ESG INTEGRATION IN FIXED INCOME

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1 ASSET MANAGEMENT ESG INTEGRATION IN FIXED INCOME RESILIENCE TO CLIMATE CHANGE IN THE ENGLISH WATER SECTOR The view from Royal London Asset Management (RLAM) This analysis represents crucial progress in the ongoing collaboration between RLAM s Fixed Income and environmental, social and governance (ESG) teams, targeting a sector that is not captured by off-theshelf ESG research. The research has also provided useful context for targeted engagement with issuers, regulators and public bodies. The necessary integration between the two teams, combining quality ESG insights and an understanding of their transmission into identifiable credit risks, should leave us well placed to better future-proof portfolios without compromising return. This project gives me great confidence that RLAM s objective of delivering Fixed Income and ESG integration that truly enhances our proposition for clients is achievable. Introductions Martin Foden, Head of Credit Research Third party ESG research has historically been equity focused, but as part of an ongoing collaboration between RLAM s Fixed Income and ESG teams, we are seeking to enhance our understanding through focused analysis. The water sector has been specifically targeted due to its primarily private ownership and significant use of debt capital markets, maximising the potential for genuine information discovery as a foundation for focused issuer and stakeholder engagement. Really, truly long term The water sector is unusual in that people who work in it are equally focused on both short-term and long-term risk. Stewards of assets with lifetimes measured in centuries and unable to up sticks and leave when the going gets tough means that the very nature of water and wastewater companies work is long term. RLAM holds significant debt positions in English utilities companies, almost all of which are private and rely on debt markets for their capital spending; a number even have long-dated debt stretching out to the 2060s. The water sector is the classic buy-and-maintain sector where returns, being regulated, are predictable and risk and reward are modest. The past may not be a reliable guide to the future Residents of the UK will be familiar with an increased incidence of severe flooding and temperature and rain variation from season to season over the past decade. There has been much debate over whether these events can be attributed to climate change and more specifically man-made or anthropogenic

2 climate change. Climate scientists are in the main reluctant to back this connection yet, because the sample size and time period is too small to extrapolate. However, they do forecast that variation of this nature is consistent with what we can expect over the coming century. The ESG team surveyed the water sector for plausible risks, with a focus on climate change because of its expected impacts on extreme weather and water quality. Most of the South East of England is classed as water-stressed. The Met Office s projections suggest drought and greater flooding will only intensify, putting greater strain on the ability of companies and agencies to deliver the high standard we have become accustomed to. The Environment Agency Fund Strategy Opposite: The Environment Agency Pension Fund uses similar assumptions to RLAM on timing and severity. This is that the physical impacts from climate change will come to the fore progressively over the 2030s and 2040s. The Anglian Water region is on the frontline of the global climate change challenge. It serves the largest geographical area of any water company in England and Wales and is the driest and fastest growing in the UK, with over a quarter of the land below sea level. The impact of climate change will be felt here first, with likely severe consequences. Anglian Water s Water Resources Management Plan 2014 Climate change in practice: how will it affect the water sector? The Government s National Infrastructure Plan 2010 projects a need for over 375 billion to be invested in infrastructure over the next decade (The Climate Change Committee, 2014). The Plan recognises climate change as one of the five things that will have a major impact on the country s infrastructure. Some of the impacts that can be expected from climate change, assuming little by way of mitigation and adaptation, are as follows: Primary Effects Physical Impact Outcomes for companies Increased flooding incidence and severity Storm damage to water infrastructure, much of which is coast or riverine based Increased spend on repairs and upgrades Cross-contamination of waste and drinking water (sewer failure) 2 P A G E

3 Primary Effects Physical Impact Outcomes for companies Increased drought incidence Increased evaporation Increased and unsustainable use of slow-accumulating underground water ( groundwater ) Regulators impose restrictions on companies abstracting groundwater Supply curbs Lower reservoir levels affect hydro power Increase in expensive supply alternatives: e.g. trucks, desalinisation Secondary Effects Physical Impact Outcomes for companies Ecological changes New pathogens enter water system because of increased sea temperatures Increased spending on water purification and treatment Infrastructure interdependency Current electricity generation from coal and nuclear needs lots of water. Unless we switch to less thirsty sources that can meet growing demand, there will be a conflict between power and water needs. Capex may be skewed toward certain technologies e.g. desalinisation Acutely uneven changes in rainfall would increase demand for water trading, which is expensive and energy/carbon intensive Global problem, local solutions The connection is often made between the onset of climate change and dwindling freshwater resources worldwide. But water problems are inherently local in nature and so are the remedies. What is striking is how even in a small country such as England the challenges facing a water company in one zone can be entirely different to one a mere hundred miles away, including the anticipated effects of climate change. Although credit rating agencies are beginning to look at ESG issues like corporate governance and climate change, how safe they think these companies are does not yet capture the often stark differences in the local circumstances companies face, which could be critical to their ability to adapt to climate change in the future. As a creditor, this information discovery can give us an advantage over a market which often defers credit analysis to credit rating agencies and ESG analysis to the equity market. 3 P A G E

