PIMCO credit analyst Christian Schuetz discusses the Environmental Social and Governance (ESG) factors he looks at when evaluating the European utilities sector, and why understanding these is critical for thorough credit analysis.
Q: Why is it important to integrate ESG factors in credit analysis?
A: The idea of incorporating ESG factors in an investment process has been growing in importance and is a trend that looks set to stay. In part this reflects increased demand from investors who seek more than just financial return, and wish to align themselves with processes that reflect this. But it also makes good investment sense.
At PIMCO, we seek to deliver risk-adjusted returns for our clients in a manner that is sustainable over the long term. That means making sure that the investments we make on their behalf represent business models that are competitive not only today but well into the future, and this requires looking at ESG. In European utilities for example, which is the area I focus on, many large vertically integrated companies are facing big challenges as a result of structural changes in the market. Most of these changes are directly connected to "E", "S" or "G".
Q: Can you provide an example of how ESG factors have influenced an issuer's credit quality?
A: A good example of this is RWE, a German-based vertically integrated utility, which has seen its credit rating fall from BBB+ in 2014 to BBB- today. A combination of falling power prices, dependence on conventional power, and policy and regulatory headwinds, led to asset write-downs at the firm. A shift in strategy and a split of the company into two separate entities followed (see Figure 1).
All of this had important implications for bondholders. Not only did credit quality deteriorate over the period, but the split of the company ushered in a divergence in rating between RWE (the group containing the old thermal power assets) and Innogy (the new company containing grid, retail and renewables businesses). Senior unsecured bonds transferred to Innogy, but subordinated hybrid bonds remained at RWE.
This meant that investors in the senior unsecured bonds were able to benefit from the lower carbon intensity of the new company and from the improvement in the environmental risk profile of the credit.
Q: What ESG factors do you evaluate in the utilities sector?
A: For power generating utilities, greenhouse gas emissions are an environmental risk factor with cost and regulatory implications. So any ESG analysis of these businesses starts with looking at greenhouse gas intensity – the amount of emissions generated per unit of power produced. Given that power producers are charged or taxed for CO2 emissions, a firm’s carbon intensity influences its ability to generate earnings and cash flow.
Although Europe does not function as a single power market, it’s still instructive to compare levels across companies. Figure 2 gives a good overview of which companies are most vulnerable to costs associated with CO2 emissions. It also shows that carbon intensity is an evolving metric as shown in carbon intensity figures for 2014 and 2015.
However, while evaluating carbon intensity is necessary, we’d argue that it’s not sufficient. For example, on the environmental side, we also take account of the power production mix and the overall exposure of companies to
power generation. From a credit perspective, if power generation is only a small part of a firm’s business, then even if it has high carbon intensity, it could be relatively insulated from carbon pricing. We also look at its dependence on
regulated activities, as well as “clean-up” risk – both from an operational and handling, and a liability management perspective. On the social front, we evaluate the regulatory frameworks a company operates in and its performance under different regulatory requirements. We also take subsidy regimes and companies’ reliance on subsidy payments into account. And from a governance perspective we consider the management team’s awareness of, and its strategies in place for dealing with, global warming and managing operational transitions towards cleaner power.
Credit processes that don’t fully integrate ESG factors would likely stop their analysis at carbon intensity. We think this would miss all the other factors that are also relevant to credit quality (Figure 3).
Q: How do you integrate top-down with bottom-up ESG analysis?
A: The process I’ve described so far is really about integrating ESG analysis in our bottom-up credit research work. However, it’s important to note that at PIMCO we also focus on ESG from a top-down perspective. We discuss long-term themes such as climate change, the evolving energy mix and corporate governance trends in our annual secular forum process. This integration of top-down and bottom-up research is central to our firm-wide investment approach.
Applying this to European utilities, top-down trends we focus on include “two-degree policies” (supporting the goal of limiting global warming to no more than two degrees), the decentralization of power generation (supported by the growth of renewables) and the long-term outlook for nuclear power. Our bottom-up ESG analysis builds on these themes, adding details specific to each issuer. From a portfolio construction perspective, we add a third factor – credit valuations. Ultimately, it’s the combination of top-down, bottom-up and valuation considerations that lead us to a view on individual credits.
Q: What companies do you think are best and worst positioned based on ESG considerations?
A: Practically speaking, in the European utilities sector today, we’ve overweighted credits that are advanced in transitioning to a lower carbon model and have high exposures to regulated businesses. And we’ve underweighted firms struggling to make that transition, where cash generation from power production is under pressure and strategies to transition the business models are lacking.
Outside of this, we’re looking closely at subsidy risk across the sector as there are many firms with business models focused on renewables that are heavily dependent on government subsidies. If/when these subsidies decline, these companies will have to deal with a more merchant-based market. How they make this transition will affect how their credit quality evolves.
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