Infrastructure debt: why ESG is more than just a marketing term
Infrastructure markets recently threw up a live case study of what can go wrong when investors fail to take account of ESG risks. News that the US utility, Pacific Gas & Electric Corporation (PG&E), could be on the hook for $30 billion in unexpected liabilities, shocked markets.
As a regulated monopoly providing gas and electricity to California, this was supposed to be a textbook, low-risk, investment. The company’s corporate bonds, with their solid investment grade credit rating, were priced as such. At the start of 2017 their tight credit spreads offered very limited compensation for risk. With the company filing for bankruptcy on 29 January 2019, this turned out to be a catastrophic misjudgement.
So what happened?
California suffered some of the deadliest wildfires on record over 2017 and 2018. The initial cause has not yet been legally established but the finger of blame has been pointed at PG&E. Arid land, the result of several years of drought, encouraged the fires to spread.
A peculiarity of California law means that if PG&E equipment is found to have caused the initial spark that triggered the fires, PG&E, rather than the insurance industry, will be held liable for all damages. This holds even if no negligence is found on their part. Burdened by potentially crippling damages, PG&E and its primary operating subsidiary, Pacific Gas and Electric Company, have filed voluntary petitions, under Chapter 11 of the U.S. Bankruptcy Code, in the United States Bankruptcy Court for the Northern District of California.
Fitch estimates that recovery rates on the company’s unsecured debt will range between 51% to 70%, quite a significant shortfall compared to the average among defaulting infrastructure companies. Lenders to this supposedly low risk company stand to lose substantial amounts.
What should have been done differently?
Climate change is increasing the risk of destructive weather related events. A warmer, drier climate raises the risk that a small fire spreads, resulting in large scale losses. Several years of droughts should have been a warning sign. Geisha Williams, chief executive of PG&E until she resigned in January 2019, specifically argued that the firm was exposed to “climate-driven extreme weather, facing wildfire after wildfire”. Investors failed to price this environmental risk effectively.
We believe a core part of any credit analysis should include assessment of environmental factors and how they may impact a borrower. As a European investor, the environmental considerations Schroders evaluates are sometimes different to those affecting investments in the US, but they are no less important in their potential impact.
For example, in the case of Scandinavian energy networks we analyse how harsh winter conditions could disrupt the network and estimate how many working days may be lost due to events such as snapped cables, resulting from freezing conditions. Any periods of operation interrupted by adverse weather have repercussions on a company’s revenues. Ultimately, they destroy value for lenders and sponsors. Governance and culture are also an integral part of our research. As infrastructure debt investors, ESG considerations such as these are at the very core of what we do.