Weathering the storm: Exploring Climate Change Adaptation and the Investor’s Imperative

By: David Zahn, CFA, FRM and Kasper Hanus, Ph.D.

The Franklin Templeton Fixed Income team believe that issuers that think critically about the environment in which they operate could outperform throughout the full market cycle compared with those who are slower to adapt.

The Franklin Templeton Fixed Income team has long been aware of the need to fight the effects of climate change and we know that it is crucial not to be complacent. We must help protect communities from the increasingly extreme weather events, such as fires, floods and droughts, that we have seen of late and to check the seeming inexorable rise of sea levels, all of which threaten to wreak havoc on the global ecosystem.

In 1998, the Intergovernmental Panel on Climate Change (IPCC), an intergovernmental organization endorsed by the United Nations, was created to provide policymakers with regular scientific assessments on climate change, its implications and potential future risks, as well as to put forward adaptation and mitigation options. The IPCC recently released its sixth assessment report, summarizing the current state of knowledge on climate change.

The summary comprises multiple studies that show unequivocally that widespread and rapid changes in the atmosphere, ocean, cryosphere and biosphere have already occurred in every region across the globe. Unless we change not only our way of thinking but also our actions, the effects of climate change can only get worse.

It is therefore evident that climate-change adaptation should be a key focus alongside climate-change mitigation, and it is our view that those in the finance sector have an important role to play in the years and months ahead.

The IPCC’s report stresses that many adaptation options that are currently feasible and would be effective today will likely become more constrained as global warming intensifies. If this is true, we have no time to waste.

What does that mean for asset owners?

Of course, we acknowledge that the creation of a more secure and just future for our communities is a priority for many of our clients. However, there are other benefits of investing in climate adaptation. Identifying environmental, social and governance (ESG) indicators that provide material insights not yet captured by the market can allow us to target investments we believe are best positioned to deliver sustainable returns for our clients. In fact, there is an increasing body of data that points to sustainability as a driver of long-term value creation and portfolio performance.¹

We are certain that those issuers that think critically about the environment in which they operate are more likely to be well-positioned to weather various challenges and may outperform throughout both peaks and troughs of a market cycle.

At Franklin Templeton Fixed Income, we will work to utilize our broad investment capabilities to help support our clients’ investment goals. For insurance companies, there is a secondary benefit from financing climate adaptation: it is the potential for lower future liabilities related to extreme weather events. For example, if a company sells insurance against flood damage in the Netherlands, financing a bond where the proceeds go toward dyke improvements could earn a financial return and ideally lower the number of people negatively affected by flooding and may help decrease future insurance payouts.

The investment profile of a different type of institutional investor, pension funds, is also well suited for adding climate adaptation bonds to portfolios. A pension fund’s long investment horizon means that default risk becomes a major consideration, as an issuer’s financial health (and even existence) becomes less and less clear as we move further into the future. Therefore, it makes sense that climate adaptation could work to safeguard long-term investments, potentially helping sovereigns and corporations to thrive many years from now. Deploying capital in order to improve climate resilience can be done in two ways: firstly, by funding those countries that invest in climate adaptation as a public service, which in turn provides the infrastructure necessary for people and firms to adjust to climate change in the long-run; and secondly, funding individual corporations that invest in climate adaptation to support their own longevity. We believe that investments that include these considerations will likely be less affected by climate change, thereby potentially reducing risk for asset owners.

In terms of retail investors, we have seen time and again that individuals want to take ownership of their future and help protect the environment in which they live. Financing projects close to home can benefit investors directly.

Examples could include building protection from flooding, increasing biodiversity and consequently improving air quality around a protected area, or improving access to electricity generated from renewable energy sources.

We are aware that climate-change adaptation is necessary for the good of our communities. In the Netherlands, one of the main categories of eligible expenditures is climate-change adaptation and sustainable water management. This category shares many of the goals of the government’s Delta Plan of Spatial Adaptation,² which aims to ensure that flood protection, freshwater supplies and spatial planning are climate-proof, and works to guarantee flood-risk management. One example is the identification of weak links in flood protection; these are systematically addressed and improved to seek to meet the rising threat level foreseen for the year 2050.

The project has already made significant progress. Over the years 2018-2021, the Dutch government allocated a total of €2.9 billion to the Delta Fund, with the country’s impact report showing that while there is a way to go, 157 kilometres of dykes were improved in 2021 to meet the latest safety norms.

Conclusion

Work is being done by issuers and yet there is much more to do to improve the fight against climate change through socially and environmentally responsible investments. This is because we know that the investment choices we make can have a profound effect on the world around us. We believe that issuers that think critically about the environment in which they operate could outperform throughout the full market cycle compared with those who are slower to adapt.

However, there are also other, less obvious potential benefits for investors. These could include helping to reduce future liabilities related to extreme weather events for insurance companies if their policy holders live in a protected area (e.g., protected from flooding). Alternatively, a pension fund with a long investment horizon could possibly lessen the risk of climate-related defaults among its holdings if it chooses bonds from sovereigns or corporates that are serious about improving their climate resilience.

Finally, retail investors can decide to fund projects close to their hearts or homes, which could measurably increase their quality of life. As previously mentioned, there is much more to do to improve the fight against climate change.

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Originally Posted September 14, 2023 – Weathering the storm: Exploring climate change adaptation and the investor’s imperative

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal.

Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

Green bonds may not result in direct environmental benefits, and the issuer may not use proceeds as intended or to appropriate new or additional projects.

The managers’ environmental, social and governance (ESG) strategies may limit the types and number of investments available and, as a result, may forgo favorable market opportunities or underperform strategies that are not subject to such criteria. There is no guarantee that the strategy’s ESG directives will be successful or will result in better performance.

Not all strategies at Franklin Templeton Fixed Income have ESG-oriented objectives or utilize these capabilities.

Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.

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1. The US Sustainable Investment Forum did a round-up of studies that show that sustainable investment funds on average over the longer-term achieve comparable or even better financial returns than conventional investments. The list can be found within the forum website.

2. The Delta Plan on Spatial Adaptation sets out specific actions and goals to ensure that the Netherlands will be water-resilient and climate-proof by 2050. This Plan expedites and intensifies the measures to combat waterlogging, heat stress, drought and the impact of flooding.