Company managements are responding to water sustainability issues, but not all are forthcoming. How can investors dissect what’s really going on, and is there a way to do this systematically so it can be applied it to other ESG issues? We think there is and we build an ESG investment checklist using some surprising examples.
Still waters run deep
Still waters run deep warns the English idiom: what appears calm and placid on the surface may well hide currents of complexity below. Water surrounds us in our daily lives, and we think we understand it well, but hydrologists are still learning about its movement, distribution and quality, and its fragility. For companies, it’s an essential commodity for every-day operations but the resource is becoming increasingly scarce, partly because of expanding corporate activity.
The industrial sectors are particularly large consumers (and potential polluters) of water. Utilities are the most obvious companies reliant on water - getting it to households and taking the waste away, but it is also used for cleaning and extracting other resources in mining, provides a mode of transport for the shipping industry, and is used in waste management in the chemical sector. These uses lead to very different water management issues.
Concerns around water - and more broadly environmental, social and governance factors (ESG) - have a tangible and direct impact on valuations. ESG considerations shine a light on where risks lurk in the depths of a company’s operations. And the magnitude of risk is the essential input into the discount rate, which adjusts future cash flows to the present day to ultimately value a business.
This approach is core to investing in equities but indispensable to bond analysis. Equity prices theoretically are not limited on the upside, whereas adding value in bond investing is arguably more about risk management than betting on a winner. A careful audit of downside risk is at the heart of any fixed income investment thesis. Missing an ESG risk can easily lead to losing a chunk of value, particularly on a highly leveraged bond. On the other hand, critically analysing ESG risks can help avoid the losers (as well as spot the winners), and in the process, form an investment checklist to assess ESG risk and more accurately value a company.
Utilities: Walking on water
Utilities are one of the oldest and most regulated industries, with privatisation happening in many countries only in recent years. Given their essential role supplying our daily water, power and waste management, and their naturally monopolistic nature, utilities are kept under careful watch by governments and regulators. This scrutiny benefits investors.
In many jurisdictions water and waste companies must publish transparent reports around performance and incidents, helping investors judge the riskiness of a corporation. Companies with high or rising numbers of incidents warrant more attention, and league tables of the best performers are easy to compile.
The regulatory environment differs from country to country but it matters which approach is taken to measure ESG risks. The legal framework of the country is the starting point. Does the country have well-developed laws around property rights, procurement, labour, insolvency, insurance, and health and safety? And how exactly does the government approve and regulate projects?
A separate regulatory agency is usually the most effective at safeguarding ESG standards, particularly if the regulator is independent of the government and free from political interference. The UK has one of the most transparent and strictly regulated water sectors, arising from a well-developed legal system and autonomous regulator, Ofwat. The regulator requires water companies to make many disclosures on customer satisfaction, reliability and availability, environmental impact and its financial health.
Indeed, Ofwat has teeth. In June 2018, it imposed fines of £120 million on Thames Water for leakages from its supply network. Environmental safety failures like this can lead to more than just financial penalties, for example credit rating agency views. Moody’s issued a negative bulletin in the wake of Thames’ leakage settlement in June 2018. Ultimately, the failure to protect consumers and the environment can lead to deteriorating credit quality and ratings, as well as higher funding costs. On the other hand, companies that perform well in terms of operational performance and environmental standards, and who successfully advertise their green credentials, can be rewarded with favourable treatment from the regulator, rating agencies and bond investors.
Regulation by contract is where individual utility operators are held to a contract by the public-sector asset holder, normally a local government entity. However, the municipality may have insufficient resources to monitor the activities of providers. A third approach is self-regulation, where the utility is usually accountable to a board of directors or a city council. This generally leads to greater competition between companies but there is often underinvestment and little asset planning because providers cannot be sure their investment will be recouped through higher prices, leading to potential long-term inefficiencies in water usage.
Table 1: The regulatory structure makes a big difference
Source: World Bank, August 2018
Just how important the regulatory regime is can be seen from the 2011 Fukushima disaster in Japan. NISA (the Nuclear and Industrial Safety Agency in Japan) lacked formal independence from the Ministry of Economy, Trade and Industry’s Agency for Natural Resources and Energy - the ministry responsible for promoting nuclear power. This deterred NISA from asserting its power to make rules, order safety improvements and enforce decisions. Following the disaster, the government set up a new independent regulator within the Environment Ministry.
Regulators are only part of the puzzle. Companies decide how and what to communicate about themselves. Some offer minimal disclosures in reports hidden away at the bottom of websites while others articulate clear ESG policies and targets and actively promote detailed reports filled with user-friendly visualisations.
