Environmental, social and governance (ESG) considerations have always played a fundamental role in M&G Investments’ valuations-based investment process. For over 25 years we have considered their potential impact on a company’s sustainability, as reflected in that company’s expected future earnings and cash flows. While historically most investors have paid more attention to the governance side of ESG than to the social and environmental sides, in recent years, these factors – especially environmental – have been playing a more impactful role in our investment decisions. Here we explain why this is, and look at some of the specific environmental factors we analyse in building our client portfolios.
More impact from environmental considerations
In the past it was relatively difficult to quantify the future earnings impact of both a government’s and a company’s environmental policies (if the latter even existed). These days, however, we have many more sources of data, with much more detailed information to analyse regarding environmental risks and future costs. These stem from governments’ clearer and more numerous regulatory policies – including carbon taxes – and companies’ own business plans to reduce their impact on the environment.
The environmental cost of companies’ operations has not been taken into account accurately for decades, meaning that the damage that is being done to the planet as a result of carbon emissions and high water usage (among other unsustainable practices) is much higher than the financial cost companies have had to carry in their financial statements. The result is that future generations will have to pay for the cost of past mistakes, which governments are becoming increasingly aware of. In turn, governments are trying to “price” for the damage being done to the planet through different taxes, restrictions and regulations.
In the future, therefore, there will be a real cost to companies based on currently “intangible costs” like tons of carbon emitted. Some companies may so far have saved millions of rands in capital expenditure, which is a real cash cost, by having avoided converting their assets to more carbon-efficient methods, and managed to remain competitive with peers that have decarbonised to some extent. In a world of high carbon taxes, however, the cost to the environment will be reflected in the financials of carbon-emitters. The result? Companies that are more carbon-efficient will gain a major cost advantage over companies that are not, potentially putting high carbon-emitters out of business.
Environmental factors in investing
Climate change, carbon emissions, and water and energy usage are all high on our list of factors we use to assess whether a company’s earnings will be sustainable going into the future, and how they impact its current valuation. Companies have been getting consistently better about improving their disclosure around ESG, with many publishing their maiden Task Force on Climate-related Financial Disclosures Report (TCFD Report), where companies detail their climate change strategy and outline different scenarios around greenhouse gas reduction ambitions. Part of our job as investors is to analyse a company’s strategy and attempt to answer such questions as:
Whether the strategy is ambitious enough to remain competitive;
What capital expenditure (capex) will be needed in the coming years to implement the strategy;
Whether the company’s balance sheet strength (cash) will be able to carry out such capex plans without needing to raise more capital; and
What the cash cost of carbon emissions would be for the company if carbon taxes were to be raised to levels in line with developed markets.
Banks and capital markets are also becoming more stringent in terms of lending money to companies that have a poor ESG rating, which may drive up the cost of borrowing disproportionately for different players. Certain industries will always be heavier carbon emitters than others, and therefore the key consideration is whether the company will remain competitive within its peer group if it doesn’t reduce emissions sufficiently and within a reasonable amount of time.
In reality, the ability of a company to reduce its carbon emissions is certainly not an easy task — sometimes alternatives are just not viable for different reasons, and the landscape for these options is shifting as more investments are made. Constant engagement with management teams to learn about how they are considering transitioning their businesses, learning about their challenges and engaging with them on the importance of ESG is the final part of the analysis.
All these considerations have a material impact on a company’s free cash flows, its future dividends, and the valuation multiple the market will therefore assign to the company. So not only is their environmental impact an important ethical consideration for companies, but it is a key factor for investors in determining what the long-term fair value of a company is and whether we can make money by investing in its shares.
PPC and environmental considerations
PPC, one of the largest cement producers in southern Africa, is one company we are holding in our client portfolios which has large carbon emissions. Cement producers by their nature emit high levels of carbon, half of which result from the energy-intensive nature of the process and the other half from the chemical reaction that takes place in producing the clinker (called the calcination process, where the limestone is heated to extract the calcium oxide but releases carbon dioxide as a by-product).
The primary area where most of the reduction in emissions can be achieved over time is from a company’s energy sources, but the calcination process is very difficult to adjust. PPC has committed to reach net-zero, or carbon neutrality, by 2050, while at the same time aiming to cut its emissions from current levels by 10% by 2025 and by 27% by 2030. It has set aside a budget of some R664 million to achieve its 2025 target in several ways: investing in renewable energies such as wind and solar power to add to its mix of energy sources; using alternative fuels to coal; and making its plants more efficient, among other initiatives. In time, as technology improves, the need for clinker-based cement products should be reduced, so ensuring that PPC spends enough on research and development is an important element in helping them remain at the forefront of the industry as cement-alternatives become more common.
Given that it operates across a number of southern African countries outside of South Africa with less sophisticated economies, PPC’s decarbonisation efforts beyond 2025 will likely be even more costly. At the same time, its cost of capital could be under pressure to rise should investors opt to avoid carbon emitters. The company has been de-carbonising since 1990, having already cut its CO2 emissions across its power generation system nearly 30% since then. However, it still pays carbon taxes and faces the likelihood of paying significantly more in the years to come if they do not reduce their emissions.
In conclusion, this is only a glimpse into the environmental considerations we take into account when conducting our analysis of PPC and other companies. These days “E” factors are playing an increasingly impactful role in our investment process given the availability of more data and environmental policies. It is still early days in terms of the disclosure and strategies that companies have in place, however — the investment industry has an important part to play in encouraging improvement in this area as it also improves our decision-making ability around a company’s longer-term sustainability. Our ultimate goal is to determine whether the company’s current market valuation makes sense in light of these additional risks, and consequently whether it is a good candidate to add to our client portfolios.
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