Managing Climate Risk in Investment Portfolios: PIMCO’s Approach

We designed seven proprietary tools to assess, manage, and help mitigate climate-related risks in our portfolios, and to harness potential opportunities in the evolving market landscape.

Climate change is likely to be a disruptive force in the global economy over the very long term. Average temperatures around the globe continue to rise, and the consensus across the scientific community is that human activity is the driving force – largely in the form of greenhouse gas emissions (source: Intergovernmental Panel on Climate Change (IPCC)). Many investors, companies, organizations, and nations are starting to hear the alarms about climate-related threats and seeing dramatic, sometimes devastating impact on economies and markets in addition to communities and ecosystems.

In 2018 alone, there were notable instances when markets felt the consequences of deadly wildfires, hurricanes, typhoons, and other climate-related catastrophes across the globe. Climate change can affect investments across asset classes, including a wide range of fixed income securities: corporate credit, mortgage-backed securities, sovereigns, and municipalities.

Therefore, as a steward of our clients’ assets, PIMCO believes it is critical to incorporate climate risk evaluations in our investment decisions. As active asset managers, we must be forward-looking – considering material risks on the horizon, not just those immediately affecting issuers. And in our view, those long-term risks are significant, systemic, and rising. Even while many dedicated groups work hard to limit climate change and mitigate or adapt to its effects, the window of opportunity to prevent lasting global damage may be closing, according to recent reports from the IPCC and the Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES).

As risks mount, many issuers around the world are shifting from climate awareness to action, giving rise to new investment opportunities. Many investors are monitoring government responses to climate risks in the form of regulation, carbon taxes, and public investment, as well as shifts in consumer sentiment and business models. We expect this will change the investment landscape: The transition away from fossil fuels toward clean energy, for example, could transform the global economy and create significant investment opportunities. ESG-focused (environmental, social, and governance) investment approaches as well as broader portfolios can be positioned to harness these kinds of potential opportunities. Fixed income markets, in our view, may present a diverse array of sustainable investment options in the years to come. We assess both top-down macro trends and bottom-up ideas amid the evolving environment of climate risk.

Figure 1 is a line graph that superimposes atmospheric carbon dioxide levels with annual mean temperature anomaly in degrees Celsius, over the time period 1958 through 2018. The two variables roughly track each other over the time period. CO2 emissions steadily increase to more than 400 parts per million by 2018, up from about 315 parts per million 60 years earlier. The temperature anomaly was about 0.8 degrees Celsius in 2018, compared with about zero in 1958.

PIMCO’s climate risk analysis framework

PIMCO’s climate research is led by credit analysts – the experts in their market sectors – who build on the structure of our broader ESG specialist desk for coordination and consistency. Climate risk now features in our proprietary ESG scores for the issuers we evaluate. In this way, PIMCO leverages the expertise of our analyst teams, while harmonizing climate risk analysis across asset classes and sectors. Our ESG scores inform broad PIMCO portfolios, not only ESG-focused portfolios with specific sustainability objectives.

To help analysts evaluate climate risk, PIMCO’s ESG specialists designed seven proprietary tools (see Figure 2), drawing on our decades of experience in fixed income analysis. The insights these tools provide are intended to help portfolio managers to better manage and mitigate climate-related credit risks and align ESG dedicated portfolios with the Paris Agreement targets – as always, working within specific portfolio objectives and guidelines. (The Paris Agreement is the global accord to limit the global temperature rise by year 2100 to 1.5°C – 2°C above pre-industrial levels.)

These analytical frameworks serve the whole spectrum of PIMCO’s ESG-specific and broader investment strategies and enable PIMCO’s ESG dedicated strategies to align with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).

PIMCO’s seven climate tools: risk analysis in practice

Figure 2 is a table that groups PIMCO’s seven tools for climate risk analysis and management. Three tools fall under the broad objective of lower credit risk, three fall under the objective of reducing carbon emissions, and one uses both of those objectives. The chart further breaks down each of the objects in terms of their PIMCO tool name and the key question they seek to address.

Tool #1: Climate Macro Tracker

To ensure we have a robust long-term, top-down perspective on climate risk, PIMCO designed and developed our own Climate Macro Tracker (Tool #1). This tool monitors the broad momentum in climate change across key themes and scenarios, and measures the gap between the real-world metrics and global climate goals.

Currently, our macro tracker (see Figure 3) tells us that despite progress in some areas, broad global trends remain deeply concerning as the concentration of carbon dioxide (CO2) in the atmosphere continues to rise and is projected to lead to a temperature rise exceeding 3˚C by 2100 at this pace.