Good ESG reports should be included in different corporate communications from the annual report to presentations to analysts and shareholders, quarterly calls and standalone documents. They should clearly identify standards, procedures, and any breaches along with their associated costs. The company’s record of achieving key performance indicators (KPIs) is a measure of how well a company can meet its goals. These communications help build a picture of a company’s ESG track record. However, if the disclosure level is poor, a skilled investor can gain an advantage over the market by undertaking their own due diligence.
It’s often said that ESG isn’t an issue until it becomes a problem. There’s some truth to that: often companies don’t provide detailed ESG data until there is a breach and the scrutiny of the market is on them, and bad PR can make a difference. The regulator is not immune to this effect either. The Fukushima disaster led to regulators around the globe tightening their (already quite strict) supervisory regimes. Spotting where the weaknesses lie before the event is difficult, but there are some methods which can point investors in the right direction.
Monitoring a company’s capital spending can identify risks before they happen. Companies which reduce capex may flatter their earnings but they could also be sowing the seeds of future problems: inadequate investment in physical assets often leads to a tired, worn out plant. There is a correlation between low capex and high numbers of operational issues, and investors should not automatically give a company credit for reducing capex. Generally, capex should at least match depreciation - the natural rate of deterioration of physical assets - if operational integrity is to be maintained. Comparing capex to historical levels and a company’s peers can indicate what the true rate of maintenance capex is. If a company cuts capex then management needs to justify why.
- Who are the regulators? - the regulatory environment offers clues as to how safe a company’s operations are, the incentives to avoid incidents, and how likely failures will be spotted quickly and remedied.
- The quality of management - is the management team competent and does it perform well on operational measures? Does the management team have a strong or poor track record in its area of business?
- Does the company communicate its thinking around ESG? - how well a company communicates its ESG policies and performance indicates how seriously it takes ESG.
- Monitoring capex - the level of capex is a strong barometer for future operational issues. Spending on capex should at least cover the cost of depreciation.
Mining: Glass half full
The mining sector often gets a bad reputation when it comes to water. The industry is one of the most intense users of water, which companies use in extracting and processing commodities. But miners, particularly multinationals, have some of the most rigorous and developed approaches to water efficiency.
For miners, managing water is essential, not only for day-to-day operations, but also because regulators and governments take it very seriously, particularly where companies are in competition with local communities for a scarce resource. It’s easy for a mine to contaminate the local water supply, which would be disastrous for the local community, so authorities cannot be seen to turn a blind eye. Investors know that clean-up costs are high and contamination can make them less willing to fund future projects and make new licenses harder to acquire.
For those reasons, before the first rock is turned over at a new pit, a good miner will have completed an extensive environmental evaluation and produced a comprehensive mine plan, including a detailed strategy on how to source and recycle water, and dispose of waste.
The approval process for a mine often places high importance on local community acceptance, obliging miners to be open about their policies. In most cases, miners simply won’t get approval unless there is a clearly communicated water plan. Therefore, counterintuitively, miners have long been focussed on ESG, while operating in a sector with high environmental risks. Because the easy gains were made long ago, water efficiencies in mining tend to be incremental, although that’s not to say there’s not more to be found.
Note: Water extracted per cubic tonnes of ore milled. Lower amount means more efficient milling.
Source: Randgold Resources, August 2018
However, given the risks involved, invariably things do go wrong. Even among the big, established miners with leading safety records accidents happen. Samarco, the Brazilian iron ore joint venture by BHP and Vale (both with industry leading safety records at the time), ran the Bento Rodrigues dam, which failed in 2015 causing catastrophic flooding, killing 19 people and displacing several local communities.
We had invested in the bonds of Samarco and, in the aftermath of the accident, formed a bondholders group to negotiate with the company. The group, together with the government, demanded a cleanup of the mess to be funded by BHP and Vale, and a return to normal, safe operations. This made sense from an ESG and business perspective. Accidents can’t always be avoided, but the response of investors can make a difference to how a company manages the fallout.
To assess a project’s sustainability investors can check several factors. Differences in location and geology are very important. Other areas of risk lie in licensing, community engagement, and infrastructure. Having a solid understanding of the political landscape will put these risks into context.
How comfortable can investors get on execution? Excellent plans can be undone by many issues - controllable and uncontrollable. To assess delivery risk, it’s important to look at how the company intends to manage the project - whether that’s EPC (engineering, procurement and construction) contractors, company-managed or a hybrid - and to track progress as far as possible against the key milestones.
The macroeconomic backdrop is crucial to consider. Inflation, commodity prices, currency exchange rates and other macro risks can affect the cash flows of a project and, if they result in higher costs than expected, companies may have to raise additional capital, potentially hurting current investors.
