Transcription:
Lynne Funk (00:03):
Hello everyone, and welcome to another Bond Buyer podcast. I'm Lynne Funk, executive editor at The Bond Buyer. I'm excited to welcome Ruth Ducret, Senior Research Analyst at Breckinridge. Ruth has more than 19 years of experience in the investment industry. Prior to joining the firm in 2016, she was an analyst with Standard & Poor's where she covered local governments for the firm's US public Finance group. She also analyzed money market funds, local government investment pools, and longer duration bond funds. And prior to S&P, Ruth worked for the Michael J. Fox Foundation. So welcome, Ruth.
Ruth Ducret (00:38):
Hi Lynne. Thanks so much for having me.
Lynne Funk (00:40):
Great. Great to have you. Before we get into the meat of the topic, which we are going to cover — ESG and climate risk — Can you just tell us a little bit about the Michael J. Fox Foundation work you did?
Ruth Ducret (00:53):
Sure, sure. Well, it was a job I had right out of college and working with the foundation for Parkinson's Research and really an amazing experience. Got to meet Michael J. Fox a bunch of times, and he really is as great of a person as he appears. Really wonderful, wonderful man. So enjoyed my time there.
Lynne Funk (01:17):
Great. Thanks for that. I know municipals are very interesting, but when I saw that in your bio, I was kind of like, we have got to hear about this too. So let's talk about your role at Breckinridge. Can you lay out what you do and what you cover and Breckinridge's way of thinking about climate risk?
Ruth Ducret (01:41):
Sure, sure. Happy to do that. I've worked at Breckinridge now for about seven years as a municipal research analyst and as a member of the municipal research team, I cover tax-backed sector from the state level down to the school district level, as well as a variety of revenue sectors such as water, sewers, airports, and hospitals. Those are the three main enterprise sectors that I work on. And at Breckinridge, I think we really have a unique way of thinking about ESG and incorporating it into our research. So thinking about environmental, social and governance risks is something that goes hand in hand with our traditional credit analysis at Breckinridge Capital Advisors. We started purposefully integrating ESG considerations into our analysis over 10 years ago. So we don't have a separate ESG department, but rather we have all of our analysts on the team is responsible for and really involved in the integration of ESG factors into our analysis.
(02:47)
So our fundamental view is that ESG research gives us a more holistic understanding of an issuer's credit profile and credit risk profile. And so it's more about trying to incorporate non-financial metrics and data into analysis, but we think about how this data can ultimately impact the balance sheet. So it's really the integration of E S G into everything we do. So it might not always move the needle, but our research has proven to be valuable in identifying outliers in key metrics. Then that'll prompt an analyst to dig a little deeper into that risk that in order to determine if it's material on top of the creation of our frameworks, which I'd like to talk about in a little bit. Sometimes it also involves direct engagement with an issuer, so that can also supplement our research and hopefully raise awareness for the issuer. So there's a real give and take and real engagement there.
(03:49)
And then the added benefit is that over the years with this engagement with talking directly to issuers, it's helped to frame and inform our frameworks and learning about emerging trends and risks and any limitations that communities might be facing in order to address certain risks that can be incorporated into our frameworks. So the way that we integrate ESG into our traditional credit analysis, we've created 10 proprietary sector specific muni-focused frameworks. Depending on the sector, the frameworks might be more heavily weighted towards the E, the S, or the G. So for example, our water sewer framework has more environmental factors. While our hospital framework is more focused on social factors, the frameworks are run every time we look at an issuer. So every time we're doing a credit review, we're also incorporating these frameworks and they're a blend of both quantitative and qualitative metrics.
(04:50)
So where the data is scalable and it's repeatable and it has a sound methodology, we use quantitative metrics. But if there's a concept that's material, but maybe the data's not scalable or repeatable, which you can also often encounter in munis, we try to develop a qualitative way to assess the risks, and we try to align that thinking with the work of broader thought leaders in the different areas. So a for higher ed healthcare, hospitals or the American Society of Civil Engineers for transportation. Once all the metrics in our sector framework are scored, that the analysts can then review the data and assigns an SS 1 to an SS 4. So SS 1 is the best in class and SS 4 is the worst. And then that sustainability rating feeds into our underlying credit rating, and it also determines an issuer's eligibility into our sustainable strategies. So we have a best in class sustainable strategy, which will only take SS 1 and S 2s into that strategy. And when using the framework, then we are ultimately looking for outliers, and then those SS 1s through SS 4s will influence our traditional credit rating, and that's what traders use for price execution. That's generally an overview of how we think about E S G and how we really integrate it into everything that we do.
