The risk/return trade-off is a fundamental principle of investing. Risk versus rewards … what's your tolerance?
Higher levels of risk should be compensated through a higher level of return. This principle is why equities have a higher expected return than fixed income. It's why corporate bonds command a spread over Treasuries.
Yet when it comes to climate change and environmental impact, these risks are not being accurately priced into financial instruments. Unlike most traditional applications of this rule, these risks don’t only impact those invested—it affects all of us who live on Earth.
In August, the Intergovernmental Panel on Climate Change (IPCC) released its latest report. The report warned that limiting global warming to 2 degrees Celsius above pre-industrial levels would be “beyond reach” within the next two decades without immediate, large-scale reductions in greenhouse gas emissions.
An increase of this magnitude would have drastic negative consequences for agriculture and human health.
Muni ETFs Face Direct Impact
Nowhere does this climate risk show up more directly than in the municipal bond market.
With various parts of the United States facing dramatically different climate risks ranging from drought in the West to flooding in the East, ETF.com has made the case for why active management is critical for this asset class. (Read: Muni Market ETFs Ripe for Active Management)
Yet the largest muni bond funds are passive.
|MUB||iShares National Muni Bond ETF||$23.56B|
|SUB||iShares Short-Term National Muni Bond ETF||$6.18B|
|SHM||SPDR Nuveen Bloomberg Barclays Short Term Municipal Bond ETF||$5.05B|
|TFI||SPDR Nuveen Bloomberg Barclays Municipal Bond ETF||$3.84B|
|HYD||VanEck High Yield Muni ETF||$3.67B|
Assets in these funds dwarf those in the largest active municipal bond funds.
|FMB||First Trust Managed Municipal ETF||$2.38B|
|JMST||JPMorgan Ultra-Short Municipal Income ETF||$2.22B|
|MUNI||PIMCO Intermediate Municipal Bond Active ETF||$681.07M|
|SMMU||PIMCO Short Term Municipal Bond Active ETF||$549.21M|
|MMIN||IQ MacKay Municipal Insured ETF||$496.83M|
According to Lauren Kashmanian, senior portfolio manager at Parametric Portfolio Associates in Seattle, ratings agencies are not yet systematically accounting for this type of risk when assigning a credit rating to a municipal bond.
“There have been no downgrades in the muni market related to climate risk. That is something that the rating agencies are preparing for down the road, but that has not been reflected in external credit ratings as of yet.”
More Weather Events Coming
Taking these risks into account is imperative because they could significantly impact financials, especially as these weather events become more frequent and extreme in nature.
Though economic losses are mostly covered by private insurance and federal disaster aid, climate change also has potential to cause demographic changes such as population shifts and a declining tax base regionally.
Kashmanian adds: “Being able to avoid downside risk by incorporating ESG factors is really important, and obviously one of the biggest being talked about right now is environmental and climate. ESG integration is a way to avoid that potential downside risk.”
ESG Investing Isn’t Enough
But some say that even environmental, social and governance (ESG) integration isn't enough. Many of the largest ETFs in the ESG space rely on basic negative screening, yet still include many stocks that face ESG risks themselves. (Read: What ESG Investing Is Meant To Be)
Critics of these “greenwashed” ESG funds, such as Peter Krull of Earth Equity Advisors, believe that companies need to face financial impact before real change can be made.
“I think one of the biggest opportunities that we have to push change is through the insurance companies. They’re the ones who are making policy pricing decisions based on risk. [There’s a need] to be pricing climate change risk into every single policy they write. You’ll start to see these corporations move much faster because the way our Congress is right now, I’m not confident that we’re going to see any regulatory action happen.”
There are signs the tide is turning. Last week, MSCI launched Climate Lab, an application to assist with the management of climate and financial risks for investors. MSCI offers a Climate Value-at-Risk research product that seeks to give a valuation assessment of climate-related risks and opportunities in an investment portfolio.
ETF.com’s Editor-in-Chief Drew Voros even predicts that ‘climate change’ ETFs will be popping up in the U.S. sooner rather than later. (Read: ‘Climate Change’ Coming to ETFs)
Whether or not that prediction comes true, the growing risks of climate change are real. And just as with traditional risk measures, investors need to be sure these risks are being accurately measured and priced in when considering their investments.