Our experience as investors and research shows that ESG risks influence credit spreads, and therefore the prices of credit securities . This empirical data support our long-held view that investors need to look beyond credit metrics to develop a more complete picture of corporate risk and potential return.
In this issue of Spectrum, we dig a little deeper to reveal how the relationship holds up in one sub-sector of the asset class: basic materials, which is particularly exposed to ESG risks. Extracting and processing the world’s natural resources is both integral to the global economy but also fraught with risks due to labour relations and social and environmental concerns, which can ultimately impact financial performance.
Nearly all global miners with a diversified base of operations need to mitigate ESG risk.
In this issue, we also use two case studies – mining companies Vale and Freeport McMoran – to show how contrasting ESG profiles influence our view on how their instruments should be priced. Before turning to our examples, however, we highlight how the relationship between ESG and credit spreads holds in the basic materials sector.
High scores, low spreads: mining the data
In the basic materials sector, we have compared median annual CDS spreads with Hermes’ proprietary measure of ESG risk, the Quantitative ESG (QESG) Score, to establish if a relationship could be shown between the ESG profile of a company and the market-priced risk.
In a manner consistent with our previous research, we assessed all relevant companies from 2012 to 2016 in four credit-default-swap (CDS) indices: the CDX High Yield, CDX Investment Grade, iTraxx Europe, and iTraxx Crossover. This exercise yielded 135 data points.
For these companies, we sorted the data into quintiles in which every quintile contained 20% of the observations: the first quintile contained those companies with the lowest QESG Scores while the fifth quintile comprise those with the highest scores.
Our analysis revealed a general trend for companies with higher QESG Scores to have lower credit spreads. Figure 1 shows a clear relationship between QESG Scores and credit spreads for companies in the sector. We found that looking at the first and fifth quintiles when sorting by QESG Score, the first quintile had a substantially higher average credit spread than the fifth quintile.
We then looked at the data for each sub-category of the QESG Score: QE (environmental), QS (social), and QG (governance). However, the relationship was not as linear in QS and QG, which is driven by the relatively small sample size.
Figure 1. Comparing average CDS spreads by QESG, QE, QS and QG quintiles 2012-2016 for companies in the basics materials sector
Source: Own calculations. Data from Hermes Global Equities and Bloomberg. Corrected for outliers. Data as at February 2017.
Looking at the dispersion of spreads (see Figure 2), we can see a wider range of CDS spreads in the lower QESG Score quintiles. This implies that credit spreads have higher variance for companies with lower QESG Scores.
Therefore, while the QESG Score offers useful insight for credit investors, the pure data of the quantitative analysis should not be considered in isolation – a qualitative analysis of ESG fundamentals becomes increasingly useful for companies with lower QESG Scores.
Figure 2. Dispersion of credit spreads across QESG Score quintiles for companies in the basic materials sector, 2012-2016
Source: Own calculations. Data from Hermes Global Equities and Bloomberg. Corrected for outliers. Data as at February 2017.
How qualitative research sharpens an investor’s focus on ESG
As we have shown above, ESG scores can serve as a good indicator of expected spreads on a population basis – in this case, the population of the basic materials sector. In addition to showing the relationship between credit spreads and QESG Scores, our analysis could also help identify industry outliers, indicating potentially mispriced ESG risk in the market.
However, just as in traditional financial and business analysis, if ESG research is to provide a forward-looking indicator of corporate credit risk we must also consider qualitative factors.
This approach allows investors to gain a deeper insight into the impact ESG issues may have on the absolute value and volatility of enterprise value: this approach can also inform investor engagement with issuers, such as that performed by our stewardship team, Hermes EOS, to improve their ESG practices.
Based on this holistic ESG analysis – taking into account quantitative and qualitative research – in the case of lower rated ESG companies, credit investors can either demand a higher spread to justify the investment or exclude certain issuer’s debt from their portfolios. The reverse is also true, and investors can prioritise high-rated ESG companies.
We demonstrate how this operates in real-world investment decisions in our analysis of two global mining companies: Freeport McMoran and Vale. Both miners have an advantageous position on the cost curve and a high concentration in a single cyclical commodity: iron ore in the case of Vale, copper for Freeport.
