News & analysis
CLIMATE STORM GATHERING ABOVE CORPORATE BONDHOLDERS – REPORT
A new paper on climate risk in developed-market corporate debt portfolios exposes some interesting issues for inves- tors, finds Andrew Holt.
Bondholders are lagging shareholders when it comes to shield- ing their portfolio from climate risk, MSCI has discovered. Its concerns were outlined in a new paper – In Transition to a New Economy: Corporate bonds and climate-change risk, where it revealed the four areas owners of developed-market corporate bonds could potentially be holding huge climate risk. The first is that credit spreads of companies with the highest potential exposure to climate-policy did not reflect the full extent of such risk. “With their significant contribution to greenhouse gas (GHG) emissions and their dependency on polluting sources of energy, companies in the utilities, materials and energy sectors are exposed to climate regulations and uncertainties around their implementation,” the paper said. These sectors’ strategic role in economies around the world make it more likely that the pro-environmental policies target- ing them will be combined with measures to protect those busi- nesses through the low-carbon transition, observed the paper. Nevertheless, the uncertainty around the transition path and cost trajectory, as well as their potential failure to achieve net zero, suggest these sectors have the highest exposure to cli- mate-policy risk.
Do the credit spreads of firms in these sectors reflect the risk? “Our analysis shows that – controlling for credit rating, sector exposure, size and economic output – utilities, materials and energy firms did not face a statistically significant higher cost of borrowing – despite their higher climate-policy risk,” stated the report.
Outside of these three sectors, direct emissions seemed to have an impact on credit spreads in other sectors, such as financials and communication services. “However, given the size and significance of the indirect emissions for companies in these sectors, we cannot infer a meaningful relationship between their exposure to climate-policy risk and their credit spreads by only studying direct emissions, and defer this question to our future studies.”
Paying the price
The second point the paper highlighted is that corporate-bond investors are lagging equity holders in systematically pricing in climate-policy uncertainties.
MSCI studied the rolling correlations between credit spreads and emissions of companies in different Global Industry
Classification Standard (GICS) sectors and credit buckets to identify a potential trend or change in corporate-credit inves- tors’ perception of climate-policy risk.
“Our analysis showed that controlling for sector exposure, credit quality, size and economic output, the correlations between credit spreads and the direct emissions of utilities, materials and energy firms remained inconsistent between different universes and were statistically insignificant,” the report said.
Credit curves
The third area is that climate-policy has yet to be reflected in the credit curves of companies exposed to such risk. “Any uncertainty about the future asset value of a firm tends to result in a widening of its credit spread. However, different types of uncertainties can have different effects on the firm’s credit curve,” the authors of the report wrote. “Climate-policy risk, by the nature of the policy’s uncertainty, is likely to increase the volatility of the asset values of exposed firms. Consequently, it is more likely to lead to a steepening of the credit curve of these firms.”
The credit curves of companies in the utilities, materials and energy sectors exhibited a pattern of steepening since 2019, suggesting that climate “might” have had some impact on spreads. MSCI tested this hypothesis by comparing the slope of the curve of issuers with higher emissions with curves of issuers with lower emissions.
It discovered that the slope of the curve for companies with higher GHG emissions in these sectors was not materially steeper than those emitting lower amounts of harmful gases, suggesting that the market has yet to reflect climate-policy risk. “Combined with previous analysis, it becomes more evident that bondholders are lagging shareholders in pricing climate- policy risk in their portfolios,” noted the paper.
Risk magnitude
The fourth area is that credit spreads of companies with mate- rial physical climate risks appear to underestimate the magni- tude of the risk.
“In contrast to climate-policy risk, which is likely to affect the asset value of companies with higher direct and indirect emis- sions, physical climate risk can affect any company based on the physical location of assets and geographical exposure of the business,” noted the paper. Concluding, the report stated: “With this research, we aim to bring the magnitude of climate-change risk in corporate-bond portfolios to investors’ attention. “Although with uncertainty about climate policy and the nature of the physical climate risk there is no clear timeline for when this cost might materialize, investors may wish to consider the potential magnitude of the cost.”
Issue 109 | December-January 2022 | portfolio institutional | 7
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