ESG & The New Alternatives

Key Climate-Related Considerations For Investment Grade Bonds

How will advisors incorporate new strategies into their portfolios?

by Rob Fernandez

Mr. Fernandez is Director of ESG Research for Breckinridge Capital Advisors.

When it comes to climate-related risks and opportunities in investment analysis, one of the best ways to learn whether stock and bond issuers are knowledgeably and authentically responding to climate change is simply to go to the source and ask them.

The recently released Breckinridge Capital Advisors 2021 Issuer Engagement Report demonstrates the value of direct engagement with bond issuers on climate risk. In “Addressing the Materiality of Climate Risk Through Issuer Engagement,” Breckinridge security analysts offer insights gathered during their 2021 issuer engagement discussions.

Our analysts’ 2021 engagement theme took on added immediacy in the aftermath of the Intergovernmental Panel on Climate Change report that makes clear that the effects of climate change are permanent, intensifying and driven by greenhouse gases caused by human activity.

But what should investment advisors know about how this relates to opportunities and risks in investment-grade fixed income? As much as they can.

Climate change is one of the major challenges of our time. Bringing it closer to home, many of your clients may be concerned and want to help make a difference while avoiding climate-related investment risks.

How can they do this? One way is to invest in municipal bonds issued by cities to pay for cleaner water and air, creating more livable, resilient cities whose tax base will grow. Another is to invest in corporate bonds issued by companies that are financing more sustainable business operations.

Breckinridge’s recent research focused on a broad range of climate-related topics. It sought to learn what various bond issuers – corporations, municipalities and securitized bond issuers – are doing to mitigate climate risks and tap into opportunities to improve resiliency in the face of these challenges.

Why Is Climate Change So Critical?

We are experiencing more extreme weather – from hurricanes, tornadoes and coastal flooding to deadly heat waves, droughts and wildfires. Scientists expect these to worsen as average global temperatures continue to rise.

The consensus is that there is a short window in which we can act and avoid a disastrous future for the planet’s ecosystems, livability and economy. Bond issuers must integrate climate risk into their capital spending and operations.

How well bond issuers are able to do that will help determine their overall long-term success and viability. And how well investment advisors grasp this opportunity to understand and integrate climate risk considerations into investment portfolios could also influence their success.

State of the Bond Market: Good Intentions, Early Efforts, But The Clock Is Ticking

At a high level, Breckinridge found:

  • Bond issuers generally recognize the threat of climate change to their operating models and seek to manage these risks. However, most issuers still are in the early stages of addressing climate risks while the clock ticks and potentially irreversible trends continue.
  • Pervasive risks exist across all bond sectors, including many physical climate change-related risks as well as transitional risks, as bond issuers seek to adapt to a low- or no-carbon economy.
  • There are also powerful opportunities to innovate and to help reduce climate change, through energy efficiency, clean energy, and to prepare for extreme weather events.
  • Current climate risk disclosures are often inadequate for investors who seek to measure and monitor progress on how well bond issuers are managing climate change.
  • Ultimately, we believe the most sustainable businesses and municipal operations will be those that best plan for, manage and adapt to climate change risks.

Municipal Bond Opportunities And Risks

Although municipal bond issuers are financing numerous projects that could be critical to a clean-energy future, it can be challenging to find information on material climate risks in the municipal market. A Brookings Institute study of 590 U.S. counties found that only one in 10 offering statements of municipal revenue bonds mentioned climate change. That finding underscores the need for direct engagement with issuers.

In the state municipal bond sector, planning and coordinating with local governments is critical. For local government issuers, heat stress and related equity considerations are important. Three other municipal bond themes involved water projects and climate planning; housing affordability and climate change; and municipal power utilities and carbon-neutral planning.

