Do EM Investors Care About Climate Change?

Climate change worries are increasingly impacting investment mandates. By the end of this year (despite pushback from passive investors), 25% of global assets under management are expected to be covered by restrictions on coal. European asset managers have increasingly applied blanket thermal coal investment exclusions to their portfolios over the past two years (alongside broader and tighter ESG requirements). This went unnoticed at first in several Dutch funds. Then it spread to France.

The Paris Agreement on climate change has brought on global pressure for divestment. This will only grow from regulators above and customers below, creating an accelerating problem for those remaining in carbon intensive assets:

• Pressure is now double-sided across the capital structure from debt to equity

• Banks, asset managers and private equity provide full coverage of pressure by market/lending style.

• Development Finance Institution (DFI) funding is no longer available for carbon assets.

• Chinese funding is available for selective clean technologies and Russian and Chinese funding for nuclear. But both are problematic, not widely available, and related to state level rather than private sector agreements.

• Stranded assets will be the resulting problem, with fire sales of carbon assets increasingly likely. This is currently being seen in India, especially where the gap between current and future planned projects and the cost competitiveness of these projects within the system as a whole has now grown simply too wide.

These problems are compounded in emerging markets. One reason is a lack of historic fiscal room to provide subsides for early adoption of renewables.  Another is the much stronger and intertwined energy systems-sovereign credit risk nexuses from greater energy market concentration.

 

Likely Paths

For investors, it’s now a question of accumulating risk in systems and portfolios versus a lack of liquid assets available to change energy systems. Broader considerations include:

• Governments will have to make choices about bailouts or transitional support for owners of stranded coal assets and their workers. This crystallises risk onto sovereign balance sheets. This is a particular problem where there are deep patrimonial vested-interest networks (especially in EM) .

• Companies may initially resist threats from activist investors. But they will eventually give ground as more established asset managers join the fray on transparency and decarbonisation plans, creating unnecessary volatility.

• Investing in zero carbon assets or renewable energy is actually surprisingly difficult. Scalability is hard for standard investment funds due to the sectors small index weights, a large numbers of small companies, bank-led lending to the sector (rather than corporate bond issuance), and asset- and construction-backed finance (rather than annuity revenue). Insurance funds can park this in infrastructure funds, but put simply it is not mainstream enough yet.

• Government and international financial institutions (IFI) help are required to shift market structures into deeper and more liquid equity and debt products that can support the energy transition.

Fundamentally, all free(er) market economies will struggle to marshal capital fast enough for climate mitigation from the private sector asset managers. This is because there are coordination, timing, and market development problems. There is simply no ability for institutional asset managers to deploy capital in the ultra-long horizon despite whatever ESGs they may have.

This will prove especially true in market economies with weak social compacts. Countries with stronger social compacts where business plays a more formal, policy-compacting role could see attempts to marshal capital in more coordinated ways but will see a head on collision of such plans and fiduciary duty.

Banks, IFIs/DFIs, and governments will instead be the primary providers of large scale, long term, complex, project finance-based funding for climate mitigation and adaptation. The job of asset managers instead will be to deploy capital to these entities and eventually (‘late’ in some sense) take the risk from them further down the line as markets slowly start to form. Asset managers’ role will be to ensure that banks and governments are focused in the right ways with the right policies.

2020 will be a key test bed for seeing how the global capital allocation structure between different players might act on climate related issues. Transparency, incentives, and market structure developments will ultimately be what creates movement.

 

The South Africa Case

There will be many particular cases to watch – in EM especially. However, South Africa will be the most interesting:

• It possesses a huge coal endowment almost completely wrapped up in generating electricity ( 92% is from coal). Yet South Africa also has a world-leading solar and wind endowment as well.

• Coal is wrapped up in rent extraction vested interests while renewables aren’t, which is causing deep problems and policy blockages within the political economy. A world-class renewables procurement programme (‘REIPPP’) has lain dormant since 2014 as a result.

• Overall, South Africa has one of the worst per capita rates of carbon emissions (between 8.0 and 9.0 since 2010) for a major EM and is underperforming peers in terms of improvement in recent years (Chart 1). The country is the 14^th largest carbon emitter due to its heavy reliance on coal.

 

Chart 1: Carbon Emission Intensity vs GDP per Capita, 2014

Source: World Bank

 

• Advice on methods of more rapid decarbonisation in a ‘just energy transition’ are currently being side-lined in a policy morass.

• South Africa has a gap of around 5GW of capacity in the coming two years, which will result in frequent electricity outages given the underinvestment in any new technology type or new energy in recent years.

• Severe droughts are becoming more common. South Africa is uniquely susceptible to extreme weather due to climate changes influence on more volatile El Nino events from the Indian Ocean.

• New renewables are lower cost, at likely less than ZAR60cents/kWh vs ZAR90cents average for industrial electricity and ZAR150cents/kWh or more for untested clean coal technologies.

• Local research by the CSIR has shown that a renewables-led mass procurement of new energy would maximise jobs, growth, and investment and so should have labour onboard, but they are captured by nuclear and coal lobbies. For instance, in 2018 Eskom reported that almost 50,000 of its employees were based in primarily coal fired power stations while the coal mining sector itself is reported to employ approximately 82,000 people.

• South Africa has a strong social compacting mindset which attempts to bring big business to the table (including banks and asset managers).

• South African’s monopoly electricity supplier Eskom is barely a going concern, reliant on significant bailouts per year (ZAR56bn in the coming fiscal year from April). Yet it cannot ensure security of supply and suffers from being wrapped in cotton wool to maintain status quo by politicians and unions.

These issues are all present in various forms in other countries, but South Africa is a perfect microcosm. It’s open enough to foreign investors and has enough extremes of politics and bad starting point of emissions to be closely watched and so reacted to by global investors. Keep tabs on it in 2020!

 

 

 

Peter Attard Montalto is Director and head of Capital Markets Research at Intellidex – a South African research and consulting company. He advises global and local portfolio investors, corporate boards and c-suite on political economy issues in South Africa and through the rest of Sub-Saharan Africa. Currently energy policy and its interface with investors, state owned enterprises and private companies in South Africa is a major part of his focus.

 

 

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)