Lynne Funk (06:25):
That's interesting. You've been, Breckenridge has been, I would say, a leader in the space. Obviously you've been doing it for a long time. It's interesting to me that you worked with the issuers to develop these frameworks. So talk about then the investors, because clearly you are seeing a demand from the investors that want this kind of information. So maybe talk about that. I know we had spoken before we got on this podcast about some of the other stuff that you are involved in, the other groups in the industry that you engage with, so maybe talk about that for a bit.
Ruth Ducret (06:59):
Sure. Yeah, we do try to engage, and in terms of engaging with the issuers, it's really a back and forth relationship. So we hope to get ideas from them and we hope that by showing what investors are interested in and the topics that we're focusing on, that issuers can perhaps going forward incorporate that into their official statements or in some of their other types of disclosure, recognizing that this is what's important to investors out there. But just in terms of some of the other work that at least that I'm doing, this is just a small sample I'd say of what Breckinridge as a whole does, but in terms of myself, I serve on as a member of the sustainability committee at Breckinridge and then also on ICMAs Advisory Council of the Green Bond principles and Social Bond principles. So ICMA stands for the International Capital Markets Association.
(08:00)
That's been a group that set out a standard framework of how to report and disclose on green bonds or social bonds or sustainable bonds, which are part of what many people in the industry called the labeled bonds or the labeled bond market. It's very popular in Europe and around the globe. It really developed first in the corporate market, but we're seeing it more and more on the muni side, and I think munis are just so well aligned with the labeled bond market because use of proceeds oftentimes just fit so well into either a green or a social impact. So that I think we're going to continue to see a lot more issuance going forward in this market. In addition to that, I'm also a member of the Sub Sovereign Debt Advisory Committee of the PRI, or the Principles for Responsible Investment. And then recently I contributed to the California Green Bond Market Development Committees recommended approach for municipal green bond disclosure.
(09:00)
So that's kind of a mouthful, but basically it was a group that the treasurer of California, she established to help issuers in California, but then beyond California, better understand how to issue green bonds. As I was saying before, what many municipalities issue for can be so well aligned with the green bond principles. And so what our group, and it was a group of mainly of investors who got together and put together recommended guidelines that we hope will make it easier for not only the big issuers to disclose, but also for smaller issuers to disclose what they're doing and how their bonds can align to be labeled as a green bond.
Lynne Funk (09:55):
From your experience in that the California Green Bond Committee working group, what was the reception from the state and from any other issuers that have seen it?
Ruth Ducret (10:05):
Yeah, so I think generally speaking, it's been really positive. We just published the recommendations in May, so they're fairly new and a lot of people go on vacation. It's been sort of a slow summer in terms of issuance generally, but the feedback's been really good. I think it's quite straightforward. It follows the ICMA Green Bond principles, which have sort of four steps to follow and then gives broader recommendations of what we'd like to see given the specific sectors. So whether you're building some sort of green infrastructure project or a green building or water sewer or et cetera. But I think generally speaking from those I've talked to on the committee who work directly with issuers, they've had some positive feedback on the approach because a lot of these smaller, even smaller issuers, they're doing a lot of the work. They just might not be disclosing on it or they might not know how to, they might not have the resources. So again, we're hoping that this will provide clearer guidance for them.
Lynne Funk (11:10):
I think there's so often, and it appears to me at least from the issuer side, that there's a story they can tell there. They have a story to tell, but they oftentimes just don't tell it.
Ruth Ducret (11:21):
Absolutely.
Lynne Funk (11:23):
So let's get a little deeper in here. I want to talk more about, let's talk about climate change. How much of a threat of climate change or extreme weather is there to the muni sector and what sort of sectors do you see most at risk from climate change?
Ruth Ducret (11:39):
Sure. Yeah, I mean, of course the answer is that it really depends, since the market is so broad, but for certain municipalities, the threat of climate change is already really real. And then for others, these are longer-term issues that are only going to get worse over time. But historically, I'd say after natural disasters, municipality could generally build back stronger and more resilient with the help of FEMA and other federal aid and insurance. But the question really is how much longer is that outside assistance going to last? So insurers rather are already pulling out of certain areas in California for wildfire risk and in Florida, which have been impacted by hurricanes. And then what about coastal homes, for example, how long are taxpayers going to be willing to supplement wealthy people with beautiful homes by the sea through the National Flood Insurance Program? Just wondering at what point that's the greatest risk.
