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For early signs of trouble, look to credit portfolios

Credit portfolios with genuine Environmental Social and Governance (ESG) integration could be a canary in the coal mine for potentially difficult-to-quantify risks and opportunities, including those likely to stem from climate change and the energy transition.

While governments globally move at different speeds to put in place net zero policies, ESG-focused credit investors are taking decisive, early action to reflect these factors in their portfolio allocations. 

Ongoing engagement with Origin Energy by First Sentier Investors’ Global Credit team points to the weight ESG factors such as carbon emissions carry in the assessment of credit quality, even while the Australian carbon pricing market is still in a nascent stage.

The disclosure in Origin’s 2021 Sustainability report that it emitted around 16 million tons of carbon into the atmosphere in the 2021 financial year represented enough of an immediate risk for First Sentier to question the company, on the basis that its exposure to carbon risks could make it vulnerable to credit issues in the future.

We believe investors should be closely watching Origin’s climate change plan, which includes a science-based GHG (greenhouse gas) emissions reduction target of 50% from a base year of 2017 and exit from coal by 2032 or earlier. These actions show a commitment by the company to manage and reduce its exposure to carbon risks.

We expect specialist investors in the credit asset class with a focus on ESG risk will be paying particular attention to the deteriorating economics of the company’s coal power plants, potential stranded assets, and possible stricter regulation or climate litigation.

While the long-dated nature of climate goals and emissions targets makes these risks potentially difficult for equity investors to quantify, they are beginning to weigh more heavily in credit analysis, which considers early identification of the operational and economic headwinds that credit issuers might be facing. 

Through the credit lens

Risks that might appear non-financial today can become financial risks in the future, potentially jeopardising companies’ ability to service debt repayment obligations, a new report entitled ‘The importance of ESG risk in Global Credit’, highlights.

Unlike shares, which theoretically have unlimited upside potential, credit market and fixed income returns have more binary outcomes:  investors either receive scheduled coupons (which are essentially interest payments) and the repayment of the principal upon maturity – or, in the case of a default when the company can’t pay its debt obligations, something less.

The asymmetric nature of credit and fixed income returns – as explained above – means changes in risk need to be captured as early as possible, particularly where a cash flow outlook might jeopardise a company’s ability to fulfil its debt repayment commitments.

Credit analysis is not only an early predictor of impairment and financial risk, it also lends itself to the deep consideration of ESG factors, the report also highlights.     

Indeed, ESG risks rank highly among the many risk dimensions credit analysts consider to judge the creditworthiness of companies over time, the report notes.

Companies’ management of ESG-related issues has a direct impact on their risk profile and, in turn, the probability of default. If a company manages ESG risks poorly, it’s difficult to have confidence that other risks are being managed appropriately, the report concludes.

Finding red flags

Analysis that is obsessed with future financial risk and deeply intertwined with ESG considerations is likely to turn up situations and scenarios other asset class research might overlook.

Climate and energy transition is one area that lends itself to future financial risk interpretations; governance and reputation risks can also feature in credit research outcomes.  

High levels of controversy, or an unwillingness in management to change, are red flags that can turn up in ESG-focused credit analysis. 

Companies that refuse to improve processes, behaviour and culture to better manage material environmental and social risks are likely to be vulnerable to future material financial impact - through litigation, fines and loss of reputation - the report highlights.

Furthermore, formal reviews and audits of existing policies and practices can incur meaningful costs, divert management attention, and damage a company’s brand name and reputation, the report notes.

On the positive side, First Sentier Investors upgraded its ESG risk rating and ultimately the credit outlook for US-based agricultural machinery manufacturer Deere & Co in 2021 following the company’s increasing use of renewable energy sources in the manufacturing process, steady progress on greenhouse gas emission targets and a reduction in product safety recalls.

The ability to estimate the potential financial impact of a particular issue in some cases can be relatively straightforward, while other issues can be trickier to quantify in financial terms but are equally important. Exposure to modern slavery, for example – or other controversies in a company’s supply chain – can erode the firm’s financial position and are a focus of credit analysis, the report notes.

Credit analysis with a focus on ESG risk is likely to uncover potentially difficult-to-quantify risks and opportunities early that could be predictive of any future deterioration a company’s financial position.

Important Information

This material has been prepared and issued by First Sentier Investors (Australia) IM Ltd (ABN 89 114 194 311, AFSL 289017) (FSI AIM, Realindex), which forms part of First Sentier Investors, a global asset management business. First Sentier Investors is ultimately owned by Mitsubishi UFJ Financial Group, Inc. (MUFG), a global financial group. A copy of the Financial Services Guide for FSI AIM is available from First Sentier Investors on its website.

This material is directed at persons who are ‘wholesale clients’ (as defined under the Corporations Act 2001 (Cth) (Corporations Act)) and has not been prepared for and is not intended for persons who are ‘retail clients’ (as defined under the Corporations Act). This material contains general information only. It is not intended to provide you with financial product advice and does not take into account your objectives, financial situation or needs. Before making an investment decision you should consider, with a financial advisor, whether this information is appropriate in light of your investment needs, objectives and financial situation.

Any opinions expressed in this material are the opinions of the individual author at the time of publication only and are subject to change without notice. Such opinions: (i) are not a recommendation to hold, purchase or sell a particular financial product; (ii) may not include all of the information needed to make an investment decision in relation to such a financial product; and (iii) may substantially differ from other individual authors within First Sentier Investors.

To the extent permitted by law, no liability is accepted by MUFG, Realindex nor their affiliates for any loss or damage as a result of any reliance on this material. This material contains, or is based upon, information that Realindex believes to be accurate and reliable, however neither MUFG, Realindex nor their respective affiliates offer any warranty that it contains no factual errors. No part of this material may be reproduced or transmitted in any form or by any means without the prior written consent of Realindex.

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