Advantage Financial's contribution to the analysis of the link between companies' ecological footprint and the cost of debt

Speech by Francesco Confuorti on the occasion of the Meeting organized by the “Formiche” magazine, 17 March 2016

In this paper I would like to summarize my ideas on the relationship between the ecological footprint of companies and their cost of capital. I am a market operator rather than an academic, but I have always interacted with them, starting with my first mentor in my Chicago years, prof. Rudi Dornbusch, who told me "Francesco, with others I am an academic, with you work!"

For some years now, I would say from 2012, I wonder how to marry ecology and finance. Most commentators argue that the main link comes from the stock market. Companies that are more attentive to their ecological impact would create more value for shareholders, but as known among most experts, this positive link is often elusive and dependent on the context, and sometimes does not manifest itself at all in the data.

And then at a certain point I asked myself if the link between ecological footprint and financial performance does not pass rather to the cost of debt, rather to the cost of capital. This approach requires us to think of the environment as a business risk rather than an opportunity. Or, even better, as a form of extreme risk (tail risk). If you think about the problem in this way, everything becomes very clear. Will global warming cause Greenland to melt? And environmental accidents, like the oil spill from the New Horizon platform? And what about the impact of environmental measures on the current business model of companies? Consider what the famous scientist Jared Diamond claims about mining in his book Collapse: in his opinion, if mining companies were to face the real costs of disposing of the solid waste they created, instead of transferring it to the community, they would be all in a situation of financial distress.

Let's take a step closer to our home

The greatest ecological disaster in recent history in Italy is linked to the contamination of dioxin in Seveso, in Lombardy, which dates back to the seventies of the last century. To date, following the restructuring of many productive sectors, and the exit of our country from some of the capital-intensive industries, such as the chemical-pharmaceutical sector, steel is probably the most polluting industry located on the national territory (Ilva, Thyssen-Krupp). The other sensitive area is that of power plants, which are scattered throughout the country. The recent dispute between Greenpeace and Enel on the planned construction of new coal-fired power plants by the latter is the one that makes the most news for those who are attentive to these developments. The project announced by Croatia, for the start of oil exploration in the waters of the Adriatic, which would also have an impact on our coasts in the event of environmental disasters, is another development to be followed with care.

The next step is simple. If ecological risk is a form of tail risk, how can it be priced by the financial market? It is natural to think that this risk should be assessed by the credit market and not the equity market. Over the years, with the help of some distinguished academics such as Professor Stephen Brown from the Stern School of Business of New York University and Monash University, and, in my spare time, from me and my asset managers at Advantage Financial, we have collected some evidence on the connection between the ecological footprint and the cost of debt for a large number of companies, sectors and geographical areas.

Most of this evidence is contained in some studies that Advantage Financial has made available to the Ministry of Environment of the Republic of Italy since 2013. In this brief intervention I would like to summarize the evidence we have collected so far, and anticipate on what problems and sectors we will be focusing on in the future to further expand our knowledge in this area. Starting in 2013, Advantage Financial explored this connection in three different samples and main sectors.

    The first study, dated January 2013, examines a sample of the major non-financial companies listed on European and North American stock exchanges and focuses on the impact of greenhouse gas emissions and company procedures on ecological matters and measures their impact on cost of debt.
    The second study, released in Spring 2014, focuses on European sectors and companies with an important environmental impact, using data on pollutant emissions at the plant level.
    The third study, which dates back to the Spring of 2015, finally focuses on the Utilities sector in Europe and compares the differential impact of the use of clean energy or more generally of the energy mix on the cost of debt.

What we've learned 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: The ecological footprint and the probability of default in Europe.

The study is based on a large sample of over 1100 listed companies. This sample has three main advantages. First, most bond issues are applied at a relatively centralized level in company groups; the best credit risk measures are carried out at the level of the consolidated balance sheet, so that we can consider how the operating business units can create cash flows to service the debt, along the entire corporate control chain. Second, one can easily calculate a credit risk proxy at the corporate level, without having to study individual bond issues. We can use credit default swap quotes for most of these issuers. Even when there are no CDS quotes available, we are always able to develop good credit risk measurements for the most ambitious sample of listed companies. To this end, we cross the information on the company's financial leverage with information from the stock market by applying Merton's famous model of insolvency probability, a model that is known to predict default risk better than the issuer's rating, and which is available on the Bloomberg platform. Third, listed companies are more likely to disclose ecological footprint information in their sustainability reporting.

