With COP26 underway, leaders from around the world have gathered again to engage in healthy debate, revisit the Paris agreement and, to their chagrin, stare at a very expensive invoice that is rapidly coming due. The IEA projects that annual clean energy investment will need to more than triple from its current level ($1.2 trillion per year from 2016-2020, according to their estimates), to $4.2 trillion by 2030, in order to stave off its worst-case climate scenarios.
To fund these investments, many issuers will turn to the bond markets. As practitioners of sustainable fixed income investing for nearly a decade, we have been participants in an inspiring evolution in debt financing with regard to climate. The labeled bond market has grown rapidly from almost nothing ten years ago, and beyond the labeled bond universe there is also a growing amount of non-labeled debt that is funding climate-friendly projects. As shown in the chart below, the overall climate-aligned bond universe (both labeled and unlabeled bonds) comprised more than $2 trillion in outstanding issuance—still a small percentage of the global $138 trillion bond market, but a meaningful one that has continued to grow.
Meanwhile, we have spent years refining our methods for assessing the climate risks faced by each issuer and each debt security we consider for our portfolios, and bond investors around the world are rapidly recognizing how expensive climate change might be for some bond issuers in the future.
We seek to avoid climate risks while embracing opportunities for mitigation and adaptation in our sustainable fixed income strategies, using multiple layers of research and analysis in an effort to pursue improved risk-adjusted returns and decarbonize our portfolios. This linkage is essential. If climate friendly bond portfolios do not generate competitive returns, there is a risk that not enough capital will be available to fund a low-carbon economy. Conversely, climate bond portfolios that are only focused on the lowest carbon players today miss the opportunity to help finance the transition of higher-emitting issuers. We have always believed it is important to take a comprehensive approach to considering issues as complicated as climate change.
AN EXCELLENT CLIMATE FOR CLIMATE-ALIGNED BONDS
Demand has steadily grown for bonds that offer investors attractive returns, alongside assurances that the bond proceeds will be used for climate-positive projects. The Climate Bond Institute (CBI) estimates that the labeled green bond universe exceeded $1 trillion in outstanding debt as of Dec. 31, 2020, while the broader climate-aligned universe as defined by CBI (inclusive of bonds that fund climate-friendly projects, but are not issued with a green label) exceeded $2 trillion. This universe currently funds a diverse array of projects--predominantly in the transportation, energy and water sectors but also branching out into other areas.
Sources: Climate Bond Institute for green bond universe, climate-aligned bond universe market size data, and industry sector representation data for climate-aligned universe. Bank of International Settlements for global bond universe data.
The Bill Comes Due: Risks Investors Face from Climate Change
Climate-related risks are of uncertain magnitude, irreversible and uneven. They present in two main forms in our portfolios (and in the world):
- Physical risks relate to the visible, tangible damage that climate change is already producing or is projected to produce in the near future. They might include extreme weather—floods, hurricanes, drought, etc.—which disrupt supply chains, damage property and otherwise hurt an issuer’s assets or operations.
Sovereign and municipal issuers are especially exposed to long-term physical climate change risk, depending heavily on location. Coastal cities will need to adapt to rising sea levels, while cities in an arid area may see their water or electric systems heavily impacted by persistent droughts and heat. Climate risk faces a meaningful proportion of these issuers—for example, nearly 25% of critical U.S. infrastructure—utilities, airports, other key public assets—is at risk of being inundated by flooding, according to a new report by the nonprofit First Street Foundation.
One need only look back to 2019 to the PG&E bankruptcy filing to see a powerful example of how climate risk (in this case, taking the form of rampant wildfires) can impact an issuer’s cost of borrowing. As a result of the bankruptcy—itself an outcome of the enormous liabilities generated when poorly-maintained equipment sparked wildfires in areas primed for it by heat, high winds and drought—PG&E and other California utilities must issue "first-lien" bonds that pledge important corporate assets as collateral, while other utilities can issue unsecured debt. Even so, it generally costs CA borrowers more to issue secured debt than it costs other utilities to issue unsecured debt. On Oct. 28, PG&E 30-year 1st-lien bonds were trading at a yield of 4.3%; 1st-lien bonds from Southern Cal Edison at 3.2%. Meanwhile, 30-year senior unsecured bonds from utility peers around the country were trading at yields between 2.7% and 2.9%--a notably lower range of borrowing costs, despite not needing to pledge collateral against these bonds. The incremental yield difference adds up to large dollars for these California utilities—especially given their need to ramp up investment and seek to prevent or mitigate future fires.
