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ESG

ESG Newsletter published on March 27, 2020

Long-Term Climate Change Risks and Muni Bond Analysis

Breckinridge believes that municipalities that are conscious of sustainability and related environmental, social and governance (ESG) issues are likely to carry less risk over the long term. Climate risk is among the more meaningful of the environmental risks we assess in our work.

A common challenge we hear from bond issuers when discussing emerging climate risks is, “Why should I care about these long-term climate risks when my bonds mature in five years?” At Breckinridge, we understand the question, and believe that seemingly longer-term risks can have relevance today and should be included in a comprehensive credit analysis of an issuer.

Climate risks can be viewed as threat multipliers.

Climate risk can be seen as a threat multiplier in the sense that current climate events can magnify existing credit weaknesses of the issuer. For example, pensions are a growing cost for many cities. Layering on climate change challenges and the potentially large associated costs of adaptation or mitigation potentially could create a competing fiscal demand that might complicate a city’s efforts to control pension costs. Another example is the vulnerability faced by cities that are underinvesting in their infrastructure. Many cities, towns and utilities across the country are grappling with deferred maintenance backlogs. This underinvestment can be exacerbated by climate change as illustrated in the two examples below.

Recently, in Ft. Lauderdale, Florida more than 200 million gallons of sewage spilled into the city’s waterways due to sewer pipe breaches. Our analysis of the city’s financial statements concluded the city has been underinvesting in its sewer system. Age of plant has increased meaningfully over the past 5 years and aggregate 5-year capital spending lagged depreciation. News reports cited rising sea levels due to a changing climate and saltwater intrusion, as factors accelerating the deterioration of the sewage pipes and were contributing factors in the spills.1

The wildfires that ravaged Australia in recent months is another example of where poor upkeep of infrastructure was exacerbated by climate change, leading to the wildfires.2 A similar situation unfolded in California during the state’s 2019 wildfires, which threatened hundreds of issuers and led to billions of dollars in damage, fines and settlements for both municipalities and PG&E, the electric utility (See Municipal Implications of the California Wildfires).

Climate Change-Related Risks Are Expected to Increase in the Long Term.

Knowing an issuer’s exposure to risks such as rising sea levels or wildfires is critical to developing a forward-looking credit profile. Looking ahead, events often attributed to the risks associated with climate change will likely occur more frequently and their effects will be felt more widely.

For example, according to the Union of Concerned Scientists, the frequency of extreme heat days will rise in the coming years.3 This sort of risk places stress on utility grids, community services and disproportionately affects more vulnerable populations, including the elderly and low-income. It also had a detrimental effect on the agricultural sector, creating additional stress in communities dependent on the sector.4 Affected communities will face pressure to diversify their economies and could become more dependent on federal or state governments to compensate their losses.

Climate risks are generally perceived to pose challenges over a longer time period, but we see near-term material effects for some credits, and our expectation is that these impacts will grow. We focus on a forward-looking evaluation of risk by integrating ESG factors, including climate change risk, into the credit research process.

As part of the ESG integration into our fundamental credit analysis frameworks, we measure an issuer’s exposure relative to the size of its economy, both on an absolute basis and relative to peers. In addition, we periodically engage directly with certain issuers to bring awareness to climate issues that we believe are meaningful to them. Engaging directly with the issuers allows us to discuss mitigation and adaptation strategies as well as to make issuers aware that the market is watching.

Climate adaptation and resiliency projects require commitments of time and money to develop and execute; therefore, issuers will continue to be exposed in the near-term to the effects of these long-term risks. Understanding the challenges confronting issuers, the potential long-term cost of managing, mitigating or adapting to near-term effects and the potential comparative benefit to a municipality that undertakes an effective response is essential to a comprehensive and forward-looking credit analysis.

 

[1] https://wusfnews.wusf.usf.edu/post/sea-rise-making-fort-lauderdales-sewage-leaks-worse

[2] https://www.nytimes.com/2020/03/04/climate/australia-wildfires-climate-change.html

[3] https://www.ucsusa.org/sites/default/files/attach/2019/07/killer-heat-environmental-research-communications-article.pdf

[4] https://www.cnbc.com/2019/07/19/extreme-heat-wave-hits-us-farmers-already-suffering-from-flooding.html

DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are 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 such estimate, target or projection will be accurate; actual results may differ substantially.

Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. Investors should consult with their financial professional before making any investment decisions.

While Breckinridge believes the assessment of ESG criteria can improve overall credit risk analysis, there is no guarantee that integrating ESG analysis will provide improved risk-adjusted returns over any specific time period.

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