Demand for securities that comply with Environment, Social and Governance (ESG) criteria has continued to mount, especially since publication of the Intergovernmental Panel on Climate Change’s (IPCC) latest reports which highlight the existential challenge that climate change poses to life on earth. In this context, there has been an emerging shift in investor focus from solely returns (with indifference to borrower purpose and practice) to ESG mission- and outcome-driven behavior. At the intersection there is conflict. The conflict is playing out politically in the US among states that have historically relied on fossil fuel extraction. (Think Texas, West Virginia, Alaska, Wyoming.) It is also playing out among our hyper-partisan elected officials and courts. Replacement of carbon-emitting activities with viable, cost effective, robust, and clean solutions is in its infancy. Inequalities of income and wealth have only increased in the last few decades. Progress is uneven and likely to remain so for some time.
Different views on investor purpose also show up among defined benefit pension managers on the definition of fiduciary responsibility to their plan’s members. This indifference to purpose also shows up in credit rating agency approaches as well, unless and until damage from extreme climate events are severe enough to impede financial stability of a borrower and where there’s no backstop such as FEMA or some other form of insurance. This last point about financial stability and climate events has come up among central bankers and other regulators and has already worked its way into European Commission oversight.
ESG investing had its origins in the corporate equity markets. Activist investors, interested in promoting better ESG outcomes among companies, could influence share prices, vote to replace management, boycott products, etc.; each of which can be an effective way to gain management and shareholder attention.
We address some ways in which ESG concepts and impact for the equity investor differ significantly in fixed income markets, particularly those investing in state and local government securities. Direct application of ESG concepts translates imperfectly. ESG shows up mainly in certification of individual bond offerings as “green” and more rarely, labeled as “social impact”. Impactful activities to “make a better world” — such as reducing inequality and increasing access to tools for wealth-building, take place mostly in non-financial (or “extra-financial”) arenas. To be sure, such efforts, when successful, add to GDP and well-being. Efforts in the municipal market take two distinct forms:
- First, portfolio managers and investors seek to avoid risk of climate disaster that may have financial consequences to the portfolio. Companies have sprung up to assess the risk of occurrence by county, census tract and associated CUSIPs.
- Second, and separate from avoidance, cities, counties, some states (also companies) have pledged to reduce carbon emissions and other harmful gasses (consider methane and municipal waste facilities). These efforts, at best, are community-wide and most often tend to be separate from specific bond offerings.
A Brief History
In 2003, Dr. E. James Gifford was the founding Executive Director of the UN-supported Principles for Responsible Investment (PRI). He is currently “Head of Sustainable and Impact Advisory and Thought Leadership” at Credit Suisse.[1] Dr. Gifford’s work focused on factors that “contribute to shareholder salience in improving the ESG performance of investee companies…” Stated differently, what are the key attributes that get managers’ attention to meet stakeholder demands?
- Power – using formal shareholder rights; replacing company management; lobbying for regulation
- Legitimacy – credibility of stakeholder; large shareholder; shareholder has political and policy support; general social acceptance of issue; company agrees with the change
- Urgency – shareholder resolutions; deadlines to be achieved; stakeholder willingness to apply resources
These factors apply to “whole of company” behavior – how employees are treated, diversity in senior leadership, carbon emission reduction across the company, its vendors, facilities and of course, investments. The PRI website now hosts a growing library of papers addressing these and many other issues.
Municipal bond investors don’t have such “whole of municipality” influence since they don’t own a share of the municipality. One might think of taxpayers and voters in a community as comparable to shareholders. Senior management is comprised of elected officials, both executive and legislative and local stakeholders express their preferences by voted their leaders in or out of office those who most closely represent their beliefs. But bond investors are likely to be located elsewhere with little or no voting power over management. Pricing impacts, too, are limited at this time.
