On May 27, 2021, a couple of events in the energy sector occurred that demonstrated the continued mainstreaming of sustainable investing and underscored the risks and opportunities available to investors. While primarily thought of as equity-oriented, sustainable investing is becoming more mainstream in fixed income markets—and companies that fail to acknowledge changing dynamics may potentially face financially material impacts.
Sustainable Investing
Sustainable investing is an umbrella term to describe a range of investment practices that seek competitive financial returns and purposefully consider environmental, social and governance (ESG) risks and opportunities. Approaches such as socially responsible investing (SRI), ESG investing and impact investing all fall under this umbrella. These three approaches align with investors’ primary motivations for considering sustainable investing—aligning with international norms/values, improving risk-adjusted returns, and providing a positive impact on society.
Transition Risks
Equity returns in the energy sector have led the S&P 500 Index during 2021 as crude oil prices have soared and, on the surface, seem to show little concern for oil and gas companies’ approach to managing climate risks. However, energy sector bond investors appear to be reevaluating their holdings to get ahead of possible changes. Bond investors, who typically have a longer investment horizon, are increasingly having to consider the financial materiality of climate change.
On May 27, a Dutch court ruled that Royal Dutch Shell PLC needed to slash its carbon emissions 45% by 2030, a move that illustrates the increased pressure from governments to speed up the transition to a low- carbon economy. On the same day, Exxon Mobil Corp. shareholders elected board members who were nominated by a coalition of investors demanding that the company speed up its plans to transition to a low- carbon economy.
Both of these decisions accentuate the changing investment dynamics for how investors look at oil and gas companies. Transition risks resulting from changes in climate and energy policies, a shift to low-carbon technologies, and liability issues may negatively impact the cost of capital for oil and gas companies.
Even as crude oil prices have soared, bonds have lost value. As seen in Figure 1, Euro-area energy bonds have underperformed Euro-area corporate bonds. Global fixed income credit markets have seen credits spreads, a measure of credit risk, compress this year due to a recovering economy and the continued search for yield. Energy bond sector underperformance is notable and speaks to the financial consequences for companies that are lagging in adjusting to the risks associated with a transition to a low carbon economy.
Moreover, energy companies will likely continue to see their costs to issue debt increase as rating agencies are increasingly incorporating transition risks into their rating decisions. S&P, one of the main bond rating agencies, recently put the oil and gas industry at “moderately high risk,” citing concerns about energy transition risks. Analysis by Bloomberg suggests that approximately $156 billion of North American and European oil debt is at risk of downgrade. Lowered credit ratings generally mean higher capital costs on new and refinanced debt.
Opportunities
Many attribute this contrast between the energy equity and bond markets to the positioning of large purchasers of bonds, including central banks, sovereign wealth funds, insurers, and pension funds. For context, during 2020, the European Central Bank (ECB) purchased $105 billion, the Bank of England over $13 billion, and the U.S. Federal Reserve nearly $5 billion of corporate bonds through their stimulus programs. Some central banks have indicated that they would consider their role in reducing carbon emissions when selecting corporate bonds. In March of this year, the Bank of England indicated that it would adjust its corporate bond-buying program to account for the climate impact of issuers and discontinue subsidizing polluting industries.
Additionally, other large asset owners such as corporate pension funds, insurance companies, and mutual funds are also increasingly moving assets to debt linked to ESG initiatives. Over 2,300 organizations, representing over USD $80 trillion in assets under management (AUM), have signed the United Nations Principles of Responsible Investing. While certainly not all fixed income related, the sheer size of AUM interested in sustainable investing will impact fixed income markets broadly. As such, the general make-up of debt markets will continue to evolve and, we think, will include a growing share of debt linked to ESG risks and opportunities.