Sustainable transition is an important journey, but we must get to our destination

THE magic word these days for sustainable investments seems to be “transition”. How we travel, rather than our arrival, has become the principal definition for success when we discuss sustainability.

Yet, are we actually getting to where we want to be?

Traditionally, sustainable portfolios have been built using sustainability scores based on the current environmental, social and corporate governance performance of the companies in which they invest.

This is still the key approach for the vast majority of sustainable strategies. This approach reflects investors’ values while also expressing the investment thesis that companies that are more sustainable also perform better financially – though this is not yet proven beyond a shadow of a doubt.

Until now, however, this approach has not led to considerably more sustainable development or fewer carbon emissions.

The notion that the biggest polluters need to be part of the solution – investing and engaging with them while steering your portfolio on forward-looking metrics – is increasingly seen as a better way of contributing to change. This is why transition is key. How we implement transition strategies will determine whether we can accomplish our sustainability goals.

Defining transition investments

The European Commission defines “transition” as moving from current climate and environmental performance levels towards a climate-resilient and environmentally sustainable economy.

This transition needs to happen within a timeframe that can meet the goals of the Paris Agreement, including climate change adaptation and other environmental objectives.

Taxonomies in Asia include similar definitions of transition. For example, the Monetary Authority of Singapore (MAS) launched a new Singapore-Asia Taxonomy for Sustainable Finance on the sidelines of COP28 in December last year.

This new taxonomy set out thresholds and criteria for defining green and transition activities across eight different sectors, and was a world-first according to MAS.

While progress has been made, most of these definitions are still very much confined to the environment.

The United Kingdom’s Sustainability Disclosure Requirements, which are in the making, would be among the few regulations that consider a broader definition of transition.

It defines sustainability improvers’ strategies as products with an objective to deliver measurable improvements in the sustainability profile of assets over time.

These products are invested in assets that, while not currently environmentally or socially sustainable, are selected for their potential to become so over time, including in response to the stewardship influence of the firm.

Dilemmas in transition strategies of listed securities

The lack of a standardised definition on transition in finance has led to different approaches in the marketplace, leaving many dilemmas and questions.

The first one is whether a sustainable investment can be a transition investment at the same time.

According to European Union regulation, a sustainable investment is in an economic activity that contributes to an environmental or social objective, provided that such investments do not significantly harm any of those objectives, and that the investee companies follow good governance practices.

By this definition, transition assets that do no significant harm and follow good governance practices can also be a sustainable investment.

Green bonds, for example, can be seen as both a transition and a sustainable investment.

The second dilemma is which investments to consider in transition products. The first criterion is clear: high-impact companies with credible transition plans.

After that, it becomes more difficult. Should solution providers, who are helping others to transition, be a part of the transition universe?

They are not a transition asset in the sense that their own business model is transitioning, although they are certainly a very important part of the transition.

What about adaptation, which is important but only needed if the transition fails?

Can we also add some leaders in sectors with a low impact, as they (financially) diversify the portfolio?

The latter is probably a bridge too far. Any investment in a transition product should at least have material exposure to the transition objectives. The exposure to transition assets and solution providers should also be balanced.

Transition at the portfolio or issuer level?

Probably the greatest difficulty is where to promote and measure sustainable transition – at the portfolio or company level?

Let’s take as an example the EU’s Climate Transition Benchmark, which serves as both a standard and a label for indices.

To qualify, the underlying assets must be selected, weighted or excluded in such a manner that the resulting benchmark portfolio is on a decarbonisation trajectory.

One requirement is a carbon footprint that is 30 per cent lower than the investable universe, and is cut by 7 per cent year on year.

The index must also be constructed in accordance with the minimum standards of do-no-significant-harm and good governance.

The targets are clear here, and we do have the information with which to measure progress over time. A transition product following these guidelines would be clearly in line with the regulation.

The underlying investments, however, do not all have to be transitioning themselves, as long as the overall portfolio reaches the decarbonisation targets in any given year.

The question is how such a portfolio in listed securities contributes to the transition.

Seen in this light, there is room for transition strategies that invest in transition assets and solution leaders; and, from a bottom-up perspective, try to create change.

This means, however, that measuring whether transition objectives are reached should be done at the company level instead of the portfolio level. There should be room for both approaches in the marketplace.

The forward-looking frameworks to determine how credible transition targets are at the company level are being developed for climate, but are less evident for other sustainable transition topics. The measurement of progress at the company level also needs work.

Design principles for transition products

These issues should not hold fund managers back from developing transition investment strategies, but we need to be pragmatic in balancing future expected risk and returns with the sustainability objectives. We must also accept that the research and measurement frameworks are not yet crystal clear.

That is why fund managers need to set out guiding principles for developing transition strategies in investments.

There should be a clear intention to contribute to transition in the real world, and a means of measurement – so that we know the desired transition outcome and the time frame for it.

Demonstrating how we select investments, and then disclosing the progress made in the periodic reporting of our investment products, must have a base credibility.

Most of us have yet to reach our final destination in this transition journey, but it is time for us to take on the challenge of getting there.

The writer is head of sustainability integration at asset manager Robeco