To be sure, owners of a state or local entity’s bonds have a stake in the financial stability and success of the borrower (or obligor) but these outcomes do not have to align with PRI (as decades of credit ratings underscore). Credit rating agencies (CRA) play a role in the evaluation and grading of a borrower’s financial likelihood of repaying their bonds. But CRA, too, are indifferent to climate adaptation/mitigation efforts in their ratings to date. States have oversight and legislative powers over many local entities, further complicating a direct line from investors to borrower outcomes. Once a bond issuer closes a primary market offering, it has less concern about secondary market pricing (unless the borrower needs to come to market frequently).
PRI in the Municipal Market
In July, 2021, following-on PRI for corporate investors, a group of senior professionals in the municipal bond industry released a PRI report for sub-sovereign debt, specifically municipal bonds in the US. In September, 2021, PRI published this blog post, “US municipal bonds: ESG investors play catch up”. In the post, PRI calls for “better dissemination of ESG information, for example on a dedicated page on the issuer’s website or in financial statements.” However, currently, there are few pressure points for investors, aka “salience”, that connects state and local behavior with their action on climate change.
The Insurance Backstop
Reliance on federal and state financial assistance to make up for property damage is baked into the conventional credit ratings. Private insurance and assistance from NGO’s provide a financial lift as well. However, government agencies such as the Federal Emergency Management Administration’s National Flood Insurance Program (NFIP) and private insurance are reconsidering how to reform their policies now that major destructive events occur with greater frequency in certain places. The NFIP has borrowed from the US Treasury numerous times, highlighting the fact that insurance premiums do not cover the cost of damage and recovery. Given the large federal deficit, Congress and the last president looked at clipping back the NFIP’s appropriations. Re-authorization of the NFIP program has also been caught in budget battles several times, putting mortgage applications on hold, and creating risk for mortgage lenders. We expect that willingness to repeatedly ameliorate damage from major natural disasters will lessen over time.
The term “unprecedented” has begun to appear more frequently with each new storm season. Think “unprecedented” tornados in the Midwest this month, at a highly unusual time of year; “unprecedented” strength and path of hurricane Ida and others; “unprecedented” wildfires that destroyed so many homes and communities in the US Northwest, etc. The National Oceanic and Atmospheric Administration, NOAA, has published $1billion events for some time and created a handy database for risk managers. One only has to head over to the time series page to get the visual of increasing incidence. The summary notes that 2021 “is off to a record pace…” compared with the first nine months of any year. 2020 had previously set the record for the highest number of events. To be sure, protracted low interest rates have boost asset values and hence the dollar magnitude of damage but NOAA presents CPI-adjusted dollars lost, next to non-adjusted figures. It is daunting to consider the aggregate loss of value from severe climate events over time. You can see that summation on a map here.
Incorporating ESG factors in the investment decision
The municipal market has sprung a wide variety of third-party not-for-profit organizations and for-profit companies devoted to measuring risk, assessing event probabilities and certifying bond offerings as “green” or more recently “social”. Here too, there are some important distinctions.
While often used interchangeably, “climate change adaptation” and “climate change mitigation” have two different meanings, which we note, even as the two terms, in some contexts slush together.
- Adaptation, in a sense, accepts the status quo but attempts to protect a community’s residential and business property from harm from to extreme climate events. Examples include building sea walls, levees, raising coastal community roadbeds and buildings, relocating essential services to higher ground, creating absorption through permeable sidewalks and roads, green rooftops, etc.
- Mitigation relates more directly to carbon reduction, which individual communities undertake but must ultimately be global to make a difference. Examples may include ordinances to retrofit buildings with renewable resources, so they produce less carbon, swapping petroleum-fueled fleet for renewable, lower carbon-fueled vehicles, building charging stations to expand possibilities for electric-powered resident and commercial vehicles, increasing nature with plantings in the built environment to restore biodiversity.
However you choose to use the terminology there are two goals here:
- Direct protection of individuals and property at risk of damage vs.
