In December 2020, Wellington became a founding member and signatory to the Net Zero Asset Managers (NZAM) initiative. Grounded in our primary goal of achieving our clients’ investment objectives, this commitment aims to apply our research-led approach to better understand the impacts on our clients’ portfolios of the ongoing climate transition. It also helps us deepen our company research and enhance consultative partnerships with clients.

Why we have committed to net zero

Aiming to achieve competitive long-term outcomes
Our core commitment is to aim to deliver superior investment results and exceptional service for our clients. Through our research partnership with Woodwell Climate Research Center, we have come to appreciate that the physical consequences of climate change will be felt sooner and be more disruptive than markets expect. As policymakers and markets increasingly recognize and respond to this, the transition to a low-carbon economy is likely to gain momentum. As a result, we believe actively considering transition-risk management at the company and portfolio levels can help us deliver better financial outcomes for our clients.

Companies will face many climate-transition-related challenges
To remain competitive, companies need to address transition risks that may affect asset valuations and risk profiles. New regulations and shifting consumer preferences away from high-emitting companies may lead to rising expenses and falling margins from carbon taxes, litigation fees, capital costs, and loss of business. We believe a credible decarbonization strategy will help attract stakeholders seeking to reallocate capital toward companies embracing the low-carbon transition.

About our NZAM commitment

As a signatory to NZAM, we commit to:

• Set an interim target for the proportion of assets to be managed in line with the attainment of net-zero emissions by 2050 or sooner
• Review our interim target at least every five years, with a view to ratcheting up the proportion of AUM covered until 100% of assets are included¹

Importantly, the initiative “acknowledge[s] that the scope for asset man- agers to invest for net zero and to meet the commitments set forth above depends on the mandates agreed upon with clients and clients’ and man- agers’ regulatory environments. These commitments are made in the expectation that governments will follow through on their own commitments to ensure the objectives of the Paris Agreement are met, including increasing the ambition of their Nationally Determined Contributions, and in the context of our legal duties to clients and unless otherwise prohibited by applicable law.”²

The net-zero tool kit

There are several tools that portfolio management teams can use — individually or in combination — to manage transition risk and thereby reduce portfolio emissions over time. Notably, we do not mandate blanket exclusions of sectors, industries, or regions for portfolios committed to net zero. Any portfolio-level exclusions are implemented at our clients’ request. We prefer to research and meet with companies to evaluate the investment opportunity and risks, including assessing climate readiness.

Constructive dialogue
We believe constructive dialogue with companies is our most powerful tool to achieve better investment outcomes. These discussions can help companies appreciate the potentially wide-ranging effects of the low-carbon transition on security valuations. Company meetings help investors better understand a business’s emission footprint and transition-risk-management approach. To the extent that transition risk is material to the issuer, we aim to highlight this risk and encourage risk mitigation.

While an issuer’s exposure to transition risk cannot be captured in a single figure, emissions are quantifiable and comparable across industries. This data enables portfolio management teams to prioritize potential transition risks. Using the emissions footprint as a guide for potential risks associated with emissions sources, we can ask companies about their climate risk mitigation strategies to better understand their readiness for the low-carbon transition. The scope of these discussions varies by company and may include such topics as:

• Enhanced disclosures including footprinting
• Implications of transition-related policies on operations and business model
• Consideration of adoption of emissions reduction targets for transition-risk management
• Assessment of capital expenditures required to meet such targets

As more company management teams appreciate the contribution of a robust transition-risk-management strategy to long-term success, the investable universe of climate-ready companies is likely to expand. These dialogues take one of several forms, involve interacting with different company representatives, and typically continue over multiyear periods. For example, our equity, credit, and ESG analysts, with support from the Climate Research Team, host meetings focused on transition-risk research and assessment. In other cases, climate transition may be one of several topics in a broader discussion with senior management or a board member. These meetings are open to any internal portfolio management team with interest in this issue. Additionally, written communications supplement these interactions to keep investment teams apprised of interim progress.

We are able to report on this activity, along with portfolio-level metrics, so clients can monitor our progress. We may communicate with company leaders in person and through several stewardship methods, such as writing letters and voting proxies.

Investing in climate transition leaders, improvers, and solutions providers
Investment teams can also adjust portfolio holdings. For example, a team may reduce exposure to a company that it believes lacks a credible transition plan and thus may underperform its peers. As consistent with its philosophy and process, a portfolio management team may also increase exposure to climate-transition leaders that the team believes may outperform peers over time. These may include carbon-efficient companies with existing cost advantages, those that generate revenue from products or services that reduce their customers’ emissions, or those whose active decarbonization progress improvement may be underappreciated by the market.

