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Sustainability trends in energy credits after Covid-19

Sustainability trends in energy credits after Covid-19

22-06-2020 | Insight
Finding affordable, low-carbon and reliable energy sources is a challenge for investors in the energy sector. A balanced investment approach focused on long-term sustainability characteristics is required.
  • Frances Pang
    Frances
    Pang
    Credit Analyst
  • Guido Moret
    Guido
    Moret
    Head of Sustainability Integration Credits

Speed read

  • Recent market shocks have heightened the pressure on energy companies
  • We have a positive view on investing in renewable energy sources
  • We favor efficient companies with quality assets and diversification strategies

A balanced and focused investment approach

Providing affordable, low-carbon and reliable energy to a growing population is a global challenge – and a conundrum particularly for the energy sector. Companies in the sector are finding that the resilience of their long-term financial and operational strategies is being tested, thanks to the declining cost of clean energy technologies and the growing regulatory momentum to limit greenhouse gas emissions.

For credit portfolio managers, it is critical to maintain a balanced and focused investment approach towards the sector. The key will be identifying those companies that by rethinking their investment plans and business models over the longer term can offset these challenges and weather long-term volatility through the economic cycles. These businesses will be better positioned in a lower-carbon future.

Investment candidates are those companies that are building a strategy which will be implemented in a safe, responsible and carbon-efficient manner, through technology innovation, digitalization and strategic partnerships. All of this will contribute positively to the environment and society, improve the quality of the company’s asset base, and boost the sustainability of cash generation over the long term.

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Recent developments in the energy sector

A double shock
The energy sector has been under severe pressure so far this year owing to a double shock: a collapse in oil demand relating to the Covid-19 lockdowns, and the oil war and failed OPEC deal, which generated an oversupply of oil and a downward price spiral.

The sudden and dramatic drop in the oil price has had a severe impact on oil-weighted producers, which are facing difficulties in maintaining profitability and free cash flow over the near term, and are replacing reserves in order to service debt over the medium to long term. Those with large near-term debt maturities could be at risk of declaring bankruptcy.

Unlike the oil market, the gas market has not been burdened by geopolitical tensions from OPEC+ countries. Gas prices have therefore been more stable than oil prices. For midstream companies that have long-term take-or-pay contracts in place to transport, gather and process gas rather than oil, profitability has been very stable.

Favorable positioning
Our positioning within the energy sector has been supportive of our overall performance in our SDG credit portfolios during the first quarter of 2020, and in the subsequent rebound in April and May. This was, firstly, owing to our underweight exposure to the sector, particularly oil-weighted producers. Secondly, the exposure we have is in higher-quality, diversified integrated energy companies and midstream energy companies that can better withstand a sudden and dramatic drop in oil prices. These have indeed proven more resilient in the sell-off and moreover benefited from that rebound.

Longer-term, structural trends in the energy sector

Change is needed in order to stay relevant
Climate goals and changing consumer attitudes mean that that energy and mobility systems must evolve, with low-carbon energy sources gradually replacing carbon-intensive fossil fuels over the long run. Low fossil fuel prices have given governments an opportunity to reconsider existing subsidy regimes that accelerate climate change. A revised approach towards energy sources could stimulate job creation in the short term and tackle the climate change risk in the long term. In this context, our view is that energy producers will need to invest in the low-carbon energy systems of the future in order to remain relevant.

Meanwhile, oil price volatility increases the risk premium on investments in oil and gas projects, and narrows the gap between risk-adjusted returns for conventional and new energy investment opportunities. From a credit investor’s perspective, oil price volatility creates uncertainties in operating cash flow and capital investment budgets, which will have a profound impact over time on debt service capacity and refinancing risk.

What we look for in energy credits

ESG considerations affect valuations
Overall, we observe a shift among energy producers towards lower-carbon alternatives. This transition is still in its early stages, though. Companies are aware that ESG considerations affect their equity valuations and are slowly taking action. We see a trend of increased allocations of annual capital budgets to renewables and more ESG-positive business activities. Examples of such business activities include having more gas in the energy mix, recycling the water used in drilling, capturing CO2 emissions and shifting to renewables.

Efficiency, asset quality, diversification and decarbonization
In this context, we favor the more efficient players – those companies working to bring down their cost structure. We also look for those companies that are improving the asset quality across the portfolio by allocating investments to profitable low-carbon business. The added benefit is that such investment programs are likely to create opportunities for further investments over the long term.

Related characteristics that we look for are diversified business models – in terms of energy sources, footprint and customers – and business models that are evolving with the energy transition, and where the company is exploring ways to decarbonize its own portfolios.

Looking to the future

Our approach to investing in energy credits is focused on energy issuers whose activities reflect a positive contribution to the SDGs, which in turn implies more reliable and stable financial performances over the long run. On this basis, we would be positive about energy companies which are improving asset quality and reducing cost structure while actively and effectively working towards diversification. This involves diversification away from fossil energy towards more renewable energy sources, as well as diversification, generally, into other business activities.
This is an extract from a longer report.
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