(12:45)
This summer may prove to be an inflection point for many people. You think about the extreme heat that we've had with impacting over 150 million Americans, the heat's been straining hospital resources and general infrastructure, and this is going to become more and more commonplace. And so for example, I live in Boston and last weekend and even yesterday, I've seen rain like I've never seen before, three inches falling in just a few hours, and the infrastructure just isn't built for that kind of severe weather. So I think there will be some point when taxpayers are just not going to either be able or be willing to foot the bill anymore.
Lynne Funk (13:29):
And if you think about what you bring up, FEMA, and I think people, I've been hearing that people wonder, okay, the US was just downgraded by Fitch. If they do start needing to find revenue raisers or cuts to services, is FEMA, could that ever be on the table? I mean, I would think no. But as you said, is there going to be a tipping point where where taxpayers are done subsidizing the federal response to these problems?
Ruth Ducret (14:01):
Yeah, absolutely. Especially for second homes where the problem occurs again and again and again. How long will that be tolerated?
Lynne Funk (14:22):
So can you talk a little then more about you cover hospitals, you brought that up, the heat with that, what other concerns are there as it pertains to the hospital sector?
Ruth Ducret (14:33):
Yeah, I mean, hospitals, I think they are such an essential service, obviously, right? They serve a social good and they play an extremely important role in our health and the wellbeing of our society at large. In terms of sort of their approach to E in the ESG, they're often laggards compared to other sectors. So they're one of the largest polluters, they're one of the largest sources of waste in a community. I have some stats here that the EPA notes that inpatient healthcare, it's the second largest commercial energy user in the U.S. and that their facilities consume nearly 10% of the total energy used in US commercial buildings, and that they're responsible for 8.5% of U.S. greenhouse gas emissions. And that's because they have to operate 24 hours a day, 365 days a year, and the amount of waste that they produce is enormous.
(15:32)
And so even just with some small tweaks, I was at a number of conferences where CFOs are talking about just small tweaks like changing plastic straws in their facilities to paper. I think hospitals can make a big impact, but we're pretty far from there. There's only a handful of large hospital systems that have made either a carbon reduction pledge or net zero pledge to reduce emissions. And we talk about engagement. One of the topics that I engaged with a few years ago was hospitals and net zero. And in talking to many hospital representatives, the theme was that they really can never get to net zero unless they're buying carbon offsets through the offset market. And so I think that's just something that I think about in terms of the healthcare sector. So they can make a lot of great strides in the S part of the ESG, but in terms of reducing their E, that's a challenge. And then hospitals and floodplains and hurricanes, they've historically done a really great job of remaining open, but as these storms increase in their intensity, I think you're going to see more and more issues there as well.
Lynne Funk (16:53):
Can you talk a little bit about water sewer, another area you cover? I think that's an interesting, when you talk about the rain in Boston, you just had so New York City last year, or I forget which year it was. I apologize when the major flooding killed people in Queens because the basement's just flooded. So talk a little bit about that sector and how or issuers making strides to deal with this.
Ruth Ducret (17:19):
Yeah, I mean, I think the key issue in a lot of these areas is old infrastructure, water sewer systems in the Northeast and the rust belt. I mean, I was reading a report, I can't remember which city it was in Ohio, but still has wood, some wood pipes from the 1800s that hadn't been updated. And so when there's heavy, heavy rainfall, heavy downpours, the combined sewer overflows happen and they just don't have the capacity to deal with that water. And so just increased investment is really, I think, the key to making them more resilient over time.
Lynne Funk (18:06):
We're going to take a short break and we'll be right back with Ruth Ducret. And we're back. So Ruth, we were talking about before the break, you were talking about water sewer. Are there any other sectors that you want to touch on in your coverage area that you think might be of interest to our listeners?
