Global credit: what to do about rising capital costs for carbon emitters

With investors’ growing focus on environmental, social and governance (ESG) considerations, bonds issued by US utilities with high carbon emissions are increasingly trading at wider credit spreads than issues of companies with lower emissions. We expect this trend to continue and become even more pronounced in the years ahead, which reinforces the case for taking ESG factors into account when making investment decisions in global corporate bond portfolios.

Systematic integration

We believe that material ESG factors can have a significant impact on the long-term performance of the companies we invest in. As a result, we systematically integrate ESG considerations into our management of global investment-grade corporate bonds to limit our exposure to companies that aren’t addressing material sustainability risks. Similarly, we limit exposure to bonds issued by companies our analysts see as presenting an uncompensated credit risk to portfolios. We also avoid issuers with excessive ESG risk, no matter how cheap their valuations, to reduce the risk of investing in potential value traps, just as we avoid issuers rated sell by our firm’s credit analysts.

In some cases, it may even be appropriate to avoid entire industries in which companies have failed to address material ESG risks. That’s because this kind of failure creates the potential for regulatory action or shifts in investor capital that may significantly impact the value of bonds issued by companies in those industries.

Avoiding fossil fuels

For example, one of the ways we mitigate environmental risk in the Wellington Global Credit Plus Fund is to exclude issuers engaged mainly in the production or distribution of fossil fuels, as well as issuers involved in electricity generation using thermal coal. Investor capital is already shifting away from these issuers, as demonstrated by the rising cost of borrowing for issuers responsible for significant carbon emissions.

Figure 1 shows the index-relative credit spreads of two operating companies owned by a major US electricity utility. Both issues mature in 2049 and have the same credit ratings. The first (A) is an electricity transmission and distribution company that generates no direct carbon emissions. The other (B) is an electricity-generation company with a heavy reliance on coal. The coal-reliant Company B has underperformed over the last year as investors’ focus on carbon emissions has intensified.

Figure 1

In our view, this trend of underperformance for carbon emitters will become more recognised by the market over time. Through the systematic integration of ESG factors into our investment process, the Wellington Global Credit Plus Fund aims to limit exposure to this and other ESG risks, and we believe this focus on avoiding issuers and industries that represent uncompensated ESG risks will benefit the Fund’s performance in the years ahead.

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Forward-looking statements should not be considered as guarantees or predictions of future events.