Fixed Income Boutique
Every year in November, Swiss places of work welcome a batch of new employees, for one single day. The day is called Zukunftstag (Future Day). On this day, children aged 10-14 are hosted at their place of work by a parent, relative, or a family friend. Future Day is a big deal in Switzerland and here in Vontobel too.
As every year, children take the opportunity to ask us portfolio managers all kinds of questions. To keep the kids happy, we relied on what we thought as a sure-fire thing, chocolate. Well, that didn’t work as well as we expected.
There we were, passing out the chocolate, when one of the children asks.
“Is this chocolate made with palm oil?”
We were flummoxed. Where did this question come from? It turns out the child was concerned with the environmental footprint of palm oil production.
We discussed this amongst us (not palm oil production, rather that the child was so clued in on environmental matters) and found that we had all had similar experiences, with kids showing a high level of knowledge when it comes to the environment.
While politicians and investors struggle to make progress on improving the environment, the upcoming generation is laser focused on the issue. While ESG is a key part of our investment process, our recent discussions during Future Day certainly added awareness and pressure – what we, as investors, do to improve the state of our planet is something the next generation will judge us on. That is a big responsibility for us to carry. So, how can we step up to this challenge whilst still delivering attractive returns?
In this article, we look at one of the ESG hot spots and provide a case study on how active investors can use ESG analysis as a tool helping to improve the environment.
The utility sector is a major pillar of the US economy with more than 40 utility companies generating USD 351 billion in revenues in 2020 and contributing about 5% to US GDP. It is the country’s most capital-intensive industry and, given the challenges the sector faces on the environmental front, it is in the crosshairs when it comes to ESG analysis. The sector’s massive use of natural resources (albeit to satisfy basic needs such as electricity) puts it front and center in the fight against climate change.
Despite its bogeyman image it’s important to note that the industry’s power generation mix has already changed for the better over the last decade (see chart 1).
The transition to a low-carbon footprint is a priority, as electricity generation is the second largest sector in terms of greenhouse gas emissions (GHG), accounting for about 27% of the US total. On top of that, 60% of the CO2 emissions of the US electric power sector comes from coal, and the International Energy Agency (IEA) has already warned that the carbon transition is going too slowly. To speed things up, investments in clean-energy projects and infrastructure would have to triple to USD 4 trillion by 2030 to reach net-zero emissions according to the IEA.
Companies have different strategies for meeting low-carbon requirements or targets, and they are in various stages of the transition away from fossil-fuels. For instance, companies such as PPL, American Electric Power Co., and DTE Energy are still heavily reliant on coal-fired generation, while coal is only about 10% of Dominion Energy’s generation mix, and California utilities Sempra Energy, and PG&E Corp. don’t use any coal.
The transition to carbon neutrality requires huge investments by the utility companies as they shift their generation mix toward renewables and upgrade or modify their infrastructure. Currently, 68% of the utility companies in the US investment-grade index already have a net-zero goal.
Source: Barclays ESG Research, October 2021
As these firms strive to reach their environmental goals, their capital expenditures increased about 7% to USD 133 billion in 2020 and for 2021 the Edison Electric Institute1 estimates spending will grow another 8% to 143 billion. We expect the spending to be largely funded by the capital markets, and in particular, the bond market will be at the forefront. Year-to-date, investment-grade utilities have issued USD 73 billion of debt, with full-year 2021 supply estimated by JP Morgan to be 85 billion. The utility sector is also the largest issuer of green bonds in the global corporate bond landscape, relative to the sector total debt.
The move toward renewables also has implications for ratepayers, as a portion of the investment spending is typically passed along in higher rates. Keeping rate increases to a reasonable level is important for maintaining good relationships with regulators and customers. Maintaining safe and reliable systems during the transition period is also critical, especially as renewables begin to play a larger role.
Duke Energy (DUK) from North Carolina is an example of a utility company’s transition towards cleaner energy. Already back in 2019, management updated its climate strategy with a new goal of net-zero CO2 emissions by 2050 and Duke also accelerated its near-term goal by targeting at least a 50% reduction in CO2 emissions by 2030 (versus its prior goal of 40% by 2030). As Graph 3 illustrates, in 2030 coal is envisioned to decline to 7% of the generation mix, while renewables/hydro would swell to 19%.
The ambitious targets seem achievable as Duke has already reduced CO2 emissions by 40% since 2005, ahead of the industry average of 33%. To boost its strategy, the company plans to double its portfolio of solar, wind, and other renewables by 2025. Management is also committed to modernizing the grid as well as advocating for public policy that advances renewable, storage, and new nuclear technologies.
Overall, these specific transition plans in the utility sector towards cleaner energy will be key to achieve CO2 emissions targets and provide opportunities for investors.
Detailed industry knowledge lays the foundation for incorporating ESG considerations into investment decisions. Typically, many investors start with a “negative screening” by excluding sectors and market segments, which are not aligned with sustainable goals. This might include segments such as tobacco, controversial weapons, or intense thermal coal generation. However, just applying an exclusion list to an investment universe or using an ESG-labeled benchmark, leaves out the active part of investing.
To generate alpha, investors can identify and select companies with an improving ESG trend as bonds from these companies should outperform their peers in the long run. In our view, this “positive screening” should play an active part in an investor’s investment decision, similar to when selecting issuers with improving credit metrics (e.g., rating upgrade candidates, such as “rising stars”).
With the utility sector, it is worthwhile to assess the various transition strategies and select the most transparent and ambitious yet practical ones. Transition will not happen overnight, and an abrupt stop of certain power generation practices might also be detrimental to consumer interests and the broader economy. However, engaging with companies and holding management to account is another element of an active stance when it comes to ESG investing, helping to drive progress towards ESG goals.
In our example, Duke Energy lays out an ambitious plan for improving its energy mix – a potentially improving ESG credit story. We then compare Duke Energy to other companies within its peer group of BBB+/BBB rated US utilities and see striking fundamental ESG differences, and Black Hills Energy Corporation (BHK) for instance is a good comparison. We note that Duke Energy is much less carbon-intensive and more advanced in its carbon transition, with clear CO2 net-zero targets by 2050, whereas BHK is barely targeting a greenhouse gas emission reduction - 40% by 2030 and 70% by 2040, compared to 2005 levels. This glaring difference is not reflected in the current pricing of the outstanding bonds – a market inefficiency which seems worth exploring.
More than six months after the EU introduced its new Sustainable Finance Disclosure Regulation (SFDR), most of the Article 8 classified funds are not following a positive screening, according to a recent study by Barclays Research2. Exclusions, or negative screening, appear to be commonplace among Article 8 and 9 funds, at least in Europe, whereas they are less popular in North America according to Barclays Research.
It will be interesting to monitor the ongoing trends in ESG investing and we hope that the increasing focus of investors on companies with good and/or improving ESG characteristics helps to drive the positive change towards a more sustainable world. We will continue to use positive screening to help us identify the most attractive bonds, and as ever, keep you updated.
1. The Edison Electric Institute (EEI) represents all US investor-owned electric companies. Its members provide electricity for 220 million Americans.
2. Source: Barclays ESG Research, September/October 2021