From a macro perspective, climate-related risks to the global economy are real and alarming. By some estimates, climate change could result in multitrillions of dollars of economic losses and a large negative impact on global GDP, in addition to the profound impact on communities and ecosystems (sources: OECD, CRO Forum, among others). Along with the challenges and risks, we also keep an eye on climate-related macro trends (regulations, energy, and technology, for example) likely to create business and investment opportunities.

Figure 3 is a table of 18 metrics under the categories of macro climate, energy supply and storage, energy demand, and carbon pricing and investment. More details as of July 2019 are within, covering descriptions, trends, and whether each metric is aligned with the limits of 1.5-to-2.0-degrees Celsius increases set by the Paris Agreement.

Tool #2: Portfolio Climate Risk Heat Map

The pace of change is swift: Risks and opportunities related to climate change may materialize in unexpected ways. The impact on financial markets and bond prices may be abrupt and sudden, and as investors we must stay vigilant and flexible.

When evaluating climate-related risks and opportunities of specific sectors and issuers, we begin with two broad categories: 1) transition risks (e.g., tighter regulations on carbon emissions) and 2) physical risks (e.g., how the rising intensity and frequency of extreme weather events affects critical assets and natural resources used by the issuer) – see Figure 4.

Figure 4 is a table showing two major areas of risks for sectors and issuers: transition risks and physical risks. Four risks fall under transition risk, and three fall under physical risk. More description is detailed within.

PIMCO’s Tool #2, the Portfolio Climate Risk Heat Map, gives a high-level overview of exposure to climate risk (both transition and physical) among relevant sectors and assets. Figure 5 illustrates a “heat map” of select corporate sectors’ exposure, from low risk (green) to high risk (red), along with examples of relevant climate risks within each sector. Looking across the range of risks in a portfolio helps a portfolio manager assess and fine-tune exposures.

Figure 5 is a table listing 11 sectors, with examples of transition risk and physical risk for each. Each risk is color coded: red for more at risk, yellow for moderately at risk, and green for less at risk. Only healthcare is green in terms of transition risk and physical risk. Energy, and metals and mining are both red in terms of transition risk, and yellow in terms of physical risk, with potential risks of water shortages. More details, from sources as of July 2019, are described in the table.

Tool #3: Issuer Climate Risk Score

PIMCO’s Issuer Climate Risk Score (Tool #3) assesses climate change risks for a wide range of relevant sectors and issuers. In the auto sector, for example, we explore climate change in the broader context of stricter legislation covering air pollution, while for the food and agriculture sectors, carbon risks should not, in our view, be disentangled from steps taken by issuers to mitigate the underlying commodities’ water or land footprint.

As with the heat map (Tool #2), the climate risk scores are divided into transition risks and physical risks. Our transition risk scores are typically favorable for the most carbon-efficient issuers and for those proactively seeking to align with the Paris Agreement in light of their respective business and geographical contexts. The transition risk score draws on metrics such as the issuer’s current and future carbon emissions using a lifecycle approach and recognized methods such as the science-based target approach, as well as business mix outlook (e.g., revenues, capital expenditures) considering technology pathways enabling issuers to align with the limits on rising temperatures.

Case study A: Energy (corporate credit)

For instance, PIMCO’s fundamental analysis of credits in the energy sector closely examines companies’ exposure to different types of energy sources, environmental and regulatory risks to the business activities, the relative cost positions of companies and their commitments, and steps taken to diversify into low-carbon sources of energy.

Ultimately, we look to map the likely winners and losers, notably based on scenario analysis and the extent to which long-term climate risks are reflected in our credit views and bond prices, and, if they are not, what this could mean for issuers’ credit quality considering bond characteristics (e.g., duration) over time.

Case study B: Real estate and mortgage-backed securities

In general, we believe the real estate sector needs to step up its efforts to improve buildings’ energy efficiency via more extensive upgrades of existing properties. Our environmental assessment for real estate examines practices in terms of green buildings and like-for-like carbon emissions, energy intensity reductions, and reduction of physical risks.

Looking across subsectors, our climate scores for REITs (real estate investment trusts) suggest that malls and offices are generally the most advanced in their practices and trajectories. And within mortgage-backed securities (MBS), we see geographical diversity as a key edge against material losses prompted by extreme weather events.

Case study C: Sovereign credit

Our sovereign credit climate score comprises a host of metrics that capture each country’s exposure and readiness to cope with climate change, connecting environmental with economic variables. Energy-intensive and fossil-fuel-dependent economies are much more likely to be affected by the transition to cleaner energy, but the pace will be key to each sovereign’s ability to manage the transition risks, as well as their savings buffer and reforms to shore up growth from other sectors. Conversely, rising temperatures and physical climate risks are likely to disproportionally affect the credit risk of developing and smaller countries.

