Speech of Mr. Francesco Confuorti at the Formiche meeting of March 17, 2016
by Francesco Confuorti, Ceo, Advantage Financial
In this speech I would like to summarize the my ideas on the relationship between the ecological footprint of corporations and their cost of capital. I am an investment banker rather than an academic, but I always interacted with them, starting from my mentor back in my Chicago years, the late Prof. Rudi Dornbusch, who used to say “Francesco, with other people I study, with You I do business!”.
Since 2012, I have been wondering how to marry ecology and finance. Most commentators argue that the main link comes from the stock market. Corporations which are more attentive to their ecological impact would create more shareholder value. As most commentators know, this positive link is elusive and context dependent, it does not always work.
I wondered at the time if the channel between the cost of debt rather than the cost of equity does warrant more attention. This requires us to think about the environment as a risk rather than an opportunity. More importantly, as a form of tail risk. If You think about the issue in this way, it makes much sense. What about global warming causing the melting of Greenland? What about environmental accidents such as the New Horizon oil spill? What about new ecologically friendly regulation making whole business model obsolete? Think about what the famous scientist Jared Diamond claims about Mining in his book Collapse: in his opinion if mining companies would have to pay for the true disposal costs of the solid waste, part of it toxic waste, they do create, they would be all bankrupt.
Let’s move a step closer to home
Historically, the most contentions ecological impact event In Italy as related to dioxin contamination in, Seveso, Lombardy. Given the restructuring of many manufacturing sectors, and the exit of our country from some of the high capital intensive industries such as the chemical- pharmaceutical industry, steel is probably the most polluting industry located on our premises (Ilva, Thyssen-Krupp). The other sensitive area is that of power plants, which are scattered across the country. The ongoing dispute between Enel and Greenpeace on the planned start of new Enel coal power plants is one of the most notable ones. Projects by Croazia, for Deepwater oil Search in the Adriatic sea, are another notable development.
The next step is simple. If ecological risk is a form of tail risk, which asset should price it? Naturally it should be priced by credit not by equity. Over the years, with the help of some distinguished academics such as Professor Stephen Brown from Stern School of Business at NYU and Monash University, and in the spare time with my internal fund managers at Advantage Financial, we have collected some evidence that corroborates the link between the ecological footprint and the cost of credit for a large number of corporations, sectors and geographies.
Most of this evidence has been channeled in annual research reports which Advantage Financial made available to the Ministry of the Environment of the Republic of Italy since 2013. In this brief tall I would like to summarize the evidence we have collected so far and anticipate which issues and sectors we are going to focus in the future to increase our knowledge in this area.
- Since 2013, Advantage Financial has been exploring the relationship in three main samples and sectors. The first study, dated January 2013, considers the corporation at the issuing level and covers a large sample of nonfinancial firms listed in European and North American Exchanges.
- The second study, dated spring 2014, looks at European industries with an important ecological footprint, by using plant level and business unit data.
- The third study, dated Spring 2013, looks at the Utilities sector across Europe and compares the differential impact of clan or dirty energy mix for the cost of debt of each utility.
What we have learnt so far
Our first study is a Special Report prepared by Prof. Stephen J. Brown on behalf of Advantage Financial Inc. Luxembourg. It is titled: Ecological footprint and the probability of default in Europe.
The study is based on a large sample of more than 1100 listed corporations. This sample has three main advantages. First, most issues of bonds and credit is implemented at a relatively centralized level in corporations; the best measures of credit risk are performed at the consolidated balance sheet level, so that one can take into account how all business units create cash flows to service any debt along the control chain in the corporation. Second, we can easily compute proxies of credit risk for those corporations without looking at individual bond issues. We can use credit default swap quotations for the larger of these issuers. Even when no CDS are available, we can develop good measures of credit risk by crossing information of firm leverage with information coming from the stock market (we use all listed firms in this sample). This is the celebrated Merton model of credit and default risk, which is known to predict default risk better than issuer ratings and which is available on the Bloomberg platform. Third, listed corporations are more likely to disclose ecological footprint data in their ESG disclosures.
This ecological factor, which is a linear combination of ecological indicators, and as a consequence allows us to compute an individual “ecological rating” indicator for each firm, is then regressed against our preferred measure of the cost of debt. Here are out two main results:
- The Merton Probability of default regression has a climate factor coefficient of 0.6, which is statistically significant. This regression, where we also have a set of sector dummy variables plus a constant, has an R-squared of 7.7%.
