Environmental risks from a fixed income investor perspective

Yen Wong, Manager Credit in the Global Fixed Income team for Colonial First State Global Asset Management, describes the integration of environmental, social and governance issues into the credit analysis and investment process.

There is a growing recognition by fixed income investors of the impact to their investments from environmental, social or governance (ESG) risks. Increasingly corporate and even sovereign blow-ups can be attributed, at least in part, to ESG factorsi which were not identified in traditional credit analysis models. ESG risks are considered non-financial risks factors. But badly managed, these risks can and will have a financial impact for both companies and governments, thereby affecting their default or credit risk.

Changing demand for coal

One example of this is the coal industry. There has been a dramatic shift in pricing and demand both globally and regionally which has implications for extractors and generators. A variety of factors are driving the shift toward cleaner energy sources by major energy consumers like China, India, the US and Europe, which is affecting the coal industry. Concerns about air pollution are driving a decline in China’s coal consumptionii, while in the US major gas discoveries and lower cost extraction techniques are driving a dramatic shift in the power generation mixiii.

Falling demand for coal, both globally and regionally, would be negative for coal prices and have a negative impact on coal miners’ ability to service their debt. It also has implications for coal-powered generators which have seen increasing demand for clean energy. This in turn will affect the cost of debt and equity capital for those issuers. Indeed stock prices for these companies have underperformed significantly over the last five years with the Dow Jones coal price index down over 70%.

Stranded assets

Looking forward, regulatory and societal responses to climate change have sparked concern that there is a “coal bubble” which may leave assets stranded. These risks are not trivial. According to the Carbon Tracker Initiativeiv, stranded assets are fossil fuel energy and generation resources which, at some time prior to the end of their economic life, are no longer able to earn an economic return as a result of changes in the market and regulatory environment associated with the transition to a low-carbon economy. The IEA estimates as much as two thirds of current known fossil fuel reserves are at riskv.

As a result the dominant position held by coal in the world’s primary energy and electricity markets, and the sheer size of global coal reserves, are increasingly threatened by climate change regulation, economics and energy innovation. Credit rating agencies, even though they do not formally consider climate change risk in their credit assessment models, are acknowledging this growing risk with S&P saying that in an increasingly carbon-constrained environment, “most of these assets could wind up having no economic return”vi.

Changes in the energy sector

We have seen recent change in emphasis by AGL in a bid to stay relevant in the energy sector with the company committing to phasing out its current fleet of coal-fired generators and stepping up its renewable energy investmentsvii. Both AGL and Originviii are waking up to solar energy in the face of changing economics and changing customer habits. It remains to be seen whether companies like these can make the transition smoothly.

The increasing pace of change in the coal sector has implications for all players in the energy value chain. Negative externalities, including environmental risks, are increasingly driving industry dynamics and should be a consideration by all banks and investors when lending to this sector, especially given these risks are being highlighted by reputable organisations like the IEA, the World Bank and UN. In this regard, the commitment by the big four Australian banks to disclose their financed carbon emissionsix, not just their direct emissions, is a step in the right direction.

Government finance

The uncertainty in the coal industry also has implications for government finances. The Queensland government, a major bond issuer with over $80 billion in debt outstanding, had previously announcedx that it would contribute hundreds of millions of dollars towards rail infrastructure to connect the Galilee Basin coal mines with coastal ports. This decision was based on the contribution of the investment to the economy and the price for coal. However the dramatic fall in coal price and change of Government this year has created uncertainty over this investment.

Queensland Treasury has acknowledgedxi that spending on infrastructure for coal mines comes at the expense of spending on social infrastructure. This is a concern for the future sustainability of the state in terms of its impact on revenue and expenses, which in turn impacts the state’s cost of funding. This should be a consideration for bond investors who are invested in bonds issued by state governments.

Implications for investors

Bond investors can take a number of steps to fully incorporate these risks into their investment process. Our approach has been to factor ESG risks into our internal credit ratings. This approach has resulted in generally lower internal credit ratings being assigned to high ESG risk companies than the ratings agencies have assigned, which in turn has led to superior portfolio performance through our lower default experience.

