Executive Summary

Addressing the Materiality of Climate Change Risk Through Issuer Engagement

Breckinridge’s 2021 Issuer Engagement program focused on climate change risk as a unifying theme. We view climate change as a risk multiplier for corporate, municipal, and securitized bonds. It is an integral factor in our approach to environmental, social and governance (ESG) risk assessment.

During the first eight months of 2021, our research team members held nearly 60 direct engagement discussions with issuers and subject matter experts (SMEs). These meetings were in addition to the numerous interactions the analysts had routinely with issuers and SMEs as they conducted new security research and ongoing surveillance of the bonds in our investment portfolios.

UN Report Starkly Illustrates the Challenge

This year, the United Nations (UN) confirmed that climate change risks are permanent and intensifying. On August 7, 2021, the UN Intergovernmental Panel on Climate Change (IPCC) assessment report stated that climate change is unequivocally driven by greenhouse gas (GHG) emissions caused by human activity.

Climate change and its consequences—extreme weather including hurricanes, typhoons, cyclones, and tornadoes; rising seas; melting ice caps; wildfires; deadly urban heat; coastal flooding; persistent droughts—are constant threats to human life and commerce. The more than 200 scientists convened by the UN to develop the report concluded that nations can no longer stop global warming from intensifying over the next 30 years.

While the science says that there is still a short window to prevent a disastrous future, the authors warned that, even if nations started sharply cutting emissions today, total global warming is likely to rise to around 1.5 degrees Celsius within the next two decades.

Designing the Engagement Program on Climate Change Risk

During our 2021 issuer engagements, our analysts, issuers, and SMEs explored material physical risks of climate change. They also examined transition risks facing corporate and municipal issuers as they adapt to a low- or no-carbon economy.

Our engagement discussions also highlighted the dimensionality of climate change. Climate change is a pervasive risk across corporate and municipal sectors. This dimensionality of material climate change risks can complicate the task of transitioning to a low- or no-carbon economy, but it also may provide potentially powerful opportunities for collaborations that can accelerate progress. For example, representatives of city and state governments spoke of effective partnerships forged with regional groups addressing risks associated with water/sewer services. Corporate issuers discussed with us their work with SMEs to develop climate risk mitigation, adaptation, and measurement strategies.

Two of Many Investment Insights from Issuer Engagement Meetings

Two conclusions from our engagement discussions on climate change are inescapable:

1. By and large, issuers recognize the threat of climate change to their current operating models and are seeking to mitigate the risks, but remain in the early stages of doing so; although there are pioneers, and
2. Investors must be discerning as they decide where to direct their investment capital for long-term sustainable performance in the markets and society.

Corporations at Various Stages of Addressing Climate Risks

Among corporate bond issuers, we learned that companies in the banking sector are increasing lending that targets sustainability projects, specifically climate change. The banking industry is also a leader in reducing GHG emissions in operations. In the energy and transportation sectors, we believe that carbon is a financially material ESG consideration. While the energy companies we met with have room to improve GHG emission-reduction plans, the large majority of transportation companies that we engaged with are targeting science-based GHG emission reductions.

In the corporate sector, we found food and beverage companies are developing innovative approaches to addressing the climate-related risks of water stress and scarcity. Those companies are moving the fruits of their research down the supply chain to farmers and other producers. Meanwhile, in the retail sector, bond issuers continue to balance addressing climate-risk concerns with consumer sentiment that often drives business to the most convenient and lowest-price provider.

Municipal Bond Issuers Confront Multiple Challenges, Often Locally Defined

In the municipal market, we spoke with management teams at the state and city level, at municipal utilities, and at housing finance authorities. States often commented on the need for greater direction and funding from the federal level. As noted, cities are collaborating with state and regional teams that focus on local climate concerns. For example, our engagement with cities highlighted concerns associated with heat island effects in urban centers, and the inclusion of social and environmental justice considerations in mitigation and adaptation.

Municipal utilities—those providing electricity and those providing water and sewer services—also demonstrated growing understanding of the climate challenges they face. Power companies that are under regulatory mandates to achieve net zero emissions are setting strategies to reach their goals. Water and sewer utilities face a range of climate-related risks that are specific to their local service areas, from flooding in some areas to extreme drought in others.

Housing finance authorities face the dual challenge of addressing climate risk while preserving and adding to affordable housing stocks in their communities. We learned they are in the early stages of their strategy development, but some promising mitigation and adaptation responses are emerging.

Mortgage-Backed Securities and Climate Change

We also discussed integrating climate change risk in analysis of mortgage-backed securities (MBS) with one of the nation’s largest government-sponsored enterprises (GSE) that issues mortgage bonds. The agency is in the early stages of including climate change in its considerations. We had the opportunity to advocate for more robust risk disclosure.

Disclosure Must Be Improved to Better Serve Investors, Increase Climate Change Understanding

Another current vulnerability that was mentioned frequently during our engagement discussions was disclosure on climate risk. We discussed with issuers reasons that investors cannot access relevant information on climate risks. Some organizations may not have integrated comprehensive climate risk disclosures in their reporting practices. Regulatory requirements may not be up to date with the rapidly changing information required for robust climate risk reporting. Finally, and this rings true in our experience with issuers of municipal bonds, sufficient resources—financial and human—are not available to provide investors with comprehensive climate risk data.

We believe that the most sustainable businesses and municipal operations will be those that best plan for, mitigate, and adapt to climate change risk. The quality of disclosure on climate risks currently is often inadequate for investors seeking information before making an investment decision. It also is inadequate for a world seeking to measure and monitor progress in managing climate change.

In light of the IPCC’s report, there is no time to be lost in this effort. Investors will need to be discerning in their analysis of the bond issuers making the best progress to achieve their climate risk management goals.

The summaries of our engagement efforts that follow in this report, show that most issuers across corporate and municipal bond sectors have come to recognize the operational risks associated with climate change. Nevertheless, we found that they are still in the early stages of defining and setting strategies to mitigate, adapt to or become more resilient to the risks.