Floods, wildfires and record high temperatures are turning investor attention to the climate emergency, raising the threat of higher borrowing costs for Canadian provinces with large oil and gas industries.
Backed by government taxing powers, Canada’s provincial and territorial bond market receives high scores from credit rating agencies. The $1-trillion market for these bonds helps to finance schools, hospitals, social services and other provincial spending. Institutional investors have traditionally had little concern about environmental, social and governance (ESG) risks on these bonds since they are used to provide needed public services.
But climate risks are beginning to change this picture, according to a new report released last month by the Principles for Responsible Investment (PRI), a global network of more than 5,000 investors representing US$121 trillion in assets.
This is especially the case in Alberta and Saskatchewan, where provincial governments are determined to maintain fossil fuel production, despite the scientific consensus that carbon emissions must be curbed.
“Climate transition risks are significant for Canadian provinces with substantial fossil fuel sectors,” says Jasper Cox, a fixed-income analyst with PRI, in an email interview.
“Provinces’ economies and revenues can be heavily exposed to these industries, and to any fall in demand or more stringent regulations.”
With such heavy dependence on the fossil fuel industry, Alberta and Saskatchewan are susceptible to declines in their tax bases and growing transition costs due to changes in fossil fuel demand or regulation. The report notes that revenues from oil sands bitumen account for 17% of Alberta’s total revenues.
As the province with the largest greenhouse gas (GHG) emissions, Alberta faces the largest risk. In 2019, it released 58,000 tonnes of GHGs per 1,000 population, or 755,000 tonnes per 1,000 units of gross domestic product (GDP) (units are expressed in constant U.S. dollars).
Saskatchewan’s emissions were lower than Alberta’s, equating to 56,000 tonnes of GHGs per 1,000 population, but represented a higher proportion of its economy, at 834,000 tonnes per 1,000 units of GDP.
By comparison, Quebec emitted 9,000 tonnes of GHGs per 1,000 population (the lowest emissions per capita in Canada), with Ontario close behind at 10,000 tonnes per 1,000 people. By GDP size, both provinces came in at 179,000 tonnes per 1,000 units.
“Investors must assess the practical ability of provinces and municipalities first to meet net-zero targets and secondly to succeed economically during and after the low-carbon transition,” the report says.
Higher borrowing costs coming, just not yet
The strong implication in the report is that climate transition risks are likely to make debt from provinces with large fossil fuel industries less attractive to investors, eventually forcing these governments to issue bonds at higher interest rates to stay competitive in Canadian and international bond markets.
“Higher credit risk would put upwards pressure on borrowing costs, although the latter will also depend on a range of other factors,” Cox says.
High on the list of other factors is the price of oil and gas, which, at least for the time being, is far more significant to issuer ratings than ESG risk.
In January, Moody’s Investors Service upgraded Alberta’s credit rating, citing “high oil prices above pre-pandemic levels.”
Last September, DBRS Morningstar upgraded its trend on Alberta bonds from stable to positive, noting recent “strong energy prices” and plans to reduce the government’s deficit. The company acknowledged that Alberta has the largest provincial emissions but noted it has achieved a recent decline in emissions intensity.
For Saskatchewan, DBRS Morningstar recently confirmed its stable trend, also noting a “recovery in resource revenue” and deficit-reduction measures. However, it noted that Saskatchewan’s carbon and GHG costs pose “modestly negative” risk, citing its dispute with the federal government over Ottawa’s plans to phase out of coal-fired electricity by 2035.
Current high oil and gas prices could be a temporary situation as the world adjusts to shortages created by the war in Ukraine. This could mean raters are underpricing climate transition risk, especially if there is a rapid decline in oil and gas prices or the global climate continues to deteriorate badly.
This is a possibility that was raised at a PRI webinar in June on Canadian government bonds.
Climate transition risk “has faded a bit into the background at the moment,” said Saad Qazi, associate portfolio manager at Manulife Investment Management. “From a longer-term perspective, you could argue that it is being mispriced.”
Eugene Ellmen is a former executive director of the Canadian Social Investment Organization (now Responsible Investment Association). He writes on sustainable business and finance.