- The need to reduce carbon and other emissions globally since we cannot predict exactly where and when warming effects will damage individuals and property.
ESG and Pensions
PRI has numerous papers on their site related to retirement systems. The US is the world’s biggest funded pension market. PRI cites more than 700,000 private sector retirement plans covering 136 million participants and roughly 6,000 state and local public sector plans serving 14.5 million active members and 10.4 million retirees. In addition, 46 million US households own at least one personal retirement savings account. Total assets are estimated over $30 trillion.
Early in PRI’s evolution, the controversy about indifference to investment uses vs. ESG focused on whether ESG investing can be part of plan managers’ fiduciary responsibility. PRI published a detailed legal and policy discussion on this topic, “Fiduciary Duty in the 21st Century” defining fiduciary duty along with nine individual country analyses.
Green Bonds
The Climate Bonds Initiative (CBI) released its standards for certification (Version 3.0) in December 2019 and expects a major update in 2022 that will include the transition to net zero. The CBI lists approved verifiers on their website. CBI verifiers consider alignment with the Principles for Responsible Investment in their verifications. The Municipal Securities Rulemaking Board’s EMMA system has added a field to their new issue calendar to note whether a bond offering is designated (or “self-certified”) as meeting green, social, or sustainable features. To date, it appears that “social” bonds are mostly those issued to build or modernize affordable housing.
On the housing and commercial real estate front, there is activity to reduce carbon emissions, which helps the local environment as well. Tessa Hebb, et al, wrote “Responsible Property Investing in Canada: Factoring Both Environmental and Social Impacts in the Canadian Real Estate Market” (Journal of Business Ethics (2010) 92:99-115)[2] The article notes “extra-financial” determinants of business performance wherein developers and construction companies seek to reduce negative environmental and social effects of projects. Authors also mention community property development where “both social and environmental considerations related not only to the building, but also the project site and surrounding community are integrated into management and investment decisions.” Affordable housing, workforce housing, “urban revitalization and brownfield redevelopment” are included, and these activities relate to greening state and local government capital planning.
A Sustainability Index and Credit Ratings
Unlike equity markets, the municipal market is dominated by retail investors, who rely on credit rating agencies to offer an opinion on the probability of re-payment from a borrower. Credit rating agencies historically have not incorporated non-financial ESG factors into their ratings evaluation. Credit rating agencies are typically back-ward looking, preferring to wait until financial impact is visible and measurable rather than speculating about future events that might affect financial condition. Achieving carbon reduction goals, to our knowledge, are not currently part of the credit rating decision. Given the lack of precision to pinpoint disasters by borrowers, this is an appropriate approach, but gives an incomplete picture for the risk manager and for buy and hold long-term investors. That said, credit rating agencies look favorably at broad plans to manage climate risk. (Bond insurers are another available layer of oversight and evaluation for the retail investor. Offering long-term, life-of-bond policies, they typically take environmental risk into consideration.)
Mutual fund, ETF and, as mentioned above, bond insurance analysts also serve as gatekeepers for the retail investor, typically using third party data and technology to help investors decide which funds and which bonds to purchase and which to ignore.
SolAbility, one such third party evaluator, publishes a “global sustainability competitiveness Index” (GSCI) (for countries) that incorporates 131 ESG indicators and recently published their 2021 results here. The USA ranked 30th among the 131 countries. “The US ranks particularly low in resource efficiency and social capital…” according to the report. SolAbility comments that conventional CRA do not take into account factors that are fundamental to a borrower’s current situation, stating “credit ratings describe symptoms, they do not look at the root causes. It is therefore questionable whether credit ratings truly reflect investor risks of investing in a specific country, in particular for long-term bonds and investments.” The report offers a sustainability-adjusted credit rating and compares this with conventional ratings, which would raise some current sovereign ratings in the developing world and lower others (see page 14 of the report). SolAbility strongly advocates a carbon or “climate” tax and incorporates social factors into their assessments.
