what the greenhouse gas emissions intensity is for each of the holdings in our portfolio and the aggregate emissions output across our corporate bond portfolios.
We chose greenhouse gas emissions intensity as a metric because it allows us to normalise by sales as a denominator and compare the carbon efficiency of different sized firms within the same industry.
We will use the data to determine the aggregate emissions output from our corporate bonds portfolios as at the end of 2020 which becomes our reference point for measuring future progress.
"We chose greenhouse gas emissions intensity as a metric because it allows us to normalise by sales as a denominator"
As climate change benchmarks are still very much their infancy, we’re not going to adopt these currently. Instead we will look at reducing the emissions intensity by working with our individual managers with objectives reflected in their investment guidelines.
If, in the future, climate indices are deemed to be the way forward and best practice then our approach is very flexible and we would consider adopting such indices as the benchmarks for our portfolios.
We also want to increasingly invest in the companies most prepared for transitioning to a low carbon economy. As such, within our investment guidelines we will start having preferences for issuers who:
- are listed by the Science Based Targets Initiative (SBTi) as a company taking action,
- have at least a 2 degrees of better carbon performance alignment from the Transition Pathway Initiative.
Issuers with low carbon transition scores that put them at heightened risk of assets being “stranded” will be avoided.
In addition, given that coal is one of the worst offenders in terms of generating greenhouse gases we're also going to apply the following restrictions in our bond portfolios from the start of 2021:
- Mining companies that generate greater than 5% of revenues from thermal coal production
- Electricity generators that derive greater than 5% of revenues from thermal coal power generation
Organisations in these two categories will be excluded from the portfolio unless they meet our preferences for taking action via SBTi or have a favourable Carbon Performance Alignment from the TPI.
We're currently finalising the guideline changes with the managers and integrating the data from the external vendor into our reporting systems.
Once we have the greenhouse emissions intensity scores against each of our current holdings early next year we’ll be in a good position to start determining the roadmap which will keep us on track to deliver the 50% reduction by 2030. We want to make progress year-on-year towards the target, rather than significantly front loading or back loading the process.
"We will have reasonable opportunities over the next 3-5 years to use maturities in the corporate bond portfolios to shape the greenhouse gas emissions reduction trajectory."
As a P&C insurer, with predominantly short duration liabilities, the backing corporate bond portfolios also have shorter durations. We will therefore have reasonable opportunities over the next 3-5 years to use maturities in the corporate bond portfolios to shape the greenhouse gas emissions reduction trajectory. We acknowledge sales may have to be made to help keep us on track.
We’ll try and use situations such as asset re-balancing, or generating liquidity to support the payment of group dividends, to incorporate sales to support our greenhouse gas emissions reduction trajectory.
With regard to mining and electricity generators not meeting the criteria highlighted above, all existing positions will be exited within two years if they haven’t reached maturity.
Sara: What are your plans to address climate change within the rest of your asset classes?
Jim: We started with corporate bonds given they account currently for 75% of our invested assets. The other 25% will need tailored solutions which we’ll develop over the next 2-3 years. In some cases, the market will no doubt provide solutions.
We currently invest our required cash holdings in money market funds. We’re watching developments in areas such as green money market funds which are now available.
We have had the requirement for some time that each property in our commercial property portfolio achieves an energy performance certification of D. Where the current certification is lower, our manager must be working towards getting the property to a D certification. Any new acquisitions must factor in the money needed to get the property to a D certification as part of the purchase appraisal.
"We have had the requirement for some time that each property in our commercial property portfolio achieves an energy performance certification of D."
The manager is now also setting targets within the portfolio regarding energy efficiency, increased waste recycling, reduced water reduction and using tenant engagement workshops to improve information sharing on such matters.
Our infrastructure debt portfolio has a social focus presently, with existing investments predominantly in projects within the health and education sector. In the future, if we add to the portfolio, we will most likely widen the existing focus to include, for example, projects supporting the provision of green energy.
Within our commercial real estate loans mandate we will likely place increasing focus on the green credentials of underlying property proposed as collateral for such loans. For instance, maybe we won’t accept collateral which has very poor green credentials (unless the borrower is actively refurbishing the properties with an explicit objective of improving their energy efficiency etc).
Sara: How did you decide on engagement versus exclusion as a strategy?
Jim: The Paris agreement is clear that moving to a low carbon economy impacts all market sectors and investors should look to support that wider transition. While investors could re-shape their portfolios rapidly by cherry picking assets to improve their green credentials very quickly, it doesn’t solve the wider problem that this requires solutions covering the complete economy. Green assets such as wind farms still need steel and cement to build them which has got to come from somewhere.
"While investors could re-shape their portfolios rapidly by cherry picking assets to improve their green credentials very quickly, it doesn’t solve the wider problem."
So engagement (I think) is the key way forward – to continue to invest across all market sectors but increasingly invest in the companies who are the most progressive in adapting their business models to try and reduce their greenhouse gas emissions. We’re therefore looking for the signals or evidence of such progressive behaviours, such as have they got a Science Based Target initiative in place, etc.
Sara: How easy is it to engage with asset managers, particularly as a primarily fixed income investor?
Jim: Our asset managers have been very receptive. While they all have their own in-house approaches to ESG and climate change, they’ve engaged with us to work through how we want our portfolios to be managed regarding climate change objectives. There’s obviously questions and issues that arise that need to be worked through, but everyone is looking to find practical solutions rather than using issues identified as blockers.
"We want one common framework using the same underlying data and metrics otherwise reporting and measuring progress becomes very difficult."
One issue that did require some persuasion was ensuring all managers access the same data vendor for climate data. This was very important for us since our corporate bond portfolios are managed by several managers and we want one common framework using the same underlying data and metrics otherwise reporting and measuring progress becomes very difficult.
From a slightly wider point of view, we’re also telling our managers we will want to talk to their ESG teams, probably annually, to understand (and challenge if necessary) how they’re using their market presence to promote the green agenda pursued by issuers. We don’t hold equities in our portfolios, so the best way we can try and push forward the green agenda is ensuring we use what leverage we have with our asset managers to ensure they’re using their significant market presence to good effect.
Sara: How do you expect the strategy to evolve in the future?
Jim: We know our approach is not perfect, but we believe it's better to be doing something now, rather than waiting for “best practice”, if such a consensus does indeed emerge. Our approach is very much aligned to test, learn, adapt.
As we learn, we’d hope during the next ten years to be able to increase our ambition regarding the greenhouse emissions reduction target for our corporate bond portfolios by 2030. As we see new products coming to the market we will explore these. Similarly, if there’s a clear market leader in the provision of greenhouse gas emissions data in the coming years, we’ll change vendors if not the vendor we’re working with presently.
"As we see new products coming to the market we will explore these."
We recognise greenhouse gas emissions data still includes a lot of estimations and Scope 3 emissions need to be incorporated, but data can only get more reliable over time given the demand of investors to understand relevant climate metrics linked to their portfolio holdings. The Climate Biennial Exploratory Scenario exercise being instigated in 2021 by the Bank of England will certainly be a catalyst for climate data within the financial sector.