Total time: 12:22
0:02
Jessica McHugh: In today's sustainable investing podcast, we're going to talk about climate change, how well cities are prepared for it and whether it's reflected in their credit ratings. I'm Jessica McHugh and I'm joined by my colleagues, John Sama and Nick Erickson. John is a data analyst, and Nick is a portfolio manager here at Sage. Thank you for joining us.
0:22
Nick Erickson: Thanks for having us, Jessica. Feel like I'm at home.
0:26
Jessica McHugh: You are, in fact, at home. So one thing that has really been at the forefront of ESG investors’ minds lately is climate change. And it's becoming more important because, you know, while climate change squarely falls into the category of an environmental risk factor, it has implications for the S and G, or social and governance, risk factors as well. And so one of the investments Sage evaluates is bonds from cities or municipalities. And the two of you, John and Nick, recently wrote about whether a city's level of risk and their level of preparedness for climate-related events is reflected in their credit ratings. So were the results as you expected them to be?
1:05
John Sama: Yeah, overall, yes, we did see what we're expecting to see with the data. So looking at the averages, so the average readiness, going from the higher AAA-rated down to the lower rated BBB, we expected that the average readiness would decline in a steady trend. And then see the opposite with risk, where we'd see a lower risk rating for the AAA, and then a higher risk rating for the BBB. And overall, this trend pretty much held. There were some small hiccups. For example, in the A-rated credit, we saw a drop in readiness, which we weren't expecting, or the average readiness for single A's was actually below that of BBB's. So there's some little nuances there. And then as you look the regressions and the correlations, just in general, the correlations were a little weaker than we had hoped. But the regressions were in the right direction that we were expecting per credit rating.
2:16
Nick Erickson: And I think from a municipality standpoint, you know, you would expect a municipality that is higher rated to naturally have the ability to be better prepared for any type of, you know, municipal risk, be it infrastructure, whatever it may be, even in particular, this one climate risk, because, you know, they had the financial flexibility theoretically to implement programs and preparedness programs to deal with any type of risk their constituents may face.
2:48
Jessica McHugh: So, Nick, why is it important to consider climate-related event risk when we're analyzing whether Sage wants to buy a city's bonds?
2:58
Nick Erickson: I mean, it comes down to being adequately compensated for the amount of risk you're taking from a municipal bond perspective, be that financial risk, pension risk, population risk, where populations leave particular municipalities. As the Rust Belt, you know, found out a decade ago with this particular one, comes down to climate-related risk, and it's a tougher one to deal with because it's a forward-looking problem. We don't have a lot of experience yet dealing with some of the climate-related risks that these municipalities could and will face, be sea level rising, extreme storms, extreme floods, droughts, etc. So it's extremely important when you're buying these long-dated municipal bonds that are 2030, even 100-year obligations for these municipalities, to be able to kind of place a value on these types of climate risks with these municipalities and making sure that you're being adequately compensated for the risk you're taking,
4:01
Jessica McHugh: Was there risk and preparedness data self-reported by these cities or where did this data from your report come from?
4:09
Nick Erickson: The data came from, it's called ND GAIN. So Notre Dame, higher education institution, Notre Dame created this body within, and it's there to generate these reports. And what they did is they pulled down the bulk of the data from the NOAA, which is the National Oceanic and Atmospheric Administration. And then they use this data, they can start to create a methodology which allowed them to categorize and eventually assign a climate risk and readiness score to each of these municipalities. And so the NOAA reports monetary damages from floods that reside wholly within a municipality. An example would be like when the hurricanes hit Houston, NOAA would have to add on all the damages that were accumulated during that storm. And they would store that data, Notre Dame would pull that data down, aggregate it, and then develop what they will determine is a kind of an average cost for these types of storms going forward for this municipality, and that would allow them to assign a risk score. And then they would look at the infrastructure of Houston to handle that type of situation in the future, and that would allow them to help construct a preparedness score.
5:21
Jessica McHugh: Okay, so this was historical data, and not necessarily data that was disclosed by these cities. Are cities disclosing their climate-related risks?