Investing in climate solutions is critical to achieving net-zero emissions globally by 2050. Unfortunately, this approach is difficult to measure at scale with respect to quantifying avoided emissions for a wide array of products. Companies offering climate-mitigation solutions, such as utilities and industrials, tend to have high Scopes 1 and 2 emissions but low Scope 3 emissions, as emissions from the use of their products are relatively small. Investment strategies focused on these sectors tend to have higher emissions profiles relative to diversified strategies, given the current challenges in measuring Scope 3 emissions. Due in part to this data gap and rising demand from consumers seeking to lower their own carbon footprint, we believe these companies have underappreciated tailwinds to revenue growth. Standards for measuring downstream Scope 3 emissions are being developed, which should help investors and clients accurately assess and price in the demand for climate solutions.

Sell discipline
Over time, a portfolio management team’s fundamental view of a company’s long-term competitiveness may shift based on insights gleaned from conversations with the board and management team. This change in assessment may result in a reduced or eliminated position (Figure 1). The decision to sell could be temporary; a company that remains in the opportunity set may become eligible for reinvestment by demonstrating meaningful progress on risk management.

High-quality carbon offsets
Where permitted by applicable client guidelines for strategies that have adopted a net-zero glidepath, portfolio management teams may make incremental use of credible carbon offsets to meet their clients’ interim 2030 targets. While carbon offsets should not be a primary emissions-reduction tactic, they may be used to smooth a path toward net zero if the emissions profile of underlying holdings causes a portfolio to temporarily fall short of an interim target. We define high-quality carbon offsets as those that remove or reduce greenhouse gas (GHG) emissions in real, additional, and permanent ways and have minimal negative social or environmental impacts. We continue to monitor developments in carbon-offset markets and search for credible, high-quality climate solutions.

Client-driven portfolio implementation

For those asset-owner clients who have requested implementation of a net-zero strategy in the portfolios we manage on their behalf, we have developed two standard approaches: a bottom-up glidepath based on holdings’ transition alignment and a top-down glidepath based on the portfolio’s overall emissions footprint. The tool(s) selected by each portfolio management team and the resulting measurement will be driven by client objectives and each team’s intrinsic philosophy, style, concentration, and name-based turnover rate.

Bottom-up glidepath: Increasing exposure to aligned issuers
Client objective: Increase the proportion of the portfolio invested in net-zero-aligned companies

Some investment teams, in consultation with clients, will pursue net-zero implementation with a glidepath that outlines an increasing percentage of portfolio exposure invested in companies that have set science-based emissions-reduction targets. In these cases, our recommended approach for portfolio management teams is to prioritize companies that are the highest contributors to each portfolio’s footprint, encouraging them to disclose their climate transition-risk-management approach and set science-based emissions-reduction targets. Because a subset of holdings often represents most of a portfolio’s weighted average carbon intensity (WACI), we believe this approach can help align portfolio decarbonization with a goal of net zero by 2050. Depending upon the receptivity of existing portfolio holdings, some teams may also tilt the portfolio toward companies with science-based targets to achieve the target.

We believe this targeted approach is philosophically aligned with the Science Based Targets initiative’s (SBTi’s) Guidance for Financial Institutions’ Portfolio Coverage. We expect to demonstrate alignment by disclosing outcomes from our company dialogues, progress on portfolio exposure to companies with science-based emissions-reduction targets, and portfolio WACI over time. Our approach to evaluating target setting may evolve in response to improvements in data availability and changes in client objectives.

The glidepath shown in Figure 2 starts with a 2019 portfolio baseline (or later inception date), as measured by market-value exposure to companies with targets. From there, an interim 2030 target is set, consistent with a linear increase to 100% portfolio exposure to companies with targets or the equivalent by 2040, and a 2040 target of 100% exposure to companies with science-based targets. (The target date for this glidepath is 2040 because portfolio decarbonization relies on underlying holdings executing against their final decarbonization targets to achieve net zero by 2050.)

Top-down glidepath: Reducing a portfolio’s emissions footprint
Client objective: Reduce portfolio emissions, consistent with a fair share of the requisite 50% global reduction in GHG by 2030, and net zero by 2050 or sooner

The glidepath shown in Figure 3 starts with a baseline from 2019 (or later if a strategy’s inception date is more recent), representing a portfolio’s investable universe. From there, a 50% portfolio emissions-reduction target by 2030 is set, as well as a net-zero target by 2050 or sooner. We have selected WACI as the portfolio metric our investment teams will monitor and target for the interim 2030 target, as we find it less sensitive to changes in market movements and capital structures. We may adopt a financed-emissions metric (tons/US$ millions invested using enterprise value including cash) as methodological and data challenges are addressed and will report on both metrics in the meantime.