Here are the main results of the study:

    Using the data on the ecological footprint taken from the sustainability report, which are published on the Bloomberg platform, it was possible to calculate a synthetic indicator of the ecological footprint, and consequently it allows to calculate an individual indicator of "ecological rating" for each company, which is then reversed against our preferred measure of the cost of debt. The probability of default-a-la Merton has a significant impact on our ecological rating, with a coefficient of 0.6, which is statistically significant. This regression, where we also have a set of dummy variables that capture specific impacts at the sector level, plus a constant, has an R-framework of 7.7%.
    The second result of this study is that we were able to calculate the value of the ecological factor for each individual company. If our model is correct, the ecological rating for each individual company is given by the multiplication between the slope of the regression, for example 0.6 in the Merton regression, multiplied by the value of the ecological factor for that single company. The sector the company belongs to does not seem to impact on the result, with the exception of energy, a sector that would imply a more conservative rating. We calculated the positioning in terms of ecological footprint for thirteen of the largest Italian non-financial listed companies. With a couple of exceptions our companies tend to have a low ecological footprint compared to the main European peers, which is good.

Here is a summary of the main results of our second report, dated February 2014 and entitled The ecological impact of European industry and its relationship with the cost of debt. The sample we use here is based on data at the plant level and business unit data for European companies operating in highly ecological sectors such as Energy, Utilities, Metals and Construction. The advantage of this sample is that we have collected the ecological impact measurements of greenhouse gas emissions and toxic air at the plant level, as they are made available by the European Environment Agency. We then aggregated this data at the level of the business unit level plant by matching the plant data with the annual report data for listed and unlisted companies made available by the Boureau Van Dijck database. Here are the main results of the study.

    We find a positive relationship between the ecological footprint of industrial plants and the probability of failure. This confirms our results for a positive link between the ecological footprint and the cost of debt of the previous study.
    For all sectors, there is a significant effect of the ecological footprint on the cost of debt. The impact of it is greatest in the Utilities sector, which we have explored in our third report (see below). The Oil & Gas sector is the only one where we find no discernible impact. Some sectors, such as metals, chemistry and steel have a very small number of observations.
    In this study, we also carried out a benchmarking analysis of the main European steel producers, matching the costs of air pollution with two measures of financial performance, interest coverage and ROA. The positioning of Ilva is worse than the main European peer, Tyssen Krupp, both for its ecological footprint and its financial situation, but surprisingly better, along both dimensions, compared to the numerous companies in the sector acquired by the Arcelor Mittal Group.

More recently, we have examined a specific sector, that of Utilities. In fact our study released in the spring of 2015 is entitled The environmental footprint and the cost of capital in the utilities sector.

    In this study we ask whether the European utilities that have changed the mix of energy sources towards clean (dirty) energies have been rewarded with a reduction (increase) in the implied probability of default, which is the main determinant of credit spreads. We find that this is the case, at least on average: a worsening of the level of greenhouse gas emissions is mainly related to an increase in the use of for dirty energy sources, such as coal, to the detriment of cleaner sources, such as the natural gas or renewable sources.
    Using data from the previous study, based on the AEA sample, we also find a positive correlation between a measure of the impact of air pollution by individual electricity generation plants, and the implicit cost of debt. In general, plants with the highest ecological footprint are coal-fired power plants. These are more likely to fail annual health and environmental safety tests. In extreme cases, the regulator and the judiciary can request the suspension of production, which impacts the ability to generate income and therefore the risk of default of these companies. Similar problems can also cause protests from green activists, and more and more investment funds that are sensitive to sustainability.
    Furthermore, we show that the greater the share of electricity production from renewable sources at the enterprise level, the lower is, on average, the implicit cost of the debt measured by the probability of default a-la-Merton. These results are interesting because they are confronted with the poor economic performance and relative failure of many start-ups active in the production of solar panels. In general, renewable sources are a good source of diversification for the large electric utilities we have studied. This is due not only to the economic subsidies that this type of generation enjoys, but also to the growing impact of the economies of scale of the unit cost of renewable energies.

Next steps

For the future, we plan to focus the analysis on the construction and infrastructure sector, which are fundamental both for creating greater growth and also for improving the increasingly obsolete capital stock in Europe. Without any progress in managing the health of the planet, and in the logistical aspects and in general in the economy of things, as opposed to the economy of bits, as well as in the search for new areas of interaction between the two worlds, as in the new internet of things , the growth prospects for Europe would be really modest.

I am sure that a greater knowledge of how the ecological footprint of businesses affects the cost of capital, and more generally how we can use innovative finance to reduce this footprint and encourage growth is an important way to create a better world for Our children.