Asian investors in energy or utility companies who are seeking to make their portfolios more compliant with environmental, social, and governance (ESG) standards are facing a dilemma.
While it is acknowledged that coal is a heavy pollutant and coal production is now more expensive than renewable sources of energy, replacing coal-powered utilities with those powered by renewable sources of energy may not be that easy.
Japan, for example, is still heavily reliant on coal following the Fukushima disaster that saw the government trying to reduce nuclear power as an energy source. In Southeast Asia, coal alone presently accounts for almost 40% of the growth in energy consumption while energy demand in the region is expected to grow by as much as 60% in 2040.
In short, the world is not producing renewable energy fast enough to meet the growing energy requirements, according to the International Energy Agency (IEA). This means that utility companies will be forced to rely on coal in the near to medium term future despite the strong investor demand for cleaner sources of energy.
For investors who are seeking ESG-compliant investments and are currently invested in utility companies, this means they may be facing additional risk, particularly in terms of “stranded assets.”
In the case of DWS, a heavy investor in German utilities, it is facing demand from its ESG investors to exclude coal from its investment universe. To meet this client demand, DWS has excluded from its ESG-driven funds utilities that generate 25% or more of their proceeds from coal.
However, German utility companies which have been reliant on nuclear power are currently scrambling to comply with a government regulation to phase out nuclear plants by 2022. But since there are not enough renewables to completely replace nuclear power, the German utilities have to switch to coal in the meantime.
“There’s still a strong reliance on coal which endangers the CO2 reduction target that Germany has set for themselves after the Paris Climate Agreement. This is a very fluid development and to be honest I have no idea how these developments will evolve during the next 12 to 24 months. But I’m pretty sure that by the year 2050 when Germany, intends to be CO2 neutral, they can hardly afford to burn any coal, most likely much earlier,” says Fridtjof Gerstein, portfolio manager for ESG fixed income at DWS.
But despite the continuing reliance on coal, utility companies who own coal power plants have the risk of ending up with “stranded assets” which are subject to unanticipated or premature write-downs, devaluations, or conversion to liabilities. Coal power plants have the potential to become stranded assets as the utility companies attempt to phase them out in favor of renewables.
The risk from “stranded assets” is also faced by investors who are invested in the utility companies’ stocks or bonds including institutions, investors, banks, pension funds, and insurance companies.
“Therefore currently looking at German utilities, a big risk for them is to face stranded assets and nobody knows how they are going to get subsidies for that in return. So I definitely think it’s a vital or real risk,” says Gerstein.
DWS is no longer invested in traditional utility companies that still own coal power plants but are focusing on utilities with renewable energy reliant business models.
“We have a global corporate ESG strategy that invests in investment grade global corporate bonds that fulfill our minimum ESG standards. These minimum standards will exclude controversial weapons, nuclear energy, and demand compliance with UN global impact standards,” Gerstein says. This strategy currently has 87.4 million euros (US$99.5 million) in assets under management (AUM).
DWS’ biggest ESG-focused fixed income strategy invests in European short duration sovereign bonds with a three-year maturity. This strategy currently has 1.7 billion euros in AUM. They have also recently launched an ESG strategy focused on green bonds which currently has 15.1 million euros in AUM.
Source: The Asset ESG