Why: ClimateSmart.
Bonds: The risk of oil. The upside of green.

Chapter 1: Overview

How does one build a bond portfolio for the era of climate change?

Here’s our approach: 

1. Avoid areas of the market with underpriced climate risk.
2. Overweight areas with unique climate-related upside.

We believe that fossil fuel companies and their supporting infrastructure (pipelines, refineries, shipping companies) have underpriced climate risk. 

And we believe that green bonds, which are bonds that corporations issue to raise capital for the explicit purpose of financing green projects, have underpriced climate upside. 

Here’s why:

Chapter 2: The risk of stranded assets in the fossil fuel industry

If you haven’t yet read our “Why Oil Will Lag” article, go back and give it a read. 

Here’s the short version:

1. Except when oil prices are unusually high, fossil fuel companies are now a low-margin, high-volume business:
   a. The costs of extraction are rising as the “easy to get” deposits are exhausted.
   b. There’s no big technological breakthrough coming to help. The last, fracking, allowed access to new deposits, but it’s much more expensive than traditional drilling.
2. Case and point, major fossil fuel companies actually lost money most of the past 20 years.
3. And this was during a time of general expansion of demand for their products.
4. To address low margins, the industry has moved towards consolidation and scale.
5. So, should we enter a period of declining fossil fuel demand, as we believe is coming and the IEA projects will occur by the end of the decade, the process of the fossil fuel industry contracting could be messy.
6. They don’t have a bunch of small pipelines, refineries, and tankers that can be carefully phased out.
7. Instead each piece of the supply chain is big, expensive, debt-ridden, and low-margin.
8. Meaning that if demand does start coming down, it’s only a matter of time until we see the weakest links of the supply chain snap and go out of business.

That is a large capital expenditure, like a drilling rig, pipeline, refinery, etc. that was constructed using a lot of debt financing, suddenly finding itself unprofitable. Without the ability to continue paying its debt, the piece of infrastructure goes out of business, leaving those debt holders unpaid. 

The risk of fossil fuel stranded assets is very real:

If fossil fuels do enter a sustained decline, it’s going to be unavoidable. It happens when any industry contracts. Just drive around the “rust belt.”

And it’s why groups like OPEC have been mounting a major campaign against the IEA for projecting that the peak for oil demand is near. OPEC really don’t want the risk of stranded assets to start getting priced into their credit ratings (aka risk of default) as it would increase their cost of borrowing. 

We detailed at length why we don’t find OPEC or Exxon’s projections for long term fossil fuel growth to be convincing in our “Why Oil Will Lag” article. 

Perhaps we will be wrong, but we feel confident about where we stand on the debate. 

We do believe that the days of growing fossil fuel demand are numbered.

And that it’s an industry that is not set up well to contract gracefully. 

So ClimateSmart avoids all debt from fossil fuel companies. We don’t want to be those investors who fail to get paid back for stranded assets. Similarly, we also avoid holding equity from the big banks for the same reason as they are major financiers to fossil fuel companies, so are some of the most exposed to stranded asset risk.  

But our bond portfolios don’t just cut out areas that they don’t invest in. We also invest where we see climate-related upside. 

Which leads us to why we’re bullish on green bonds and it starts with a term you will probably start hearing more: “ClimateFlation.”

Chapter 3: “ClimateFlation” will be a term you start hearing more

One of the impacts of climate change will be, and already is, rising prices. 

As disruptive weather events increase, so will disrupted agricultural seasons. 

We’re already seeing this phenomenon occur. In 2024, the commodity prices of chocolate more than doubled after prolonged El Nino conditions deprived West Africa of its usual rainfall patterns. 

And unfortunately for us chocolate lovers out there, the prices haven’t come down since then. We simply could be in a new, climate-change-induced normal of higher prices. (You can check the latest commodity prices here and see if they’re still elevated).

The problem for all of us, is that climate change is not impacting just chocolate. Already, Coffee prices have spiked in 2025 (as of this writing).  

While it won’t be all crops at the same time, we probably are entering a world where shortages of various food staples will become more common. 

When shortages occur, prices go up. And when prices go up, there’s a term in economics for it: inflation. 

And while it’s not yet common in the discourse yet, we believe that terms like “Climate-Driven Inflation” or “Climateflation” soon will be. 

So, what will governments do about it?

Chapter 4: Central banks #1 job is to keep inflation low

Central banks, like the Federal Reserve in the United States, control the money supply in a given country. 

And they are critical to maintaining economic stability. 

If unemployment is high, they can lower interest rates and try to get more money into the economy to increase hiring. 

If inflation is high, they can raise interest rates and try to pull money out of the economy so you have less money chasing goods and prices stabilize. 

So what happens if a central bank has to try and fight both high unemployment and high inflation? 

They will always choose to fight inflation. 

Because central banks hate inflation. 

Inflation can spin out of control if it becomes entrenched. The more people that make economic decisions around the very belief that prices will rise next year actually will cause prices to rise more next year. It’s a collective psychology phenomenon that every central bank wants to avoid at all costs. 

Because if inflation becomes entrenched, it can topple governments. 

What do the French Revolution, the rise of Hitler in Germany, and the Arab Spring all have in common? They each followed a period of massive inflation, particularly for bread.  

So, if central banks want to fight inflation at all costs and we are facing rising levels of inflation, particularly for food, driven by inflation, how will central banks respond to “ClimateFlation?”

Chapter 5: Green bonds are one of the few tools central banks have to directly fight “ClimateFlation”

Central Banks have two main tools they use to fight inflation and both are to generally reduce the amount of money flowing through the economy: 

• Raising interest rates they pay banks to keep cash with them (effectively raising interest rates for near term borrowing)
• Selling more treasury bonds (known as quantitative tightening) so that more capital is tied up in bonds, earning interest rather than flowing through the economy.

While both of these tools are effective for fighting generalized inflation, neither is particularly helpful in fighting climate-driven inflation for specific commodities, particularly for food staples like rice, wheat, and corn. 

But central banks have another powerful tool in their toolbox: they establish policy on how much collateral private banks need to keep on hand at any given time vs. how much they give out as loans. 

And they not only can say how much total collateral private banks need to hold, but they can incentivize what types of assets they hold as collateral. 

The European Central Bank has explored doing this with green bonds, a policy that would enable a private bank to hold less overall assets as collateral (something the bank likes), the more of the assets they hold are green bonds. 

Policies like this not only encourage the generation of more green bonds, but they increase the demand for, and therefore value of, existing green bonds overnight as banks have a specific incentive to buy and hold them. 

And that could just be a start. As climate change escalates and governments face increasing pressure to take action, we could see green bonds, especially high-quality ones that finance projects that avoid emissions like renewable energy, get additional fiscal incentives, like favorable tax treatment. 

It can feel hard to imagine this scenario in the current political environment in the US, but climate change isn’t going anywhere. The worse it gets, the more suffering it causes, the harder its impact will be to ignore. Australia went from being split on climate change to majorities of both major parties in favor of action after years of deadly fires impacting the major population hubs of the continent. 

The question is not whether climate-driven inflation will happen. It’s what our governments and central banks are going to do about it. 

Let’s imagine two bonds: 

1. Has a 1% chance of default and delivers a 5% annual return.
2. Has a 1% chance of default and delivers a 5% annual return, but could go up to a 7% annual return if certain political policies are put in place.

Which would you rather own? 

#2, right? 

That (in a deliberately oversimplified example) is why we like green bonds. They carry the same risk as a given company’s other corporate debt, but they have policy unique upside that only green bonds have the potential to benefit from.