Integrating Forward-Looking Climate Metrics in Corporate Fixed-Income Index Portfolios

The landscape of climate-focused investments is evolving rapidly, with a notable shift from the use of traditional backward-looking metrics, such as carbon intensity and fossil-fuel revenues, toward forward-looking metrics, including temperature alignment and climate risk ratings. While forward-looking metrics are increasingly adopted in equity investments, their application and impact in fixed-income portfolios remain underexplored. “Integrating Forward-Looking Climate Metrics in Corporate Fixed-Income Index Portfolios” addresses that knowledge gap by examining how forward-looking climate metrics can affect fixed-income benchmarks and portfolios. The paper’s coauthors, three State Street Global Advisors researchers/strategists, offer valuable insights for investors aiming to integrate climate considerations while balancing risk, return, and diversification.

For fixed-income investors, climate-related factors can be incorporated into their strategies in three main ways, the authors explain: screening-based approaches, green bonds, and tilts based on climate metrics. Previously, screening-based approaches (for example, based on business or product involvement screens) were the primary method, but in recent years, green bonds and tilts based on climate metrics have become more prominent. Examples include the EU’s adoption of minimum standards for the Climate Transition Benchmarks and the Paris Aligned Benchmarks, which set minimum requirements on business activity screens, portfolio-level carbon intensity and related annual improvements, and green-to-brown ratios.

The authors note that these regulatory benchmarks focus primarily on backward-looking climate elements, and recent investor-led guidance on net-zero benchmarks—the Institutional Investors Group on Climate Change’s 2023 initiative and the Net-Zero Asset Owner Alliance’s 2022 report titled “Development and Uptake of Net-Zero-Aligned Benchmarks: A Call to Action for Asset Owners and Index Providers”—suggest an increased focus and preference for forward-looking elements. This paper seeks to study the effects of incorporating such forward-looking climate data in fixed-income index universes.

Types of Climate Data

Company-level climate data can be categorized into two main types:

• Backward-looking metrics:

  These metrics measure a company’s historical performance and activities, such as greenhouse gas emissions, fossil-fuel reserve ownership, and revenues from fossil-fuel-related activities.

  Backward-looking metrics help provide a historical baseline, with data often spanning five years or more.

• Forward-looking metrics:

  These metrics evaluate a company’s plans, risks, and opportunities, including emission reduction targets, temperature ratings, and climate value at risk (CVaR).

  Forward-looking metrics are relatively new but can offer critical insights into potential future outcomes, making them increasingly important for investors.

The paper focuses on the third approach, analyzing how forward-looking metrics can affect fixed-income index universes, including global investment-grade and high-yield corporates in the United States, Europe, and globally.

Key Takeaways

• Shift to forward-looking metrics in climate investing: This paper highlights a shift in climate-focused investing, with increasing availability of forward-looking metrics, such as temperature alignment and climate risk ratings. The research examines how incorporation of such forward-looking metrics can affect fixed-income index portfolios.
• Backward-looking versus forward-looking metrics: Climate data are categorized into backward-looking and forward-looking metrics. Backward-looking metrics focus on historical data; forward-looking metrics, such as Implied Temperature Rise (ITR), Carbon Risk Rating (CRR), and CVaR, can help assess potential future risks and opportunities.
• Data coverage: In investment-grade universes, coverage is strong for backward-looking metrics (more than 90%), while it is slightly lower for forward-looking data. In high-yield universes, a similar trend is apparent vis-à-vis backward- versus forward-looking metrics; however, the coverage is weaker across all data points relative to investment-grade universes. This necessitates the use of missing data treatments.
• Data relationships: Backward- and forward-looking metrics appear to be loosely correlated with each other. CRR and Policy CVaR may capture a lot of information contained in backward-looking data points, while ITR, Technology CVaR, and Physical CVaR appear to contain additional complementary information.
• Implications for portfolio construction: It may be possible to target improvements in multiple metrics simultaneously without taking on too much additional risk. Due to the correlated nature of the underlying climate metrics, portfolios that target improvements in climate metric exposure also often result in improvements in other climate metrics. Notably, portfolios that target improvements in carbon intensity, potential emissions, brown revenues, ITR, or Policy CVaR also concurrently result in improvement in the other metrics (except Technology CVaR), though the level of improvement varies.
• Tracking error: In general, portfolios targeting higher improvement in climate metrics display higher tracking error. For index investors in credit universes, the level of tracking error is typically well below 50 bps. Therefore, while small levels of improvement are possible at the lower end of the tracking error spectrum, larger and simultaneous improvements in the sustainability targets relative to the benchmark (particularly for Technology CVaR) may prove to be challenging to achieve.

Future Directions

The authors’ findings demonstrate the potential effects of integrating both backward- and forward-looking metrics in fixed-income index universes. Future research can explore simultaneous improvements of multiple metrics, potentially using optimization-based approaches. Another area of research may be on the topic of missing value treatments in universes with poor data coverage.

The Paper’s Authors

Kushal Shah, Climate Specialist, Vice President, State Street Global Advisors, London

Alexis Royer, CFA, Fixed Income Portfolio Manager, Vice President, State Street Global Advisors, London

Rupert Cadbury, Sustainable Investing Strategist, Vice President, State Street Global Advisors, London