Related to the technologies used in mining is innovation. Miners are problem solvers and constantly develop new and creative techniques, which can materially affect the ESG judgement. One recent example is the introduction of coarse-particle recovery. New techniques are enabling recovery of metals from larger particles, meaning that water is more easily extracted, so less fresh water is required. Estimates suggest it saves 30-40 per cent water.
- A track record isn’t enough - don’t assume the traditionally safest companies are immune from accidents. Where possible, dig into the specifications of individual projects reviewing any changes in the political and regulatory landscape.
- New project analysis is important - risk-based work should help to home in on the key risk factors.
- Look for innovations - companies operating in industries with high environmental risks may be developing new and creative solutions which can affect the ESG risk.
Shipping: Murky waters
Shipping faces considerable upheaval from the adoption of new regulations. Last year, the Ballast Water Management Convention by the International Maritime Organisation (IMO) came into force to control the transportation of ballast to other parts of the world. Ballast water provides stability to boats and is discharged from the ship at its destination. But the discharge, and leakage along the way, can upset local water systems with pollution and foreign organisms. In the US, ballast water is believed to be the leading cause of introducing invasive species in marine waters.
The IMO will also introduce a sulphur cap on emissions from 2020, reducing the allowable level from 3.5 per cent to 0.5 per cent. This is setting off a chain of events amongst shipping companies but the impact on them is still unclear.
Shipping companies can deal with the new regulations in two broad ways: switch to compliant fuels or fit sulphur scrubbers to ships. But the decision is not straightforward. There are too many complex factors involved and making accurate forecasts about each of them is near-impossible.
Scrubbing is a mechanism that fits onto transport ships to reduce emissions. The machines are expensive and fitting them requires ships to be taken out of service into dry docks, resulting in lost revenues. The age of ships is also a consideration; for older ships the cost of fitting scrubbers might not be compensated by revenues earned over the remaining working life of the vessel.
Neither is it clear how switching to compliant fuels would affect shipping companies’ profitability. Clean fuels with a low sulphur component are more expensive than dirty fuels, but while the price spread between them is relatively low now, it’s another matter whether that remains the case in the future. There is relatively little low-sulphur refining capacity and it takes around five years to bring on new capacity. We expect most shipping companies to choose to upgrade their fuel, meaning the spread may well increase, making such a shift costlier.
Source: Bloomberg, August 2018
Whether the industry can pass on the cost of complying with the new regulations to customers will make a big difference to shipping companies’ profit margins. We think there will be some ability to share the pain but it’s unlikely to be a full pass-through because their clients’ margins are already being squeezed and they, in turn, may not able to fully pass on the higher costs to their customers.
Shipping companies themselves are little wiser; there’s significant uncertainty about the best solution to manage the IMO regulations. Some, such as Mediterranean Shipping Co (MSC) and Evergreen, have chosen to install scrubbers on all their new vessels, while Maersk and CMA CGM have committed to using compliant fuels. However, the industry upheaval is going to be expensive. CMA CGM expects its annual fuel cost to rise by US$ 2 billion - a nearly 60% increase. Some estimates pitch the total cost to the industry of around US$ 240 billion by 2020 which is certain to reshape the industry.
Understanding these scenarios can be time consuming and difficult but there are tools which can help analyse new industry paradigms such as scenario analysis and precedents set by other industries. Thinking through different outcomes helps to home in on the make-or-break assumptions and to find the areas of research where the bulk of an analyst’s time can be spent most productively. This approach can also reveal which assumptions are priced into securities, making it possible to spot mispricings.
Lessons from other industries can support the analysis, for example, from those that have long faced curbs on emissions, or from utilities where scrubbers have been widely adopted. Moreover, some of these industries may be susceptible to knock-on effects. We expect clean fuel refiners to be winners from increased demand, and logistics companies to be losers from higher shipping costs.
- Unpack complex events - this makes it possible to home in on where to spend the bulk of their time. Scenario analysis and precedents from other industries can help here.
- Understand assumptions - learning which assumptions, and to what extent, are priced in to securities is crucial. These assumptions can then be tested and used to find mispricings.
- Check the externalities - finding other industries and companies that are indirectly affected offers more opportunities to uncover winners and losers.
Chemicals: Diving deeper
The lazy view of chemicals manufacturers is that they are a disaster for the environment, but the truth is not so black-and-white. Indeed, the industry counts some of the most ESG-aware companies among its ranks, perhaps prompted into good behaviour by public alarm at the danger posed to the environment by what they make.
Take plastics, the chemicals producers’ biggest business. Plastics have a multitude of vital uses including packaging that keeps food fresh. Banning plastics would lead to mountains more of food waste. But plastics, especially single-use ones, are polluting the oceans.
