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High and dry: mitigating the risk of stranded assets

Home / Perspectives / High and dry: mitigating the risk of stranded assets

Eoin Murray, Head of Investment
14 June 2016
Market RiskPerspectives

Water and energy are essential to the wellbeing of humanity and are vital inputs for business and industry. All investors are directly or indirectly exposed to these elements, and should watch for any change – driven either by sustainability concerns, regulation or technology – that could transform valuable reserves into stranded assets.

Water risk: when the river runs dry
Economic leaders perceive water insecurity as the greatest risk to global society 1. The Carbon Disclosure Project (CDP), a group working with investors, companies and governments on initiatives for a more sustainable world, forecasts a 40% global shortfall between demand and available water supply by 2030. Business-as-usual management of the resource will weaken companies in every sector, undermine countries’ long-term economic prospects and diminish global growth by $63tn, the CDP says. The major finding of “Accelerating action”, its 2015 Global Water Report, was that companies’ reliance on water is growing rapidly as its availability and security is in decline.

For its report, the CDP report surveyed businesses about their water usage and conservation strategies. Its database covers 1000 businesses and provides real-world case studies that demonstrate how assets are becoming stranded – by suffering unanticipated or premature write-downs or devaluations, either temporarily or permanently – due to water-related factors. For example, low water supply is limiting the operations of almost half of US oil and gas wells, and in 2015, dry weather and low stream levels compelled the Alberta energy regulator to restrict the volumes of water that oil-sand drillers could use.

Such findings allow CDP and its investor signatories, including Hermes, to gain a deep understanding of how companies are preparing for and managing the risks of water scarcity. While some focus on business constraints, others are identifying opportunities arising from superior water stewardship. For example, Ford Motor Company has developed technologies to minimise water use in painting and machining, with the latter methods saving up to 1.28m litres each year 2.

The investment response
Water management will be a defining challenge for businesses in the coming decades. Careful management will support industrial growth and minimise environmental impacts; poor management could result in corporate failure and damage to water sources, harming local human and animal populations.

This situation presents opportunities for long-term investors. Corporate bonds financing water infrastructure development, project-finance investments in water-treatment facilities, venture-capital backing for innovative water-usage technologies, stocks in listed water utilities and water rights as real assets provide access points for investors with long-term return targets.

Through stakes in Thames Water Group, Anglian Water Group and Southern Water, Hermes Infrastructure is invested in utilities providing water to 23m people in London and south-east England. These are long-term holdings, generating stable return streams that are linked to UK inflation, managed with a strong focus on good governance, stakeholder alignment and effective social and environmental engagement.

Businesses that integrate superior water management into their strategies, investment plans and risk and supply chain management programmes should better mitigate the risks of water scarcity. They are more likely to develop competitive advantages from greater water efficiency and more easily satisfy future regulations limiting water use. Clearly, such companies will help generate vital environmental and societal benefits too.

Energy risk: multiple ways to strand an asset
The fall in oil prices from well above $100 per barrel in late 2014 to about $40 now has increased pressure on oil producers – particularly in the Russian Arctic, Canadian oil sands and US shale formations, where technology has enabled producers to tap previously unviable reserves – albeit at a higher cost to more easily accessible wells.

By knowing the costs of extraction, refinement and distribution, investors can see the price levels at which revenues for various types of oil break even with the cost of production (see figure 1).

Figure1. Break-even levels for various types of oil

mrisk-chart1

Source: HSBC Climate Strategy Group

Sustained low oil prices will incur higher operational costs for some producers, an economic reality that could turn reserves into stranded assets. But there is another force at play: innovations that are lowering the cost of renewable energy, such as solar energy, which has become dramatically cheaper since 2009 (see figure 2).