Freeport and Vale also have both faced ESG challenges specifically from tailings disposals – an endemic problem in the mining industry, which we explain below. Yet, in spite of their many shared characteristics, Vale remains one of our top picks while Freeport looks increasingly unattractive due to ongoing ESG issues.
Tailings disposal: an environmental mining problem
Mining is a dirty business.
After extracting the desired raw materials from the ore rocks, waste material is produced, known as tailings. The method by which miners dispose of tailings remains one of the chief environmental problems for the industry – and a key ESG focus for investors.
Historically, early mining operations used riverine tailings – a method of disposing waste materials from mines into nearby river systems. This practice has largely been phased out in favour of a more ecologically-friendly method of containing mining waste products in ponds secured by dams.
For example, BHP closed its Ok Tedi mine in Papua New Guinea, which used the riverine tailings method, due to the high environmental impact of the operations.
The practice of riverine tailings is banned in a number of countries due to environmental concerns. However, it still remains legal on the island of New Guinea, where Freeport operates in Indonesia.
Tailings dams are not a perfect solution and still carry ESG risks: the failure of a dam can have a devastating effect on the local region’s environment and people. However, tailings dams are still generally preferred to riverine tailing: when a tailings dam is working as intended the environmental impact is lower.
As we show below, the different responses to managing the ESG impact of tailings from Freeport and Vale played a significant part in our investment thesis for the two companies.
Freeport’s Grasberg: ESG risks continue to flow
Freeport McMoran is one of the largest copper producers in the world, with low cash costs due to high amounts of valuable gold by-product in its flagship mining operations at Grasberg, Indonesia.
The gold and copper deposits are of a high grade, making them very economical to process. Approximately one-third of Freeport’s copper reserves are at Grasberg. The low-cost operations, with high gold by-product credits, help reduce the copper cost curve position for the entire group, which also spans North and South America. The combination of the low cash costs and high production volumes make the Grasberg operations key to the company’s credit profile.
However, Grasberg has an ESG problem. A combination of employment issues, social concerns about the company’s impact on the local community, and environmental concerns have weighed heavily on the group’s profile.
Negotiations with the Indonesian government about replacing Grasberg’s existing Contract of Work with a new mining licence dominated news flow about Freeport this year.
The dispute with the Indonesian government relating to the mining licence has also had an ESG impact. Freeport slowed production in 2017 to cut costs following the dispute and furloughed workers, prompting industrial action. Grasberg is also located in West Papua, which has recently been affected by alleged separatist violence.
Freeport credit spreads have nonetheless tightened in 2017, due to progress in the discussions between the government and Freeport, a supportive copper price, and a general rebound in the basics sector. Importantly, though, some details of the Freeport deal with the Indonesia government – such as pricing and the timing of divestment – have yet to be resolved.
Aside from its contractual woes, the ongoing use of the riverine tailings disposal system at Grasberg means Freeport faces a number of environmental concerns, including the impact on both the ecosystem of the river used and the local community.
To date, Freeport has defended riverine tailings disposal at Grasberg as the only viable option, stating that “extreme terrain in a seismically active area with high precipitation, [has] created unacceptably high risks of catastrophic failure [of other tailings disposal methods]” .
Freeport also argues that because of its location in a narrow and steep valley, the Aikwa river, where Freeport deposits Grasberg tailings, is fast moving and non-navigable. The part of the local river system that is used by the local population is understood to be upstream of the tailings disposal site.
However, it should be noted, the company has taken steps to limit the damage of the waste disposal method, including – but not limited to – committing that the tailings generated will have a net acid neutralisation capacity. This may help mitigate some of the impacts of acid-rock drainage. Freeport has also collaborated with the University of Papua and Indonesian Institute of Sciences to conduct research into the biodiversity of the region.
Freeport has made no commitment to changing its practices. As such, the ESG risk caused by riverine tailings is likely to remain unresolved for some time, and investors should be aware that investing in Freeport means being exposed to this practice and the controversies it generates.
Together with the industrial action and dispute with the government in Jakarta over Freeport’s contract to operate in Grasberg, the riverine tailings disposal system creates a complex set of ESG risks for credit investors. Riverine tailings is entrenched in the operations of the mine, which is the jewel in Freeport’s crown.
