Outgoing AP4 bond manager Erlandsson creates carbon footprinting thesis

Bond trader enters debate on how to carbon footprint fixed-income portfolios

AP4’s Ulf Erlandsson has entered the growing debate on how to carbon footprint fixed-income portfolios, proposing a new methodology.

Bond trader Erlandsson, who recently announced plans to leave the Swedish pension fund at the end of the summer to run a new climate-focused hedge fund for Granit Fonder, has returned 4.5% over five years at the fund. He runs the corporate bond and SSA portfolios, neither of which have carbon restraints or targets imposed on them, but are sensitive to AP4’s broader stance on climate change.

AP4 is committed to decarbonising its equities by 2020, making it arguably the most ambitious investor in the world on the topic. In an interview with ESG Magazine earlier this year, AP4 said it expected the target to result in a reduction of around 40% compared with benchmarks across all its funds.

But accounting for the carbon exposure of AP4’s debt investments is more difficult, says Erlandsson.

“Carbon footprinting in equites has tended to assume that all of the CO2 footprint is split across the shares. So if you own 10% of a company’s equity, you assume responsibility for 10% of its CO2 footprint. When you introduce debt to this calculation, you naturally want to avoid double-counting. But first there is little theoretical, or practical, underpinning for how to set a ratio between what goes into debt and what goes into equity. And secondly, there is little thinking on how to split the debt CO2 burden into the multitude of instruments in the debt spectrum.”

Erlandsson has published an academic paper titled: Credit Alpha and CO2 Reduction: A portfolio manager approach, in which he outlines his ‘Ecobar’ methodology – “an alternative approach to the footprinting techniques commonplace in equities”.

“We build out the model to encompass important credit alpha factors such as short positions, leverage and derivatives, as well as explicit green investments such as green bonds,” the paper explains, adding that its focus is on large cap corporate bonds. The paper uses CDP data for Fortune 500 companies, but Erlandsson says this can be extended “to a much bigger universe”.

“The basic idea is simple,” it continues. “We assign scores to all the issuers in a given universe based on their CO2 impact along a reasoning that company A is worse, better or equal to company B in terms of its emissions. This relative approach enables the aggregation of portfolio risks into a top-level score for the whole portfolio in a feasible and operationalisable way.”Each company is awarded a score between 1 and 3 based on the overall emissions of its sector.

“An energy sector company, however good its efforts are to reduce CO2, will be hard pressed to be lower in emissions than a company in the Information Technology sector, just by the nature of the corporate activities,” the paper states, acknowledging that there are dedicated renewable energy companies, but that these are usually to small for inclusion in large cap lists.

Each issuer is then assigned a second 1-3 score, this time based on its emissions relative to other companies within its sector.

“Arguably, the biggest CO2 reductions in absolute numbers might be achieved by switching from high-emitters to (relative) low-emitters in a sector with a high absolute impact,” it explains.

In both cases, a ‘3’ score represents the highest tier of emissions while a ‘1’ score represents the lowest. Green bonds automatically receive a ‘0’ score because they seek to have a positive net climate impact. Those investors who wish to distinguish between ‘light’ and ‘dark’ green bonds could use a more tiered scoring approach, the paper suggests.

The two scores are then multiplied, giving a high emitting utility, for example, an overall score of 9, while a green bond would finish with 0.

“The purpose for investors is to get an insight on the total CO2 impact of their portfolio, but to do so in a way that accounts for all the nooks and crannies of corporate bonds,” explains Erlandsson. He adds that if an investor has a commitment to green bond in part of its portfolio, but a very high intensity of emissions in its traditional portfolio, this would show up through the scoring, which would discourage ‘greenwashing’.

Erlandsson tests his own portfolio using Ecobar, based on trading between 2011 and 2016. Results showed “that it has been possible to own a clearly CO2 efficient portfolio whilst still generating average alpha of 4.5 percentage points per annum”.

There are growing calls for the climate finance world to expand its analysis of climate risk from equities to other asset classes. At a recent event hosted by the Financial Times, Jennifer Anderson, Responsible Investment Officer at £9bn master trust TPT Retirement Solutions said pension funds in the UK were increasingly moving away from equities into fixed income and were unable to footprint these potential investments. The 2° Investing Initiative is also working on methodologies for bond footprinting.