Table 2: Plastic fantastic - benefits of plastics
Source: Berry Global, Ocean Conservancy, August 2018
Single-use plastics are not recycled and can take 500-1000 years to degrade. PET (polyethylene terephthalate) bottles comprise 15 per cent of total marine waste - the third most common item found in ocean debris, followed by the caps/lids of PET bottles. Ocean waste also has a nasty habit of congregating in zones which are populated by sea life because the same currents act on both groups.
Diagram 1: The Pacific Garbage Patch - ocean waste converges with sea life
Source: NOAA Marine Debris Program, August 2018
The solution is more recycling but this is not as easy as it is for paper or glass. Plastic items can be complex, containing multiple layers of polymers that are extremely difficult to separate before being ready for the recycling process. In many countries the infrastructure required to recycle simply isn’t widely available, so only 14 per cent of the world’s plastic packaging is recycled.
Finding an answer to the plastic problem is made harder by the difficulty in linking a specific producer to an item. Chemical companies produce plastic pellets which are then melded together by packaging companies. And a single piece of packaging often contains multiple parts. It is extremely difficult to allocate responsibility for waste with such convoluted and intertwined supply chains. Getting the packaging brands like Coca Cola on board, as well as the plastic makers, is crucial for the recycling effort.
The good news is that the largest chemical companies are taking these issues seriously. In our experience, many of them recognise that they are big resource users and therefore must prioritise ESG. Their history of being one of the first industries to develop modern and rigorous standards around health and safety has been applied to social impact awareness and evolved into a broader environmental concern. New protocols from the Paris Agreement to emissions have added further impetus.
Fidelity engages directly and intensively with some of the largest chemicals manufacturers to encourage them to invest in sustainable production. This dialogue seems to work. Important developments include light-weighting, where the mass of material in each item is reduced without sacrificing performance, and single resin use, which removes the cost of separating polymers and makes recycling more viable.
Large investors are well-positioned to influence managements because they have access and financial clout. We note that Ineos, the third-largest chemicals producer in the world, introduced a new section on sustainability in its April 2018 presentation to analysts and shareholders following questioning by major investors some months earlier. Ineos also abandoned the construction of a new polymer facility to concentrate on more recycled materials. Solving existing pollution of the oceans is another matter but engagement like this may slow further problems. Water and waste policies from many industry players are rapidly becoming more explicit, even when compared to the start of the year.
ESG rating agencies
Investors can use third-party ESG ratings to guide them but these opinions have limits. Their views are useful, particularly at the start of the investment process, when their reports can draw attention to areas of interest and help with benchmarking a company against peers. However, their opinions are based only on publicly available financial reports, missing out the more nuanced detail in other communication and engagement. Some companies are not explicit about ESG or only provide minimal disclosures and as a result are marked down by rating agencies, even though a lack of information doesn’t necessarily mean they have a poor ESG profile.
Investors can add depth to the ratings by probing companies directly, testing ESG scores, and seeking multiple sources of reassurance. Companies with low levels of ESG disclosure can be asked for more detail, and these companies offer investors an opportunity to gain an information advantage over the market. Also, ongoing dialogue with companies creates investor value through soft diplomacy and cultivated, long-term relationships.
- Question the conventional view - stereotypical views can be overly simplistic and outdated. It’s worth delving deeper into the issues and uncovering the nuances.
- ESG engagement is powerful - directly opening and maintaining dialogue with companies can be a powerful way to affect change and create enduring advantages over the rest of the market.
- Third party ESG ratings have drawbacks - these can be useful, particularly when beginning due diligence, but they are not a substitute for a comprehensive, considered view.
Issues around water are complicated, and conventional views of industries and their ‘water-friendliness’ are often outdated. We see that some industries have very well developed regulatory structures policing water use, while others police themselves and yet others probably need a bit more policing.
What the example of water shows is that there is no ‘one-size-fits-all’ approach that can work when assessing important ESG subjects, and no substitute for individual company or project research. Using third-party ratings agencies is a good start but it will only get you so far - the heavy lifting happens with detailed analysis of each case. This deep diving can create enduring advantages for investors willing to do the work, and it sets up the conditions to engage productively with managements.
 Mining Weekly, August 2017
 Ocean Conservancy, March 2004
 Ocean Conservancy, 2017
The regulatory structure governing the industry can make a big difference to judging ESG risk
How a company communicates its thinking around ESG says much about its attitude to it
A company’s ESG track record is an important indicator of risk, but it’s not necessarily enough to judge standards. Monitoring KPIs and capex can help identify potential operational issues
Generalisations don’t always work - instead look at the merits of individual projects, noting any innovations
Unpack complex events by conducting scenario analysis, taking precedents from other industries, checking externalities and understanding assumptions baked into security prices
Third-party ESG ratings are useful but limited
ESG engagement is a powerful tool to shape corporate behaviour
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