At Hermes Credit, we have concluded that despite the attractive cash cost profile of the operations, this level of chronic ESG risk makes Freeport an unattractive investment.
Vale and Samarco: a lesson in disaster recovery
Vale has also been affected by ESG risks linked to mining tailings, most recently and severely through its joint venture with BHP in Samarco, Brazil.
In November 2015, the failure of a Samarco dam in Bento Rodrigues caused a large mudslide and flood of iron-ore tailings down the Gualaxo do Norte river, destroying villages and killing 19 people. The waste flowed into the larger Rio Doce and travelled more than 600km to the South Atlantic Ocean.
The human and environmental costs were extremely high, and public prosecutions and government lawsuits followed. Criminal proceedings against a group that includes 22 people, Vale, BHP and two other companies, resumed in November 2017. For investors in Vale and BHP, the potential fines and financial liabilities wrought by the dam collapse demonstrated how quickly ESG issues can morph into credit risks.
In response, BHP and Vale established the Renova foundation to help the communities affected by the disaster. In March 2016, Samarco, BHP and Vale signed an agreement with the federal government committing a collective BRL20bn (over $6bn) to environmental and social reparation efforts in the affected areas.
While the agreement is currently on hold, subject to the separate public prosecution lawsuit, the Renova foundation is responsible for executing 42 programmes for reparations.
According to Vale, steps taken since the incident include, though are not limited to:
- Regular meetings with communities, local authorities, the state and federal government, environmental agencies, the public prosecution office, the public defence office and other relevant bodies;
- Emergency financial assistance for the families that lost their source of income as a result of the incident;
- Detailed verification of structural conditions of all of its dams;
- Monitoring the tailings from the dam; and
- Performing diagnostics along the River Doce.
The tailings study confirmed that the Samarco waste output was predominantly silica, an iron ore-processing by-product, and the tailings did not contain any chemical element that is harmful to health. An analysis of the Rio Doce in December 2015 confirmed the presence of fish and shoals along the river. Furthermore, it revealed that the affected area amounted to less than 1% of the river basin.
Other rehabilitation efforts by Samarco include cleaning the Candonga Reservoir, replacing vegetation along the Gualaxo river and mapping life in the river using sonar.
Samarco and the Renova Foundation are still engaged in remediation efforts, indicating a genuine commitment from all parties to repair social and environmental damage caused by the dam collapse. Talks are continuing with the Brazilian government to obtain the required environmental licenses to restart operations. However, Samarco chief executive, Roberto de Carvalho, said this is unlikely to happen in 2017.
The Samarco incident had an obvious impact on the enterprise value of both BHP and Vale: namely, the fines already agreed as well as the potential future financial penalties relating to the civil prosecution. Vale has made combined provisions of over $1bn to cover costs from the dam failure.
However, the response by both Vale and BHP means that investors are informed of the risks and liabilities and they can price this into their view of Vale’s credit profile.
In our assessment of Vale, the company’s ESG profile seems to be on a positive trajectory – an outlook that is further boosted by general governance improvements.
Notably, Vale is in the process of converting its dual share class into a single share class. Ultimately, Vale is targeting “Novo Mercado” listing, a form of listing which involves adhering to standards of transparency and corporate governance practices more stringent than those required by law in Brazil.
This positive ESG momentum, in conjunction with Vale’s favourable business profile, new low-cost production model and its announced focus on deleveraging, makes the company one of our top picks for the sector.
ESG: a differentiating factor
Both Freeport and Vale are exposed to a number of ESG issues, including tailings disposal risks. Nevertheless, our views on both firms differ.
We view Vale as on a positive ESG trajectory. Meanwhile, Freeport’s efforts to mitigate environmental and social costs are limited by the very nature of its operations at one of its assets.
Both companies’ debt have performed well over the past year, with spreads tightening considerably in line with the general rally in commodities businesses. However, it would be simplistic to take a constructive view on both companies based on this alone, ignoring the forward-looking ESG profile.
Our quantitative analysis of the basic materials sector shows also companies with higher QESG Scores tend to have lower CDS spreads. This reinforces our belief that it is imperative credit investors integrate ESG analysis into their investment decisions. As we have shown, it can be a crucial difference when comparing issuers in the same sector. : “Pricing ESG Risk in Credit Markets”, published by Hermes Investment Management as at April 2017