4 Regional vulnerability to water shortages Opposite: reliance on groundwater (aquifers) which is typical in drier regions, as opposed to the rain-fed and riverine supply system of wetter regions, increases vulnerability to water shortages. Source: UK Groundwater Forum as at 2014 Southern Water operates across multiple conservation areas and gets as much as 72% of its supply from rain-fed groundwater. Population is also forecasted to increase by 19% by 2040 and rainfall to drop by as much as half by Southern Water reports climate change as only its 3rd biggest risk. Its more pressing concern is how to overcome large reductions in what they are allowed to withdraw from the ground, driven by EU law. Its customers will have to become more efficient at saving water or some restrictions will have to give way. Our methodology We went through the following steps: Identify investee companies in water-stressed zones Review company literature on forward planning & climate change Evaluate Ofwat's company scoring on environment and service quality Rate each company's corporate responsibility data Company engagement & refinement of scoring The ESG and credit research teams then selected four companies for engagement that had high physical risks or were performing badly or very well according to our desk review. We met with each company to better understand the risks they face and their unique circumstances, and we also met with the regulators, Ofwat and the Environment Agency. Following the meetings, we refined the original scores 4 P A G E

5 and ranking. The most advantaged company was that which had relatively low physical risk from climate change and strong management of environmental issues. Key Findings The most common operational risks that water companies identify were climate change, population growth and prospective legal reductions in water abstraction. The order of these risks varies from company to company. We agree with the view expressed to us by the Environment Agency, which is that climate change is genuinely embedded in how water companies plan for the future. It is not a secondary consideration. In the next 10 years, improving resilience against climate change will not involve many megaprojects. Rather, the leading companies are seeking to increase headroom in their physical assets to deal with an increase in the frequency and severity of climatological events by making adjustments to their existing plans. In the short term we do not expect to see huge calls on debt markets to fund resilience infrastructure. Rather we think the burden will creep up, over time. Local factors and constraints are highly relevant, which makes each company s circumstances and their ability to meet their obligations very different. We think this is something which is overlooked in mainstream research. The credit market is not differentiating significantly between issuers in credit risk and return terms. This is an opportunity for informed investors to dampen future risks without compromising return. Ultimately, political will, and how it interacts with the regulator, will be a key factor determining the level of protective investment from the sector. Whilst potentially constraining resilience investment, the current regulatory framework provides a very favourable backdrop to creditors. A marked change to these protections would allow for the transmission of higher investment spending into credit risk; for example, if water companies had to fund coastal protection projections without being compensated through price increases (as has happened on at least one occasion). Implications for our Investments This research will aid RLAM in adjusting its clients portfolio towards companies that scored best and vice versa, with the analysis further informing our investment view on two companies in particular. One company faced higher long-term risks from climate change, and the second company, which is a smaller position in portfolios, faced significantly lower risks. Based on the assessment, RLAM considered: a) Could it justify forfeiting some immediate financial advantage in a company that is exposed to high climate risk in favour of another company with low climate risk but lower return? 5 P A G E

6 b) Would the credit analysts favour a company that had lower climate risk and better management of it when considering companies offering similar compensation for credit risk? RLAM took the view that b) was the most proportionate approach in order to balance clients long-term risk and return requirements, especially in the context of the broad and significant protections within the sector from the regulatory framework. Further consideration is also being given to the company that RLAM has smaller exposure to but performed well in the climate resilience assessment. ESG research now forms part of the assessment process for water utility companies before a recommendation is made to invest and will provide ongoing context for continued engagement with our borrowers. The water sector deserves credit for being impressively advanced in planning for long-term environmental and regulatory change. However, there is reluctance for large scale investment. That fact is compounded by a political environment giving mixed signals about priorities. WATER: MARKET FAILURE? At least one company talked bluntly about storing up a market failure due to the fact that the public is not willing to accept higher utility bills in the short term in order to fund infrastructure investment that may keep costs down in the long term. But, as a study of infrastructure by engineering giant URS pointed out, inaction is not an economic option. The problem is compounded by the fact that companies often put off precautionary investment because there is a large margin of error in long-term forecasting which means it s not yet clear that large interventions would be the right ones. Conclusion While our work finds that it would not be justified to use climate change as a primary factor in determining the attractiveness of a company s debt, our analysis has given us a window on which companies are facing the biggest operational challenges and their capacity to overcome them. RLAM s holdings are favourably positioned in those who performed best on climate change resilience, with the exceptions noted above. Fixed income investors that understand the subtleties of this operating context are better placed to make better informed investment decisions. This analysis and engagement has provided a real opportunity for us to better future-proof our clients portfolios without compromising short-term returns. Issued by Royal London Asset Management May Information correct at that date unless otherwise stated. For professional investors and advisers only. Royal London Asset Management Limited, registered in England and Wales number ; Royal London Unit Trust Managers Limited, registered in England and Wales number RLUM (CIS) Limited, registered in England and Wales number All of these companies are authorised and regulated by the Financial Conduct Authority. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number Registered Office: 55 Gracechurch Street, London, EC3V 0RL. The marketing brand also includes Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between sub-funds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number Registered office: 70 Sir John Rogerson s Quay, Dublin 2, Ireland. Our Ref: 486-PRO-05/2015-AB 6 P A G E