Securitized assets are also impacted by climate risk. Research from the Mortgage Bankers Association and other groups is beginning to show that hurricanes, flooding and other natural disasters pose a far larger threat than is currently priced into residential and commercial mortgage-backed securities. Climate impacts have the potential to increase mortgage default, increase the volatility of house prices and produce significant climate migration. One recent example is 2017’s Hurricane Harvey which devastated portions of Texas and Louisiana; 80% of homes within the federally declared disaster had no flood insurance, because those homes weren’t normally prone to flooding. Mortgage delinquencies on damaged homes in the region jumped more than 200% in the aftermath of Harvey, according to mortgage data provider CoreLogic.
- Transition risks arise from the shift to a low-carbon world, and include the abrupt introduction of regulation, shifts in consumer demand, technological changes and investor sentiment. For example, there is a massive transition taking place in the automobile market right now—major global automobile companies committing heavily to EV, countries like the U.K. instituting future bans of sale of gas and diesel vehicles—and there will be winners and losers in that transition. One transition example we often reference is NextEra, one of the biggest electric utilities in the U.S.; as of the end of 2020, its 58GW of generation capacity was approximately 59% derived from wind, solar and other renewables sources. It still operates a meaningful portfolio of fossil-fuel derived energy, but it has been proactively leading its peers for years with regard to substantially adjusting its energy mix in favor of renewable energy.
In our view, many of our society’s current business models—and perhaps some of our societal models as well—cannot be sustained in the absence of commitment to address these material climate risks. As investors, we feel that we absolutely need reliable, actionable climate data and related insights, so we can direct capital to investments that are positioned for long-term success.
From Risk to Opportunity: How We Choose Investments
We focus heavily on considering climate risk from many angles as we source ideas and make choices about which to include in our portfolios. It can be a challenging exercise, for us and for other investors; beyond the complexity of the topic, we also must reckon with the industry’s current lack of transparent, standardized data disclosure when it comes to climate change and other environmental, social and governance (ESG) risks.
Our process is rooted in bottom-up, primary due diligence on individual issuers and projects—on climate and other ESG matters, and more broadly on fundamental creditworthiness. We seek to complement our data gathering with a qualitative assessment of various climate-related factors: Does the issuer have robust climate adaptation/resiliency strategies in place? Is the issuer currently vulnerable to risk, but in the midst of an active push to decarbonize? Do its products/services play a role in helping others mitigate or adapt to climate change? Has the issuer earmarked proceeds for use on specific projects that will reduce its carbon footprint or that of its customers or other constituent stakeholders?
To answer questions like these, we have developed a variety of tools and methods, from deep primary ESG research to comprehensive use-of-proceeds assessment so we can gain confidence that issuers are funding impactful climate projects as promised, and doing so effectively. (For more on our methodologies, we encourage you to review our 2020 Impact Reports for our U.S. core and U.S. tax-exempt sustainable fixed income strategies).
The factors we consider vary considerably from asset class to asset class, and from issuer to issuer. Let’s look at an example within the U.S. municipal market, to illustrate how a broad perspective can help illuminate the merits and risks of an investment opportunity.
Climate change can jeopardize water supply and water quality in many ways, from shortages during droughts, to system stress during floods, to water pollution/contamination brought on by flooding or coastal saltwater intrusion. We look for opportunities to invest in projects that improve efficiency of water delivery, incentivize water conservation and increase water recycling, with a focus on water-stressed regions. Resiliency of water systems will be critical for cities impacted by warming temperatures. Additionally, investments that improve stormwater management and flood protection systems can better prepare cities that will be impacted by increasingly catastrophic weather events.
Recently, the Colorado River Authority declared a water shortage that forced all municipal entities that draw water from the River to think about resiliency plans and how they are going to be able to provide clean water to the communities in which they serve.
Many of these entities that draw from the River are being forced to raise the cost of water, at least during the current shortage, but many others have been preparing for this eventuality for years. Obviously, as investors, we are drawn to those issuers who have prepared, and seek to avoid those who were caught flat-footed.
For example, Phoenix Water (a large water utility serving several million residents in five Arizona cities) has prepared for water scarcity for years, with 50-year and 100-year water resiliency plans that reduce reliance on the River by building aquifers, establishing wastewater and water recycling programs and creating other innovative solutions. We believe Phoenix Water has done an excellent job on climate adaptation and preparation, but mitigation risk is not completely within its control given its desert location, worsening drought conditions, and reliance upon interstate collaboration. These dueling factors help inform our decisions regarding investments in Phoenix Water debt, in terms of whether to invest, and how to size those investments.
Bond Markets: One Path To “Net-Zero”
As the climate crisis becomes more urgent, institutions of all types are increasingly announcing ambitious decarbonization goals. A prominent example in our own industry is the Net Zero Asset Managers (NZAM) initiative, which looks to investment firms to commit to “zeroing out” the carbon footprints of their assets under management by 2050. Brown Advisory, alongside 220 firms managing $57 trillion in global assets as of Nov. 1, 2021, have signed the NZAM pledge, which entails a concrete long-term philosophical commitment paired with a flexible framework for setting initial carbon-reduction goals and targets.