5:31
Nick Erickson: That's a tough question to answer because in the municipal world, it's tough to figure out if municipalities are reporting any data accurately, let alone climate-related forward-looking risks. My honest opinion is no, I don't think they are even looking, necessarily reporting on what they view as our climate-related risks. If you're a municipality on the Eastern seaboard of Florida, it probably doesn't behoove you to forecast out what your future climate risks are for sea level rising and hurricane risk because it would negatively impact theoretically your municipality from either a bond funding standpoint, population standpoint, or any of these types of things.
6:12
Jessica McHugh: Got it. And so where do rating agencies come into play here? I imagine that the municipalities aren't reporting it in part because it's not required. Are rating agencies currently including some climate-related risks in their ratings of these cities?
6:30
Nick Erickson: Yes, I think they are to a degree. I think their focuses right now are on the more heavily at-risk municipalities like Florida, the eastern seaboard, the western seaboard, anywhere where the economic cost of a climate-related risk could be huge. They're going to focus there first. As with all things in fixed income, municipals come last. And so you know, the ratings agencies are buying up these kind of climate-focused software and data analytic firms, and they're applying the methodologies that they are acquiring into the corporate bond space first – this is one of the largest – but the trickle-down effect is coming, you're seeing them apply their methodology to, you know, some of the bigger municipalities on these seaboards. And they're filtering that into the credit ratings of the particular type of bonds that are being issued, especially when you're looking at different term structures. If it's a 30 year, you know, Miami shorefront municipal bond, they're going to factor in future climate risk into that credit rating.
7:38
Jessica McHugh: And speaking of data analytics, John, you did the data analysis for the report. How did we process the data and how did you illustrate it within the report?
7:48
John Sama: That's a good question. So we took the data that we got from Notre Dame, and we were able to enter it into Tableau, which we then clean the data a little bit taking out some of the non-relevant pieces and some of the cities that didn't fit within the model. From here, what we did was group the data by credit rating. And we kind of used the separated credit ratings throughout our analysis. First, we did some simple statistics, just looking at your basic box and whisker plot. So that looks kind of like the median, your average, your quartiles, and things of that nature. So we did the risk and readiness for each credit rating and then put them side by side. So we can kind of see where the general trends of the averages within credit ratings lied, and then also how the trends went from credit rating the credit rating. Then going a little more in depth, what we did was we plotted all the cities by credit rating on a scatterplot. This gave us kind of some quartiles that you can kind of see when you look at the charts to see are these municipalities more risky, less risky. And then using that scatterplot that's kind of where we went into the more in-depth stuff, which was looking at correlation, regressions, and things of that nature.
9:10
Jessica McHugh: What are some other factors that maybe aren't reflected in the data that would be important to look at when making conclusions about the correlations between a city's credit rating and its level of risk and preparedness for these climate-related events?
9:24
Nick Erickson: I would think it would be very important to kind of look at if you're looking at a municipality who might have a high preparedness rating, to really dive in and look at where they are geographically. You know, are they are they adequately using their resources to obtain this high preparedness rating? Are they overextending the resources to obtain this preparedness against the climate risks that probably won't materialize? On the flip side of things, you know, if we move out of general obligation-type bonds into kind of a revenue-type bond, like a water bond or those types of bonds, it would be important to look at, you know, kind of the geographical sources of water as a risk to the municipality – typically those areas would be more at risk to extreme events like droughts, and being able to factor that in on a geographical basis and where their water sources are, would be a huge determinant on how we value that particular type of credit, especially on a forward-looking basis. Population growth, population density are all important factors that, you know, as we move forward, we would want to incorporate into our analysis as we're looking at these climate-related risk, and the level of preparedness for these risks.
10:41
Jessica McHugh: And so those sort of explanations will be forthcoming. Right?
10:46
Nick Erickson: I think so. I think we have enough data here and we have, you know, the ability to really kind of parse it out and create a construct, a coherent thought on how these municipalities are being affected by particular climate risks and you know whether their credit rating reflects that or whether they're being properly valued in the market.
11:12
Jessica McHugh: Perfect. Well, thank you, John and Nick for joining us today. To view this and other ESG perspectives from Sage please visit our website, sageadvisory.com.
Sage Advisory Services is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. This podcast is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.
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