On Limited Progress in the US
The United States ranks second in the world, after China, for producing the highest levels of CO2 emissions. India, the Russian Federation and Japan round out the top five. In the US, EPA shows the inventory of emissions by type and source between 1990 and 2019. Greenhouse gas emissions (GHG) have moved very little over that time. In fact, US GHG emissions (which include CO2, methane, and other gasses) increased 1.8% over the period. In contrast, the EU has reduced emissions by more than 28% in the same time frame. The next largest emitter, the Russian Federation, has reduced its emissions almost 33%. However, if one measures the US from 2005, there has been a decline but that decline shaved off the steady increases that occurred from 1990-2005.
Municipal solid waste (MSW) landfills are the third-largest source of human-related methane emissions in the United States, accounting for approximately 15.1 percent of these emissions in 2019. MSW, however, can be re-designed to capture emissions, recycle the energy or sequester CO2 in the ground.
Local Governments in the US are Actively Limiting Carbon Emissions
In 2015, world leaders came to agreement to substantially reduce global greenhouse gas (GHG) emissions to limit the earth’s temperature increase to 2 degrees Celsius (above pre-industrial levels) with a further goal to pursue a limit increases to 1.5 degrees – also known as the Paris Agreement. The agreement went into effect November 4, 2016 and updates on five-year cycles. The Intergovernmental Panel on Climate Change indicated that we would need to lower CO2 emissions about 45% by 2030 (relative to 2010) to achieve a reduced warming of the earth to 1.5 degrees.
Following the Trump administration’s withdrawal from the Paris Agreement, many municipalities rose to the occasion to work on reducing carbon emissions. When President Trump withdrew US support, 4,000 entities, including numerous cities, states and private organizations joined together to form “We Are Still In”, to chronicle their efforts to reduce carbon emissions despite the federal government. The coalition is comprised of governors, mayors, legislators, universities, investors, faith groups and healthcare organizations which officially signaled their commitment to the Paris Agreement. These pledges include investing in clean buildings, low carbon transportation, a modern electric grid and other infrastructure, smart agriculture that together would set the United States on a target to zero emissions by 2050.
Commitments were submitted to the UN on behalf of the United States. Climatemayors.org is a member of this organization and publishes an annual compendium of pledges and outcomes to reduce carbon.
Under the new administration, this coalition continues and has been re-named: America is All In (The link lists the 147 city signatories, 13 counties, 1161 businesses, 42 investors, 3 states, 2 tribal nations, 127 colleges and universities, 42 cultural institutions, 250 faith groups, and more than 300 hospitals.) In a way, the US presidential withdrawal motivated these institutions to independently rally around the decarbonization mission.
Other local government organizations that are similarly active include:
- ICLEI – Local Governments for Sustainability is a global network of more than 2500 local and regional governments across 125 countries. ICLEI embraces five pathways that guide local and regional development: low emission, nature-based, equitable, resilient and circular development (think re-use and re-generation of bio-diversity). ICLEI maintains a database of activities towards these goals on their website.
- Global Covenant of Mayors for Climate and Energy encompasses almost 12,000 cities comprising more than 1 billion people in 140 countries is dedicated to leading solutions to climate change – lowering carbon emission and increasing resilience to adverse climate events. Leadership is held between the European Commission Executive Vice President for the European Green Deal, Frans Timmermans and the UN Secretary-General’s Special Envoy for Climate Ambition and Solutions Michael Bloomberg. (We note that ESG job titles tend to be very long!)
Their advisory committee also includes these local government organizations:
- C40: includes 97 member cities across the globe, encompassing more than 700 million people. C40 is focused on social issues as well as climate, such as climate migrants and gender equality. C40 was founded in 2005 by then Mayor of London Ken Livingstone.
- UCLG: United Cities and Local Governments is “committed to representing, defending, and amplifying the voices of local and regional governments to leave no-one and no place behind.”