Fixed income assets, in our view, will continue to be an essential part of the financing mix for decarbonizing the economy. In particular, labeled bonds can help direct assets to specific projects that help issuers achieve their carbon reduction goals. Labeled bonds not only allow issuers to be transparent about their climate goals and strategies, but they also allow investors to hold those issuers accountable and demand evidence over time that progress is being made against projected progress against emission reduction targets or related goals.
For years, we have invested in bonds that steer proceeds to “climate-positive” projects; many of these have been labeled bonds, but many others were not issued under any certification process. Labeled or not, we do not rely entirely on outside verification when evaluating these securities. Not only do we conduct our own use-of-proceeds assessment, but we also spend the time to understand the context of the bond within the issuer’s broader climate strategies, and its commitment to adapting its operations to a low-carbon future.
Finding Justice at the Intersection of “E” and “S”
In our ESG research, we believe it is important to focus equal attention on the “E” and the “S,” even for issues that seem on the surface to have purely environmental implications. Environmental injustice—defined as disproportionate harm inflicted on some population segments vs. others by climate change, toxic pollution and other environmental problems—has devastated communities around the world for as long as pollution has existed. Not only do these situations present important moral considerations, but they can represent material financial risks for some entities.
And, in line with our recurring theme, these social risks can also be turned into opportunities for issuers and investors alike. When bond issuers take steps to address head on the injustice that may be embedded within their operating models, they reduce the probability of direct legal, reputational and other potential damages, while also strengthening the health and economic stability of their constituent communities.
We aim to be attuned to intersectionality issues like these across our sustainable strategies. As noted in a recent white paper by our global sustainable fixed income team, “Sustainable Sovereigns,” social and environmental intersection can affect the evaluation of sovereign debt as well. In the paper they discuss Indonesia as a case study; Indonesia and other emerging-market countries are investing in transitions to lower-carbon economic models, but they need to balance this effort with their need to increase electric service penetration across their countries to promote economic growth. An interesting note is that many models for evaluating sovereign climate risk focus on measuring emissions relative to national GDP; this choice of metric unfairly penalizes emerging-market nations that are trying to do the right thing for citizens seeking a better life with basic services that wealthy nations take for granted. This is yet another example supporting our contention that every investment situation must be evaluated in context, using a combination of standardized data and specific analysis of the issuer’s circumstances.
A Time of Transition—For the Climate, And Investors
The time for viewing climate change as a theoretical abstraction is over; the bill for our carbon-intensive society is past due. Unfortunately, we are past the point where we can push back global temperature increases completely, but we can still achieve a prosperous, low-carbon future with a dedicated, global effort to steer capital markets toward a new investment mix that favors clean energy development and increasingly de-emphasizes fossil fuels.
We are deeply engaged with leading industry organizations that seek to improve the transparency, quality and consistency in climate data, such as the ICMA (the lead organization behind the Green Bond Principles and other frameworks for issuance of bonds and loans that aim to earmark proceeds for positive impact), as well as the Sustainability Accounting Standards Board (SASB), the Task Force on Climate-Related Financial Disclosure (TCFD), and CDP (formerly the Carbon Disclosure Project).
But as we’ve said, the process of redirecting trillions of dollars of capital annually is much more likely to succeed if we can “pull” people toward climate-friendly investments that perform well for them, rather than “push” them in one direction or another through regulation, heavy persuasion tactics or other means. We have always built our firm’s strategies and client solutions with this mindset, and it is our hope that we can produce compelling results over time because of our devotion to bottom-up ESG research, not despite of it. 
The views expressed are those of Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested.
ESG considerations that are material will vary by investment style, sector/industry, market trends and client objectives. Our ESG strategies seek to identify companies that we believe may have desirable ESG outcomes, but investors may differ in their views of what constitutes positive or negative ESG outcomes. As a result, our strategies may invest in companies that do not reflect the beliefs and values of any particular investor. Our strategies may also invest in companies that would otherwise be screened out of other ESG oriented portfolios. Security selection will be impacted by the combined focus on ESG assessments and forecasts of return and risk. Our strategies intend to invest in companies with measurable ESG outcomes, as determined by Brown Advisory, and seek to screen out particular companies and industries. Brown Advisory relies on third parties to provide data and screening tools. There is no assurance that this information will be accurate or complete or that it will properly exclude all applicable securities. Investments selected using these tools may perform differently than as forecasted due to the factors incorporated into the screening process, changes from historical trends, and issues in the construction and implementation of the screens (including, but not limited to, software issues and other technological issues). There is no guarantee that Brown Advisory’s use of these tools will result in effective investment decisions.
The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.