Rebecca Sherlock explains how ESG considerations can help improve the performance of a listed infrastructure portfolio
Environmental, social and governance (ESG) practices have come under more scrutiny in recent years as environmental disasters, large executive payouts and little or no disclosure has led to significant shareholder discontent over certain business practices. Considering ESG as part of your investment process helps mitigate risk and drives the long-term performance of an equity portfolio.
Taking ESG into consideration is an important part of managing risk because these issues can have an effect on the performance of an investment portfolio. Some of these risks can be more pronounced with infrastructure companies due to the social contract embedded in their right to operate and the operational risks that certain infrastructure assets carry, such as oil and gas pipelines. Points that should be considered to evaluate these risks include: environmental impacts, carbon footprints, safety statistics, employee turnover, historical governance practices, independence of the board and executive incentive structures.
Taking governance as an example, one attraction of infrastructure companies from an investor’s perspective is the strong and predictable free cash flow generated by these assets. This certainty at the asset level only translates into increased shareholder value if the executives’ incentives are aligned with those of shareholders. If incentives are misaligned then that certainty can be offset through financial leverage or non-accretive acquisitions.
Transurban Group, the Australian toll road operator, is a good example of how this has worked in practice. Transurban was originally a listed investment vehicle with a single purpose: to fund, own and operate the CityLink toll road concession in Melbourne, Australia. In 2002, it removed its single purpose status and grew through acquisitions both domestically and overseas. This acquisitive behaviour left the company with a stretched balance sheet and an unclear strategy.
In February 2008, Chris Lynch, ex-BHP CFO, was appointed as CEO with an increased focus on operating cash flows and reducing financial leverage. In June 2008, the company announced a capital raising and a distribution cut to better align cash outflows with the operating cash flow of the business. He also announced a cost reduction programme to increase operational efficiency to provide a more sustainable business model.
After creating a leaner, more disciplined business, executive remuneration was tackled, removing the focus from easily achievable EBITDA growth targets to incentives focused on total shareholder return and earnings per share. The company was also restructured to increase operational efficiency, reduce financial leverage and improve the relationship between executive management and shareholders. Considering ESG issues helps identify and avoid stocks that may face significant restructuring events.
Most infrastructure companies are in the privileged position of owning monopolistic assets that provide essential services to the community. The essential service nature of these assets means they face a high level of public scrutiny, be it opposition to a third runway, public outcry as electricity and gas prices increase, or access to land for oil pipeline construction. This means that shareholder value is predicated upon a company’s commitment to all stakeholders including customers, suppliers, staff and regulators.
Taking regulated utilities as an example, placing the customer at the centre of their business model drives them to increase reliability of the network and provide greater service to customers, which in turn allows them to receive financial performance incentives through the regulatory framework and hence earn better returns for shareholders. SSE, a UK utility, says its core purpose is to “provide the energy people need in a reliable and sustainable way”. This means creating a workplace environment based on safety and operational efficiency which translates into productivity gains, increased customer satisfaction and ultimately a higher return on regulated equity than their peers.
Getting a grasp on whether a culture of safety and operational efficiency permeates each level of an organisational structure can only be truly understood by meeting with operational management and seeing it first hand. This is why I abandoned the corporate suit for a pair of overalls and visited SSE’s 2,000mw coal plant in Ferrybridge, West Yorkshire. In all the asset tours I have done it was the safety culture that I found hard to miss, even down to the small things such as holding the handrail wherever you walk as there is an office policy in place to reduce the number of accidents taking place.
There are some industries where investing in sustainability initiatives has a direct link to earnings growth and, in turn, shareholder value. The US water industry is a great example. The network of pipelines is ageing and without renewal of the existing systems, pipes classified as poor, very poor or life elapsed will rise to 44% by 2020, which will lead to increased leakage and drinking water standards violations affecting households and businesses. To invest in the network, and hence increase drinking water standards, companies need to be incentivised through the regulatory framework and allowed to earn a return on the capital they deploy.
American Water Works is a listed water and wastewater operator with its largest operations in New Jersey and Pennsylvania. This company was privatised by RWE in 2001, which resulted in an agreement to stay out of rate cases in certain states. This meant that the lag between any capital investment and its corresponding remuneration widened, leading to declining return on equities and a lack of incentive to put capital in the ground.
When the company re-listed in 2007 it was a low-earning water utility with a large shareholder that wanted an exit strategy. As RWE sold down its remaining stake and the new CEO took charge, the company started to gain momentum in operational efficiency, portfolio optimisation, ROE improvement and hence share price appreciation. Over the last five years after re-listing, the company’s earnings have grown 12%, driven predominantly by capital investment, accounting for 7%, and operational efficiency accounting for a further 5%.
We believe consideration of sustainability issues improves performance of an equity portfolio. Within the context of our global listed infrastructure fund, consideration of sustainability issues is an essential part of the investment process where it both reduces risks and improves returns, delivering unit holders superior risk-adjusted returns. Portfolio risk is reduced via sustainability issues being identified, analysed and quantified prior to investing in a company. Returns of a portfolio are enhanced by sustainability considerations from both identifying value-adding opportunities and avoiding value-destroying situations. ESG factors are key components of a company’s long-term value proposition and must be considered in an equity portfolio.
Rebecca Sherlock is senior analyst for global listed infrastructure securities at First State Investments