- CDP: CDP is a not-for-profit charity that runs the global disclosure system for investors, companies, cities, states and regions on environmental impact. CDP has scored 965 cities as of 2021 of which 95 cities received an “A” rating. We counted 34 of the 95 in the US.
- The UN Habitat for a Better Urban Future has significant resources about cities, with a focus on children, particularly those that have been displaced, smart cities and the “blue economy”.
- The Urban Sustainability Directors Network (USDN) is a group of local government professionals across Canada and the US sharing best practices on creating a healthier environment, economic prosperity and increasing social equity.
- Finally, the United Nations Climate Change includes a host of COP26 resources.
Carbon Tax?
William Nordhaus, economist and Nobel Laureate gave the keynote speech at the G20 gathering of foreign ministers in July 2021, watchable on YouTube here. (Foreign Affairs, October 2021, reproduces the main points from the keynote, “Why Climate Policy Has Failed”, paywall likely). The speech was disheartening for those concerned about carbon reduction. Nordhaus asks whether our political systems can “catch up with the geophysical realities that threaten our lives and livelihoods.” Measuring success is largely about knowing the existing level of carbon emissions and their sources and progress made in reducing it. As mentioned above, the rate of decarbonization has remained unchanged between 1990-2019.
Nordhaus argues that the price of emitting carbon into the atmosphere is essentially zero. Secondly, there are few incentives to invest in low carbon emitting technologies. Third, he asserts, there is limited international policy that advances carbon reduction. Current policies would increase emissions 25% by 2030 while achieving the Paris Agreement’s two-degree target would require a 30% reduction. To have real change, each of these factors need to be addressed. Nordhaus favors carbon taxation, which would more accurately recognize the cost of carbon emissions and help pay for damage recovery.
Learning from the European Union
The EU has created a permanent expert group from the private and public sectors, industry, academia, civil society and the financial industry. The group is are charged with developing a “taxonomy” of definitions for activities that are considered environmentally sustainable. The taxonomy is designed to help differentiate meaningful activities from “greenwashing” and encourage creating a circular economy that restores, renews and revitalizes energy and materials. Their six objectives:
- Climate change mitigation
- Climate change adaptation
- Sustainable use and protection of water and marine resources
- Transition to a circular economy
- Pollution prevention and control
- Protection and restoration of biodiversity and ecosystems
For more on the EU’s activities, see here, here and here.
Coming Soon to a Securities Industry Near You
EU investors are now required to disclose how they integrate ESG factors into their investment decision-making. In the US, the SEC has requested input on disclosure related to climate change; the CFTC has established a new climate risk unit, the Federal Reserve has created a new committee to explore the relationships among climate change, banking and the economy and the Federal Housing Finance Agency has issued a request for disaster risk information and the housing finance system. (From PRI, “ESG Integration in Sub-Sovereign Debt: the US Municipal Market”, July 28, 2021, sourced December 18, 2021). The significant recent increase in US municipal taxable securities, many of which were bought by global investors, is likely to increase demand for ESG integration on municipal borrowers. The “Big Four” accounting firms have agreed on metrics on disclosure in Europe; they will likely move to their US clients before too long. In Europe, compensation for senior management is increasingly being tied to achieving effective ESG standards.
Investors should be aware of and prepare for these trends to continue. It is important to acknowledge the distinctions between adaptive infrastructure and mitigation of carbon emissions. It is also important to recognize that many activities considered ESG for equity investors are “extra-financial” for fixed income, nevertheless important. In determining the impact of fixed income investing, recognizing the different organizational structures of companies vs. state and local government issuers may help better focus one’s impact.
[1] His article in the Journal of Business Ethics “Effective Shareholder Engagement: The Factors that Contribute to Shareholder Salience” (2010, Vol. 92, Supplement 1: Investing to Build Sustainable Communities” pp. 79-97 may be accessed through JSTOR).