Our consideration of the ESG risks for fixed income investments is part of our overall responsible investment and stewardship strategy. Our latest reportxii provides further case studies of how ESG is influencing our investment approach.

i A common example is the rating downgrades and the credit spread blow out for Egypt following the Arab Spring. PRI Sovereign Bonds: Spotlight on ESG risks 2013 http://www.unpri.org/viewer/?file=wp-content/uploads/SpotlightonESGrisks.pdf

ii PRC National Energy Administration Oct 2014 cited by http://cleantechnica.com/2015/03/13/china-coal-consumption-co2-emissions-drop-2014/

iii http://insideclimatenews.org/carbon-copy/22052015/analysis-shows-clean-power-plan-would-cut-coal-use-energy-information-agency

iv http://www.carbontracker.org/

v IEA World Energy Outlook 2012 https://www.iea.org/newsroomandevents/pressreleases/2012/november/name,33015,en.html

vi Standard & Poor’s, Carbon Constraints Cast A Shadow Over The Future of the Coal Industry, 21 July 2014, http://www.carbontracker.org/wp-content/uploads/2014/09/2014-07-21-SP-Carbon-Constraints-Cast-A-Shadow-Over-The-Future-Of-The-Coal-Industry3.pdf

vii http://www.agl.com.au/about-agl/media-centre/article-list/2015/april/agl-policy-to-provide-pathway-to-decarbonisation-of-electricity-generation

viii http://www.originenergy.com.au/content/dam/origin/about/investors-media/docs/results-interim-presentation-2015.pdf

ix Australasian Centre for Corporate Responsibility, Financed Emission, ‘Unburnable Carbon’ risk and the Major Australian Banks, October 2014, http://www.accr.org.au/bigbankreport

x http://www.statedevelopment.qld.gov.au/assessments-and-approvals/north-galilee-basin-rail-project.html

xi https://cgc.gov.au/index.php?option=com_attachments&task=download&id=1727

xii http://ri.firststateinvestments.com/

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jasper says

26 June 2015

What does it mean when corporate bankers speak of "responsible investment". If you read the article carefully, it's likely the answer to that question is far different from what you'd think. To be clear, nobody with any degree of concern about climate change (or any other environmental matter) should take any comfort from hearing a banker reassure them that they practice some form of "responsible investment", because the objective is more aligned with growing the wealth of rich people than it is with playing any kind of role in the responsible stewardship of the environment or care for humanity in general. The bank marketing department may want to play up a stewardship angle, but as illustrated in the article, stewardship is not the analysts' job, nor is it their intention. Simply put, it's essentially about profit and loss and the harnessing of greed.

So one might ask: " why is examination of a company solely through the lens of profit and loss such a problem, mate??". Well, the typical person with a concern about these matters probably looks at climate change in absolute terms (climate change is bad, and we need to do something about it, right? right!). From perspective of profit and loss however, there are two sides of the ledger, even though the author conveniently only speaks of one. To the banker, for every way climate change presents a risk to some industries or corporations, there are likely to be innumerable ways it may present an opportunity for others. Consider the impact of climate change on the arctic: due to loss of the ice some shipping companies are preparing for the opening of the fabled "Northwest Passage through the arctic which could shave 4,000 miles off the trip for ships traveling from Europe to Asia - allowing them to avoid the Panama Canal. Most of us should be alarmed by the prospects of an arctic melt-off, but when the ultimate test of a good investment is profit and loss.... well, no worries mate (at least if you're in the shipping business, or your bottom line would otherwise be improved by a quicker turn-around in moving goods between Europe and Asia)! (Footnote: banker would probably get giddy over the promise under these circumstances of "creative destruction" - which is often good for bankers, but almost invariably results in misery for workers and communities).

The point of all this is to not be fooled by the idea of decisions by these banks and their well paid analysts as being any less amoral than they were before; in the end, it's essentially still all about making rich people richer and maybe sometimes, just sometimes (and largely by accident), their ratings will be aligned with the broad human/global interest. And if we take the bankers at their word (despite - for example, recent news the big four banks were involved in an interest rate rigging scam - the profits of which probably figured all of the x-mas bonuses at CBA) just because they tell us they're "investing responsibly", well then, shame on us.

This is all to say that banks cannot be considered "responsible' on the basis of their purported "responsible investment" practices - it would be naive to believe so given all the evidence to the contrary. If we want to see greater responsibility by the banks, it will have to be demanded by a fed-up public, by shareholders, and forced upon banks through greater regulation, greater transparency - and through real accountability. We should not be fooled by slick marketing schemes; there's too much at stake.

Jasper Steinmetz

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