Our discussions with municipal bond issuers surfaced these key takeaways:

  • Smart intergovernmental collaborations: States are able to offer economies of scale to local and regional governments through collaboration, as they identify and manage priorities on climate mitigation, adaptation and resilience. This can help environmentally sound projects get implemented more quickly.
  • City climate resiliency projects: Because heat stress tends to have the greatest impact on the poorest and most disadvantaged within cities,[1] some municipalities are pursuing climate resiliency projects to enhance their city’s livability and attractiveness. A more livable city is more likely to retain residents, attract new ones, and grow the tax base. To address heat islands, cities are planting trees, creating shade structures, promoting energy-efficient appliances and green infrastructure, such as cool roofs and pavements.
  • Systemic approach to varied water challenges: Water and sewer preparedness in confronting varied climate risks is complex and challenging. Concerns include stormwater management, erosion, conservation and clean water supply. A systemic approach often works well, with various departments teaming up with one another and with local and regional communities tackling multiple risks.
  • Affordable housing and climate change: Rising sea levels and coastal flooding could threaten the future of affordable housing. Housing Finance Agencies (HFAs) that don’t address climate change face financial risks to the value of real estate as well as risks to the health and welfare of residents. By investing in HFAs that are pursuing affordable housing best practices, the goal is to identify providers that are meeting community needs and bondholder obligations.
  • Municipal electric utilities transitioning to low carbon futures: The move to carbon-free power is a central concern for investing in bonds issued by these utilities. Municipal power providers face numerous challenges as they move to carbon-free energy production. For example, they must meet customer electricity demands while replacing fossil fuel generation plants with cleaner alternatives. While many municipal power providers have defined target goals, they differ on how to reach their goals. There is also a wide range in how much progress is being made on the transition from carbon-based operations.

Corporate Bond Challenges And Progress

As with municipal bond issuers, progress varies among corporate bond issuers as well as they seek to mitigate or adapt to climate risks and measure their efforts and overall success.

Key corporate bond takeaways we gathered during our engagement discussions included:

  • Large banks are increasing their financing of sustainability projects and reducing their own greenhouse gas emissions. Among banks with whom Breckinridge engaged in 2021, there has been a substantial increase in green, social, sustainable and sustainability-linked bonds plus bank lending to support climate change action. Banks that take this type of proactive approach could be better positioned for growth while protecting against climate risks.
  • Within energy and transportation, carbon is a financially material consideration. Many transportation firms are targeting science-based greenhouse gas emission reductions. Some energy companies are reducing carbon emissions in their own operations (Scope 1 and 2 emissions) and emissions of the products and services used by consumers (Scope 3 emissions). These Scope 3 emissions make up almost 90% of the energy sector’s overall emissions and are a key focus.[2]
The consensus is that there is a short window in which we can act and avoid a disastrous future for the planet’s ecosystems, livability and economy. Bond issuers must integrate climate risk into their capital spending and operations...

Strikingly, there is a great divergence among energy companies on their Scope 3 emission reductions. While some companies are innovating as they address transitional risks and greenhouse gas reductions, others are doing little or nothing. Because U.S.-based energy firms generally are slow to respond to climate change risks, this poses a threat to the sector’s future performance.

  • Transportation exposed to numerous risks. The transportation industry must navigate several climate change risks. In addition to reducing greenhouse gas emissions and hazardous pollutants, they are managing adverse weather conditions while seeking to improve fuel efficiency.

Railroads must deal with lower revenues from declining freight volumes while managing rising expenses of track repair and maintenance caused by extreme temperatures or flooding, all while attempting to improve operational and energy efficiency. Meanwhile, road-based transportation companies are focused on alternative fuel vehicles, leveraging route optimizing software, facility automation and drones.

  • The food and beverage industry focuses on water use. Food and beverage corporate bond issuers are focused on how well they are managing their use of water. Bond issuers in this industry see managing water use as essential to their financial success. Some are taking innovative approaches, such as pushing these innovations into their supply chains, which can benefit those businesses and their communities.