- Knowing the climate factor coefficient for the sample as a whole, we have been able to compute the value of the ecological factor for each individual firm. If the ecological rating is just the slope of the regression, e.g. 0.6 in the Merton regression, multiplied by the value of the ecological factor for that individual firm. The individual sector does not seem to market except for the energy (and maybe the communication) sector, which warrant a separate and more (less) conservative rating.
Here is a summary of the main results of our second report, dated February 2014 and titled The Ecological Impact of the European Industry and its relation to the cost of debt. The sample we use here is based on plant level data and business unit data for European corporations operating ecologically intensive sectors such as Energy, Utilities, Metals and Construction. The advantage of this sample is that we collected measures of the ecological impact of greenhouse and toxic air emissions at plant level, as they are made available by the European Environmental Agency. We then aggregated these plant level data at business unit level data by matching the plant data with unlisted annual report data made available by the Boureau Van Dijck database. Here are the main results:
- We find a positive relationship between the ecological footprint of industrial plants and the probability of bankruptcy. This confirms our results for a positive link between the ecological footprint and the cost of debt of a sample of large international companies, with the universe of the most polluting plants operation on the soil of the European Union.
- For all sectors, we get a significan impact of ecological foootprint on the cost of debt. The impact of the ecological fottoprint is larger in the Power Sector, which is the focus of a specific report (see below) The Oil & Gas sector is the only one where we find no discernible impact. Some sectors, such as Metals, Chemical and Steel have a very small number of observations.
- In this study, we performad a benchmarking analysis of the major steel producers in Europe by matching the EEA air pollution costs scaled by sales and compared them with two measures of financial performance, the interest cover and the ROA. The EEA performance of ILVA, if scaled by revenues, is average, and better than most of the performance of the ArcelorMittal subisdiaries, even if ILVA lags ThussenKrupp, as alreaddy noted. The fiancial performance of ILVA, despite being bad in absolute terms, is average in the sector, and on average better than most of the ArcelorMittal subsidiaries.
Most recently, we looked at a specific sectors. Last Year the Advantage ecological footprint report focused on the important Utilities sectors . This study is titled The Environmental Footprint and the Cost of Capital in the Utilities sector, dated spring 2015.
- In this report we ask if the utilities that showed the highest deterioration in GHG emissions shows the highest increase in the implicit probability of default, which is the main determinant of credit spreads. We find that this is the case, at least on average: a deterioration in the level of GHG emissions is mostly related to an increase in the use of for dirty sources of energy, such as coal, at the expense of more clean sources, such as natural gas or renewables.
- We also find a positive correlation between a measure of the toxic impact of air pollution by electricity generation plants, and the implied cost of debt. In general, the plants with the highest ecological footprint are coal plants. They are more likely to fail annual environmental and health security tests. In extreme cases the regulator and the courts may ask for suspension of production, which also impact their revenue generation capacity and their risk of default. Similar problems may result if green activist protest against the operation of new or existing coal plants.
- Further, we collect evidence showing that the higher is the share of renewable electricity generation at firm level, the lower is, on average, the implied cost of debt measured by the Merton probability of Default. These results are interesting because many commentators hint at the very bad economic performance and related bankruptcy of many startups active in the production of solar panels. In general, renewables are a good source of diversification for the electric generation business. This is not only related to the economic subsidies that this kind of generation enjoys, but also to the priority in capacity generation over non-renewable sources of energy and to the increasing impact of economies of scale in the unit cost of renewable energy.
For the future, we will look at the construction and infrastructure business, which is critical both for creating more growth and also for improving the depleting stock of capital in Europe. Even if we are addressing an IT revolution, without progress in managing the health of the planet an in moving and delivering good and services in the economy of things, as opposed to the economy of bits, as well as in finding new areas of interaction between the two worlds, such as in the novel internet of things, the chances for Europe to greater growth and to make our large stock of debt economically sustainable, are slim indeed.
I am positive that knowing better of the ecological footprint of corporations affect the cost of capital, and how to create an ecologically friendly infrastructure and construction business is an important route to the creation of a better world for our kids.