Case study D: Municipal bonds

PIMCO’s municipal climate score considers a variety of factors to assess the economic vulnerability associated with climate risks, as well as the ability and willingness of states and local governments to adapt and achieve sustainable initiatives.

In the municipal market, high physical risks are generally concentrated around coastal communities with elevated incidents of storms and flooding, while high transition risks reflect economies with larger exposures to the energy and mining sectors.

Tool #4: Portfolio Energy and Technology Mix Measured Against the Paris Agreement

We complement our sector-based and bottom-up analysis of carbon risks with a portfolio tool that monitors the carbon impact of corporate holdings across a portfolio and seeks ways to mitigate emissions beyond exclusion screens. PIMCO’s Energy and Technology mix compared with the Paris Agreement (Tool #4) assesses the average technology and energy mix of a portfolio compared with global energy scenarios modeled by the International Energy Agency (IEA), including the potential impact of green bonds, considering their specific environmental features and issuer-level data. Figure 6 compares PIMCO’s ESG portfolio with current and future IEA estimates of Paris-aligned portfolios.

Figure 6 is a bar chart comparing PIMCO’s energy mix compared with various scenarios modeled by the International Energy Agency. PIMCO’s ESG portfolio, represented on the left-hand side, shows a 42% allocation to renewables. A second bar shows how that number jumps to 71% when accounting for green bonds use of proceeds. On the far right, the chart shows the IEA World scenario for 2025, with renewables at 20% of the energy mix in portfolios. The PIMCO portfolio shows a higher reliance on nuclear power, at 18%, more than the IEA scenarios, but that drops to 5%, lower than the IEA examples, after accounting for green bonds use of the proceeds.

Tool #5: Portfolio Carbon Intensity Analysis

Moreover, as part of PIMCO’s Portfolio Carbon Intensity Analysis (Tool #5), we have developed high-level portfolio screens that allow comparison of carbon intensity of different portfolios and benchmarks based on the weighted average sum of both direct greenhouse gas emissions and greenhouse gas emissions due to purchases of electricity, heating, and cooling (i.e., scope 1 + scope 2 emissions in tonnes of carbon dioxide equivalent, or tCO2e / revenues in USD (weighted based on percentage of market value)) – see Figure 7.

Figure 7 is a bar chart showing how three PIMCO ESG products have much lower absolute carbon emissions than their benchmarks. For example, the Global Bond ESG Portfolio has an equivalent average weighted sum of 10 gigatons, compared with about 37 gigatons for the Bloomberg Barclays Global Aggregate USD Hedged Index. Similarly, PIMCO’s Total Return Bond ESG Portfolio has the equivalent of about 18 gigatons, compared with 35 for the benchmark. PIMCO’s Global Investment Grade Credit ESG Portfolio has about 17 gigatons, compared with 41 for the benchmark. The chart also shows levels of carbon intensity for each portfolio and benchmark.

Tool #6: Green Bonds Score

Green bonds and other debt instruments geared toward sustainability are proliferating in the global marketplace. Our ESG process integrates analysis of debt instruments geared toward climate solutions via our proprietary Green Bonds Score (Tool #6).

We assess green bond instruments both prior to and after issuance, mapping them across a spectrum based on strategic fit, potential impact, red flags, and reporting, resulting in PIMCO’s impact score for green, social, or SDG bonds. PIMCO’s green bond scores aid the investment process and security selection, allowing for stronger differentiation among green bond issuers and frameworks.

Tool #7: Engagement With Issuers on Climate Change

We engage with bond issuers both to bolster their Paris Agreement alignment and to help them improve their management of the underlying credit risks, moving from awareness to readiness, and ultimately commitment (Tool #7: PIMCO’s Engagement With Issuers on Climate Change). To learn more about how we use issuer engagement as a tool to actively monitor and encourage issuers’ disclosure and strategy on climate change, please see our latest ESG Investing Report.

PIMCO is part of Climate Action 100+, an investor-led climate engagement coalition that works with selected issuers among the largest carbon emitters in a broad range of sectors.

Key takeaways

As we discuss in PIMCO’s latest Secular Outlook, we believe the disruptive impact of climate change on human lives, economic activity, and financial markets will create many winners and losers, which will require active management of credit and other risks. Climate-related shocks could become more frequent and severe, and have the potential to wreak havoc with economic activity and inflation, and thus could make it more difficult for investors and central banks to separate the noise from the signal.

As an active investment manager, PIMCO seeks to understand and act on that signal – to proactively assess and manage the risks and opportunities created or compounded by climate change. Our proprietary tools and methods are designed to help investors navigate an uncertain future in an evolving global economy.

Learn more about our innovative approach to ESG investing in fixed income markets.


Download our latest ESG Investing Report, featuring detailed insights into trends and tools for sustainable investing.

The Author

Samuel Mary

ESG Research Analyst

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