For example, regenerative agriculture is gaining acceptance among leading firms in the food and beverage industry. In contrast to traditional farming, which tends to deplete resources including soil and water, regenerative farming is sustainable as it can enrich soil, promote biodiversity, improve water quality, and capture carbon.

Companies with effective strategies in handling water scarcity and stress also tend to provide best-in-class ESG disclosure, which is important for investors who seek to integrate material ESG factors into their security analysis.

  • Retail bond issuers are balancing climate-risk concerns with consumer sentiment. Breckinridge focused on how retailers are managing climate-related risk at brick-and-mortar stores. Retailers’ efforts on sustainability range from perfunctory to proactive. A challenge is that consumers are largely focused on convenience and price.

That consumer price-sensitivity has led retail bond issuers to be more focused on sustainability within the context of price and convenience. Several firms reduced energy use and greenhouse gas emissions by converting to interior LED lighting and more efficient heating, ventilation and air conditioning.

The retailers we spoke to run the gamut. For example, one retailer is working to source products from cargo carriers that are certified by the Environmental Protection Agency’s SmartWay program. Meanwhile, another retailer has no appointed sustainability leader, no greenhouse gas emissions reduction target, and is not systematically measuring energy consumption price/supply risks.

Breckinridge believes that energy efficiency can help to improve customer service, enhance sustainability and achieve environmental goals, all of which can bolster a retailer’s long-term competitive market position and financial performance.

Opportunities For Advisors To Better Serve Investors Related To Climate Risks

Where does all this leave investment advisors? Investors increasingly are driven by concerns regarding sustainability. Sustainable investments make up more than one-third of all assets ($35.3 trillion) in the United States, Canada, Europe, Japan and Australasia, according to the Global Sustainable Investment Alliance.[3]

The issuance of ESG and sustainability bonds keeps skyrocketing: In 2020, ESG bond assets increased 66%, far more than the 12% growth of the overall fixed income universe, according to a Morningstar report.[4]

Clearly, investment advisors who are knowledgeable and concerned about climate risks and ESG in general will be better able to engage with, attract and retain investors who are passionate about and driven to invest with ESG issues as a core concern.

And, as advisors consider investment managers for their clients’ sustainable assets, advisors may want to seek managers who fully integrate ESG into their investment process, which includes a robust issuer engagement program.

 

 

 

[1] .https://www.npr.org/2019/09/03/754044732/as-rising-heat-bakes-u-s-cities-the-poor-often-feel-it-most
[2]. https://ihsmarkit.com/research-analysis/oil-gas-companies-under-pressure-to-manage-scope-3-emissions-t.html#:~:text=IHS%20Markit%20data%20show%20Scope,the%20oil%20and%20gas%20sector.
[3]. https://www.reuters.com/business/sustainable-business/sustainable-investments-account-more-than-third-global-assets-2021-07-18/
[4]. https://www.reuters.com/business/sustainable-business/sustainable-investments-account-more-than-third-global-assets-2021-07-18/
DISCLAIMERS: This article is limited to the dissemination of general information about Breckinridge Capital Advisors (“Breckinridge”) and should not be construed as a solicitation or offer of Breckinridge services or products or as legal, tax or investment advice. The content is current as of the time of writing or as designated within the material. All information, including the opinions and views of Breckinridge, is subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any estimates, target or projection will be accurate or prove to be profitable; actual results may differ substantially.
Some information has been taken directly from unaffiliated third-party sources. Breckinridge believes such information is reliable but does not guarantee its accuracy or completeness. Any third-party websites included in the content has been provided for reference only.
Breckinridge believes that the assessment of ESG risk can improve credit assessments. However, there is no guarantee that integrating ESG analysis will improve risk-adjusted returns, reduce volatility over any specific time period, or outperform the broader fixed income market or other strategies that do not utilize ESG criteria when selecting investments. All investments involve risks, including the loss of principal.

 

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