Ruth Ducret (18:25):
Sure. I think when you're thinking about thinking about climate change, you can think about both the physical climate risk, but then there's also the transition risk, which is thinking about a transition to a low-carbon economy. And so for physical climate risk, I think what we worry about a lot are those really small issuers that have concentrated risk like a one mile town or a hospital system that only has two buildings. And so those are going to be much more likely to be impacted by the physical climate risks. So heat, hurricanes, flood, wildfires. But in terms of the transition risk, probably the most obvious tax-exempt sector that could be impacted is the public power sector, which frankly, I don't cover with another colleague on my team cover that, but they're most likely to be impacted by the changes of regulation and the transition from coal and other dirty power sources to more renewable energy, or a municipality that's highly exposed to the oil and gas industry as its main source of employment could be at risk for transition risk. So we certainly think about that over the long term. When thinking about ESG and climate change,
Lynne Funk (19:48):
Do you think that this is hard because as we said at the outset, the muni market's huge and bifurcated and geographically diverse, but I would imagine particularly when issuers hear about this that they worry about the cost to disclosing. But do you think though that issuers on the whole are doing enough to disclose their risk?
Ruth Ducret (20:17):
Well, I'd say generally speaking, unfortunately, no. The larger issuers that have the resources to commit to better tracking and disclosure, and they're doing a good job, and there really are some best in class examples, I'd say Washington, DC, Montgomery County, Maryland, San Francisco, they're doing an excellent job at disclosing what they're doing, how they're thinking about both adaptation and mitigation. But like you said, there's 90,000 state and local governments in our market, and about 48,000 of them have bonds outstanding. And so the vast majority of these, they just don't have the resources or the staff to report on their climate risks. So at Breckinridge, we're focused on issuer-level data. We're focused on use of proceeds, but our main concern is issuer-level data, and we've contracted a third party data provider to better understand the climate risk across the entire municipal market.
(21:15)
So we actually get information on over 800,000 CUSIPs. We focus on heat, flooding, hurricanes, drought, wildfire across our entire investible universe so that we can better compare and contrast each one and see how one issuer stacks up against the entire market. And so that way we don't have to rely on an issuer to tell us what kind of risks they're facing. We have an outside data provider that does that for us. And then what we do though use and really encourage and welcome is better disclosure about what is an issue we're doing to mitigate or to adapt to the climate risks that they're facing. So what kind of plans do they have in place? Do they have a climate adaptation plan? Are they thinking about changing their zoning laws or their building codes? Those are some of the things that we're focused on, and most municipalities have that information. It just might be very deep, deep, deep and not available online. So we're encouraging more disclosure.
Lynne Funk (22:25):
What's your third party data provider?
Ruth Ducret (22:27):
So we use risQ, which is now currently part of ICE, and we've been using them for many years now.
Lynne Funk (22:38):
Okay. Yes, I familiar with them for sure. So then talk about when you hear from investors, Breckinridge, your investors are telling you, 'we need this data, we want this.' Is there a strong demand for labeled bonds or even just sustainability? Maybe it's not labeled green bond, but what are investors asking?
Ruth Ducret (23:03):
So yeah, I'd say investors are demanding more information. However, that being said, I'm not totally convinced that we're seeing that reflected in price and the price that they're willing to pay for the bonds at this point. But investors just generally are more interested in climate risk, and ESG factors generally are just more top of mind than they were 10 years ago. You think about bond insurers, they're certainly thinking more and more about climate risk. And so as I was saying before, I'd say that the frustrating thing is that a lot of municipalities are doing great work in terms of disaster preparedness and adaptation efforts, but they're not necessarily disclosing that information in the official statement. And oftentimes it might be the bond attorney or just a lack of staff, or maybe just a lack of understanding of what investors are looking for. But I think investors are going to demand, as we see, if this truly is an inflection point in terms of climate change with a more recognition that things are getting a lot worse here, I think we're going to see more and more demand for climate disclosure when bonds come to market.
(24:35)
And at Breckinridge, we're already incorporating these risks into our traditional bond ratings, which ultimately drives execution price.
Lynne Funk (24:45):
You often hear from the issuer too, 'why should I disclose this? I'm not seeing a pricing differential.' And I think there have been certain deals that have gotten done, I want to say something in Chicago recently that they saw a slight pricing differential. But I wonder, if I flip the question, will they start to see a penalty at some point? When maybe does it tip? And now that investors are saying, 'if you don't do this, we're going to charge you more.'
Ruth Ducret (25:16):
Right? I think at some point it will. I just can't tell you exactly when that will be. But I think for now, given the market technicals and generally just how poor supply has been and just how high demand remains for tax-exempt debt, we're just not seeing that penalty right now. But you think about that, the total size of the muni market hasn't changed, I think over either 10 or 20 years now. I mean, some crazy amount of time, there's just not the issuance, but there's a lot more buyers. And at this point, not enough supply means that people are willing to pay a price for something that may happen or may not happen. Climate change is a longer-term issue for some issuers. I mean, right now it's very real for others, but it is a longer horizon sort of question. And at Breckinridge, we're certainly thinking about it, and we may avoid certain credits altogether, and we may assign a lower rating, lower internal rating compared to the agencies so that our traders incorporate that risk into their trade execution. But not everyone in the market may be thinking the same way we are at this point.