Figure 2. The falling cost of solar photovoltaic cells

mrisk-chart2

Source: HSBC Climate Strategy Group

Fossil-fuel reserves could also become obsolete or less valuable if regulations stemming from the Paris Agreement of late 2015, under which 195 countries will aim to limit global warming to less than 2ºC from 2020, come into force. Such new rules could change the costs of producing fossil-fuel energy and consequently re-price reserves.

Hermes Infrastructure manages direct investments in the solar and wind energy sectors. It owns two portfolios of rooftop solar panels that together generate about 35 megawatts, with approximately half of this electricity for domestic use and the remainder channelled to the National Grid. The assets were acquired to provide stable cash yields that are directly linked to UK inflation with limited volatility. The team also invests in two wind farms – a majority stake in Fallago Rig in the Scottish Borders and a 50% interest in the Braes of Doune near Stirling – that also seek to generate inflation-linked returns and offset about 190,000 tonnes and 70,000 tonnes of carbon dioxide each year respectfully. None of these renewable-energy investments involve third-party leverage.

Energy use in a climate-controlled future
Scenario analysis by the HSBC Climate Strategy Group models not only the impact of countries fulfilling the Paris Agreement, but also the continual reduction of the cost of clean energy sources – renewables, electric vehicles and battery storage – and how industrial and transport fuel consumption would change as a result (see figures 3 and 4).

Figure 3. Forecast industrial fuel consumption under a successful Paris Agreement

mrisk-chart3-V2

Source: HSBC Climate Strategy Group

Figure 4. Transport fuel consumption under a successful Paris Agreement

mrisk-chart4-V2

Source: HSBC Climate Strategy Group

As shown, coal would continue to be a major fuel for industry. But in the transport sector, oil and oil products would be the dominant source before declining steadily from 2030 as gas, renewables and hydrogen are used more broadly. Such changes would be gradual. However, the real energy revolution needed to stay within the 2ºC limit would be in the generation of baseload power (see figure 5).

Figure 5. Power generation under a successful Paris Agreement

mrisk-chart5

Source: HSBC Climate Strategy Group

In this scenario, coal would almost be completely removed from the energy mix by 2050 as nuclear, solar and wind gradually consume its substantial share. Carbon intensity, the amount of carbon emitted per unit of energy consumed, would halve by 2030 and fall to almost zero 20 years later.

Managing stranding risk
As long-term investors, such insights into water risk and potential changes in global energy supply in coming decades helps guide our investment strategies. We are aware of the investment threats and opportunities, across public and private markets, emerging from businesses’ approaches to water management. We consider the impact of low oil prices in our valuations of producers – particularly those facing higher operational expenses – and seek opportunities among clean energy providers that are innovating to lower costs.

  1. 1 “Global Risks 2015,” 10th edition, published by the World Economic Forum in 2015
  2. 2 “Accelerating action: CDP Global Water Report 2015,” published by the Carbon Disclosure Project in 2015.
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Eoin Murray Head of Investment Eoin is Head of Investments and a member of Hermes’ senior investment leadership team. The Investment Office is responsible to clients for the investment teams’ consistent delivery of responsible, risk-adjusted performance and adherence to the processes which earned them their ‘kitemarks’. Eoin joined Hermes in February 2015 with over 20 years’ investment experience. Eoin joined from GSA Capital Partners, where he was a fund manager. Before this, he was Chief Investment Officer at Old Mutual from 2004 to 2008 and also held senior positions at Callanish Capital Partners LLP and Northern Trust Global Investments. He began his career as a graduate trainee at Manufacturers Hanover Trust (now JPMorgan Chase) and subsequently performed senior portfolio manager roles at Wells Fargo Nikko Investment Advisors (now BlackRock), PanAgora Asset Management and First Quadrant. Eoin earned an MA (Hons) in Economics and Law from the University of Edinburgh and an MBA from Warwick Business School. Eoin is a member of the Exmoor Search and Rescue team, and a fully qualified Swiftwater and Rescue Technician. He is also a member of the management team and the trustee board of the Salusbury World charity.
Read all articles by Eoin Murray