While the utility sector is not renowned for its ESG credentials, some companies are pioneering the new technologies that will drive the sector in the years to come, cleaning up energy production in the process. One such example is Dong Energy, a leading provider of wind power and a shining reflection of the benefits of responsible energy production.
Dong Energy was founded in 2006 when six Danish power companies merged. The company has described its business at the time of the merger as one of the most coal-intensive utilities in Europe. It also owned a large number of oil and gas resources. This exposure to fossil fuels posed significant investment risks.
First, the accelerating pace of global warming, and the broadening understanding of it, meant that governments were becoming increasingly likely to limit fossil fuel burning on an absolute basis.
This scenario would leave traditional energy producers with ‘stranded assets’: unusable resources which are prematurely written down, resulting in a significant financial loss. This operational risk has become particularly acute following COP21, the United Nations’ climate conference in 2015, where representatives of 195 countries committed to limiting global warming to two degrees Celsius above pre-industrial levels.
From a holistic perspective, the company’s contribution to climate change was also problematic. Fossil fuel energy production is unsustainable in the long term and serves to undermine the interests of all stakeholders, as it damages the environment in which our clients live.
We opened a position in Dong at its initial public offering in June 2016. The company has many of the characteristics we seek in an opportunity: strong financial statements, a competitive advantage, high-quality management and excellent ESG exposure – all at an attractive valuation.
Over the last five years, Dong has rapidly reduced the role played by fossil fuels in its business model (see chart). Its main focus has been its offshore wind farm business and it is now the largest global developer of offshore wind farms. Its installed capacity doubled from 2012 to 2016 and Dong aims to double this again by 2020. It is also developing the world’s biggest offshore wind farm off the coast of North East England.
The company has run the wind farm business prudently in comparison to its competitors, typically selling half of the interest in a new wind farm prior to completion to crystallise the value of the project. This reduces the risk for equity investors and has nurtured a valuable pool of infrastructure-investor partners.
Dong has also effectively used its existing assets to reduce the fossil fuel exposure in its portfolio, by converting existing coal and gas power plants to use sustainable biomass. It is aiming to produce 60% of the heat and power from its power stations through sustainable biomass by 2020.
Finally, in November 2016 the company announced its intention to sell all of its remaining oil and gas resources, becoming the first in the industry to transform into a purely renewable energy company.
Dong’s environmental, social and governance (ESG) profile has rapidly improved over the last five years and return on equity has also been strong. In 2011 the company’s earnings before tax, interest, depreciation and amortisation (EBITDA) was 15.8bn Danish Krona (DKK) ($2.2bn). EBITDA rose to DKK18.5bn ($2.6bn) in 2015.
The company’s oil and gas business has weighed on its valuation as the broader market has struggled over the last two years. The disposal of these assets will strengthen Dong’s balance sheet and increase strategic options for growth. Although there are some challenges, most notably the price the business is likely to attract, the recent rebound in the oil price and the deferred tax assets that may be available to the purchaser mean we do not see this as an issue. Dong is not a forced seller in the short term and therefore the company can wait for energy demand to stabilise.
A more pertinent headwind is the uncertainty surrounding climate change policy, particularly in the US, which is a particularly strong potential growth market for offshore wind. President Trump has been both for and against climate change in the past, and has most recently favoured fossil fuels. However, many energy-mix investment decisions in the US are made at state level and the time horizon for offshore wind extends far beyond the four- or eight-year term of a president.
Dong has achieved double-digit growth in the past few years and, with a high level of earnings visibility, it looks likely to continue achieving this. Dong has exemplified the case for investing in companies with improving ESG characteristics. With potential to further improve its ESG profile while continuing to grow, Dong is a compelling, long term and responsible investment prospect.
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