Lynne Funk (26:42):
I'd be remiss not to ask you about the elephant in the investment room, I guess, is sort of the politicization, can't even say the word politicization of ESG. Do you have any thoughts on that? On how might that be affecting issuer behavior or investor behavior? How do you view it in Breckinridge?
Ruth Ducret (27:06):
Sure. Yeah, it's certainly a very topical question as a lot of people are talking about it. I would say I have to just go back to the fact that at Breckinridge, we are thinking about ESG in terms of materiality. So how is this risk ultimately going to impact our investment over the long-term horizon? And so from our perspective, climate change is real. These issues that these municipalities are facing in terms of more frequent and more violent storms and rising heat wildfires, these perils are happening, and we feel that it is an important aspect of our traditional credit analysis to incorporate these risks into our analysis of an issuer's overall credit quality.
Lynne Funk (28:07):
Okay. Thank you. Thank you for that. Sure. So let's just go one more question here for you, and that is, do you think the industry writ large public finance is behind in addressing risks and as a result is unprepared for some of the consequences?
Ruth Ducret (28:26):
Yeah. So again, I would say yes and no. I'd say there are many, many municipalities that are fully aware that climate change is happening and that the risks of climate change are real and are actively planning and implementing adaptation solutions. Some of the good examples I think about are Newport in Virginia or Louisville Water in Kentucky. San Francisco Airport is another issuer that they issued bonds a few years ago to build a sea wall because of rising sea levels. Boston is another example of a city that has an extensive climate adaptation plan, but there are many others who aren't planning sufficiently, maybe because they don't have the political motivation or the pressure, or because they're understaffed and can't implement these kinds of action plans. So that's on the physical climate side, climate risk side. But in terms of transition risk, I'd say as a whole, the industry is pretty far behind the corporate market. So right now, there's no currently agreed upon way of even measuring emissions for many entities. There's different reporting standards, there's no universal reporting standards, and I think we have quite a long ways to go as an industry just in terms of thinking about transition risk and understanding it.
Lynne Funk (29:55):
So do you think, do we covered it all?
Ruth Ducret (30:02):
It's a huge topic, but maybe hopefully we covered a bit.
Lynne Funk (30:06):
Is there anything that you think I didn't add you'd want to leave our listeners with?
Ruth Ducret (30:12):
That is a good question. I think we covered a lot. It's important to remember, which I think is often confused, is that there's really a lot, when people think about ESG, they're thinking about a lot of different things. And investors approach to quote unquote ESG can be different depending on their viewpoint. So at Breckenridge, we think about ESG integration and really incorporating the risks, these sort of non-financial risks, which you can't get out of an audit statement, which may not be where there may not be whole-scale data available all the time. Thinking about governance risks, thinking about social risks, climate risks. But then there's others, other investors who are impact investors, and they're thinking a lot more about use of proceeds. They may not be thinking about risks. They may be thinking about allocating capital based on need. And then there's some that are sort of a combination of the two. So when you're talking about it, it's just important to think about where the investor is coming from. I think that can really set a framework,
Lynne Funk (31:31):
Right? No, universal language. That's actually where I'll plug a survey for our listeners. I'm running a survey right now on ESG for the industry, and one of the questions is, should there be a universal language of sorts for ESG? And last time we did this in 2021, the response was about 72% said yes, but nobody had any idea or inkling of who should write it and who's making that definition and that standard. So it's a tough one.
Ruth Ducret (32:04):
That's why we love the muni market.
Lynne Funk (32:07):
Yep. Well, thank you so much, Ruth, for your time and your insights. I think this is a great discussion. Obviously, with everything that you laid out, there's still more discussion to come on this, so thank you again.
Ruth Ducret (32:20):
Thank you. It's a pleasure to be here.
Lynne Funk (32:23):
Thank you for listening to this Bond Buyer podcast. I produced this episode with audio production by Kevin Parise. Special thanks this week to Ruth Ducret of Breckenridge. Rate us, review us and subscribe to our content at www.bondbuyer.com/subscribe. From the Bond Buyer, I'm Lynne Funk. Thanks for listening.