Water and Sewer Bonds Fit the ESG Mission, but Some Issuers Stand Out | Lord Abbett
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Fixed-Income Insights

Exceptional performers combine environmental protection with affordable rates, prudent capital investment, and proactive management.

Read time: 3 minutes

This article, from the forthcoming edition of The Muni Quarterly, is the second in a series of pieces exploring ESG considerations in different sectors of the municipal bond market.

Our nation’s water and sewer systems provide essential services that many of us take for granted but that produce some of the most important environmental and social benefits of any municipal entity. While we consider many types of municipal bonds to be suitable for ESG-sensitive strategies, water and sewer systems make especially strong candidates for inclusion. In fact, we already own several of these bonds in the taxable Climate Focused Bond Fund. However, there are still ways that individual systems can stand out.

Environmental: Sustainable Water Sources and Leading-Edge Purification

Public water and sewer systems are regulated by the Environmental Protection Agency, which is empowered by the Clean Water Act to limit the pollution potential of wastewater discharge, and by the Safe Drinking Water Act, which sets minimum water quality standards. We expect every water and sewer system to comply with federal regulations, and thus from an environmental impact perspective, what differentiates these systems is often not what they do, but rather what they fail to do. This is one of the many areas where ESG considerations can tell us about potential future financial burdens, as failure to comply with environmental regulations can result in fines.

For water systems, environmental considerations mainly concern inputs—protecting and preserving the sources of our drinking water. Systems that have diverse, sustainable sources are likely to perform better. Utilities that are overly reliant on imported water run the risk of burdening ratepayers with larger bills, should their costs increase, while those that rely only on one local source can also be a problem. In fact, we have seen water systems that were so dependent on local groundwater that their excessive draws lowered the elevation of the land surface over the course of multiple decades, leaving the service area at increased risk for other environmental threats, such as rising sea levels.

For sewer systems, environmental considerations are primarily concerned with outputs—making sure that the water and biosolids remaining after treatment are purified so as to minimize environmental impact. There are three main stages of wastewater treatment, each successively outputting waste material that is cleaner and more environmentally friendly, but not all treatment plants do all three. We view wastewater treatment plants that use tertiary treatment methods as most environmentally beneficial. Wastewater treated with tertiary methods is clean enough to be safely discharged into rivers and oceans, and the biosolids can be used as fertilizer.

Social: Affordability and Regular Maintenance

In many ways, the social mission of water and sewer systems is defined by their environmental mission: How can their environmental commitments be met without imposing undue burdens on those paying for the service? To this end, rate affordability and regular maintenance are the critical metrics we evaluate to judge the social impact of a water and sewer utility.

We measure rate affordability by calculating the percentage of monthly income a family must spend for water and sewer services, considering rates below 2% to be affordable and rates beyond 3% to approach unaffordability. This allows us to get an apples-to-apples comparison across service areas that vary widely in income and water-usage levels. In terms of maintenance, we look for capital spending that is adequate to offset depreciation against the utility’s assets. Proper spending on regular maintenance ensures that pipes will not leech chemicals into drinking water and helps prevent small problems from snowballing into expensive failures whose costs ultimately fall on the ratepayer.

One other social consideration for water and sewer systems is community outreach. Particularly in drought-prone areas, water utilities should publish usage data and provide their ratepayers with best practices for conservation, such as recommending low-flow showerheads or low-flush toilets.

Governance: Proactive Management and Stable Rates

Our main governance consideration lies in the differentiation between proactive and reactive management. A management team that upgrades a wastewater treatment plant to comply with new environmental regulations, though certainly demonstrating responsibility in governance, would not be considered as responsible as one that recognized and responded to the threat on its own. To this end, many water and sewer utilities in California are notable for their proactive management, as the state is frequently ahead of the federal curve in terms of discharge regulations.

A management team that is proactive about environmental considerations can get ahead of potentially costly regulatory actions, particularly in the ever-changing regulatory landscape, and one that sticks to a diligent maintenance schedule will help prevent problems from building up and costing even more in the long term. Along these same lines, a team that gradually increases rates to support long-term capital plans provides a greater social good than one that keeps rates stable for several years, only to implement sharp hikes when new debt is issued.

Conclusion

Essential by any measure, our nation’s water and sewer systems are excellent examples of municipal entities whose debt makes a strong case for inclusion in an ESG strategy. Due to federal and state environmental regulations, most entities in this sector are able to provide their services at affordable rates and are able to do so while minimizing their environmental impact. The social and governance factors mainly revolve around how proactive management performs regular maintenance and prepares the system for upgrades to comply with potential future regulations, ensuring that ratepayers receive environmentally friendly service that is both reliable and affordable.

IMPORTANT INFORMATION

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in portfolios managed by Lord Abbett and, if such securities are held, no representation is being made that such securities will continue to be held. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government, in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action, as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product, or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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