We recognize that there is no one-size-fits-all metric, and we continue to evaluate additional metrics that may be added to our glidepath implementation toolkit. As more of our asset-owner clients inquire about the use of additional metrics, such as implied temperature rise (ITR) or transition alignment assessment criteria, each investment team evaluates the merits and drawbacks of the metric in the context of its specific philosophy and process.

Where a glidepath is adopted as a complementary investment objective, investment teams are likely to use a combination of constructive dialogue and portfolio construction, depending on the pace of progress among net- zero aligning companies. Our preference with any glidepath is that it be considered directional and nonbinding, as progress is not expected to be perfectly linear year over year. That said, we are committed to reporting on our progress along such glidepaths and proactively communicating any challenges we encounter.

Measurement through proprietary dashboards

Our Climate Research Team has developed proprietary dashboards that facilitate company- and portfolio-level monitoring. These tools and datasets are available to all Wellington portfolio and product management teams.

Future emissions reductions matter more than current emissions
While our dataset includes both recorded and estimated emissions, we weigh a company’s future emissions-reduction commitments more heavily than its current or historical emissions. As a qualitative overlay to these quantitative metrics, we aim to assess the credibility of each decarbonization plan and consider its implications for broader corporate strategy and capital allocation approach.

Current and historical data

Forward-looking data

Investment strategies in scope for net zero

Currently, only strategies investing in equities, investment-grade bonds, or high-yield bonds can adopt net-zero glidepaths because these are the only asset classes for which emissions data is available and accepted decarbonization approaches are implementable. We also consider inclusion of multi-asset mandates — within which corporate exposure is a meaningful subset — on a case-by-case basis. We will expand the universe of eligible strategies over time as better data and methodologies emerge (Figure 4).

Methodology for determining committed AUM

Wellington operates as a community of boutiques; each investment team acts as a fiduciary for its clients and is responsible for managing climate-risk exposure consistent with its philosophy and process. Nearly 90% of our business is comprised of separately managed and subadvisory accounts we manage on behalf of clients. Our AUM commitment therefore takes a bottom-up approach and includes two categories of client accounts:

• Accounts in which clients have requested or approved implementation of a decarbonization glidepath objective consistent with net zero by 2050 or sooner
• Strategies for which the investment team, as part of its philosophy and process and with the aim of improving investment outcomes, engages with select companies for which the team deems transition risk to be potentially material to long-term value. Here, there is no portfolio construction expectation as a unique result of an investment team’s engagement. For these strategies, we have then sought client consent or notification as appropriate to include their accounts within our AUM commitment.³

In line with the NZAM commitment language, we commit to restate NZ AUM every five years. In the interim, NZ AUM can fluctuate for many reasons, including net client growth, investment performance, and client consent. Ad hoc restatements may also occur in the event of a meaningful change. Please let your relationship management team know if you would like to explore potential net-zero glidepath implementation in greater detail.

Collaboration to develop best practices for net-zero implementation

Through numerous industry-led initiatives, including NZAM and the Paris Aligned Investment Initiative, we collaborate with other signatories to help define benchmarking criteria, develop best practices for decarbonization methodologies, and shape industry standards. Within these industry initiatives, we do not form groups, act in concert, or make collective-investment decisions with other investor participants. Nor do we ask, encourage, or allow other participants to represent our views or speak on our behalf. The initiatives do not issue individual or collective recommendations, arrangements, agreements, or understandings with respect to any company or its securities, including voting or investment decisions.

Holding ourselves accountable

To ensure a high-integrity approach to portfolio-level net-zero implementation and firmwide target setting, we aim to adhere to the following governance and monitoring processes:

• Our Investment Stewardship Committee will review firmwide climate engagement activity to ensure a robust approach to engagement, provide evidence of outcomes where appropriate, and recommend suitable policy changes.
• The Sustainable Investment and Climate Research teams will enhance net-zero-related data and tools.

We will continue to:

• Partner with and educate our clients on the financial materiality of climate change
• Help clients assess the potential portfolio impacts of net-zero objectives, formalizing glidepaths where appropriate
• Develop strategy-specific climate action plans aligned with client objectives and investment teams’ philosophy and processes
• Encourage companies to improve disclosures and develop robust climate transition-risk-management plans
• Enhance portfolio reporting to clients to drive greater transparency and accountability
• Report periodically on our progress relative to our committed AUM
• Contribute to the evolution of best practices

¹Net Zero Asset Managers initiative. | ²Net Zero Asset Managers initiative. | ³Should an expectation of portfolio construction arise from NZAM for a client account to remain within our AUM commitment, we will reach out to those clients to discuss the best course of action. Inclusion/exclusion in our AUM commitment does not alter the materiality-driven engagement process that an investment team undertakes across its strategy.