The ESG Risk Atlas
Jun. 03 2019 — To calibrate the relative ranking of sectors, we use our environmental, social, and governance (ESG) Risk Atlas (see "The ESG Risk Atlas: Sector And Regional Rationales And Scores," published May 13, 2019). The Risk Atlas provides a relative ranking of industries in terms of exposure to environmental and social risks (and opportunities). The sector risk atlas charts (shown below) combine each sector's exposure to environmental and social risks, scoring it on a scale of 1 to 6. A score closer to 1 represents a relatively low exposure, while 6 indicates a high sectorwide exposure to environmental and social risk factors (for details see the Appendix). This report card expands further on the Risk Atlas sector analysis by focusing on the credit-specific impacts, which in turn forms the basis for analyzing the exposures and opportunities of individual companies in the sector.
Environmental (Risk Atlas: 6)
Mining is by nature hazardous to the environment. In all its forms, mining has the potential to release toxic elements to the air, water, or soil. Open-pit and underground mining involve the crushing and treatment of large amounts of ore, which may alter ecosystems if containment isn't proper. Other forms of mining, such as heap leaching, use toxic fluids (i.e. cyanide, sulfuric acid) that can be devastating if leaked into the environment. If an accident or leakage takes a significant human toll, as witnessed in Brazil Samarco (2015) and Vale (2019), it can take a toll on credit ratings.
The production of steel and aluminum are extremely power-intensive. Most steel is still produced with blast furnaces, releasing large amounts of carbon dioxide, nitrogen oxide, and particulate matters into the air. Despite the efforts to scrub the toxins before they are released, the process is in essence detrimental to the environment. That said, we expect electric arc furnaces, which generally have a lighter environmental impact, to gradually replace blast furnaces.
Some in the industry see aluminum as the metal of the future. Aluminum is lighter, stronger, and has better connectivity than steel, making it advantageous to, say, auto manufacturers, who are in a race to build lighter--thus more fuel-efficient--vehicles. Moreover, once produced, aluminum can be easily recycled with very low costs. However, the production of aluminum consumes about 10 times more energy than the production of steel, and about 70%-80% of the costs of aluminum production are energy related. About 50% of the electricity used to produce primary aluminum worldwide comes from environmentally-friendly hydro-electric power and other renewable, nonpolluting sources. A further 3.5% comes from nuclear power, which is substantially free from CO2 emissions but has its own set of risks.
Complying with the different environmental regulations around the world remains a significant capital expenditure (capex). For example, in Europe the companies have CO2 quotas, making them slightly less competitive than their peers in Asia. Other capital expenditures targets include the need to reduce costs and improve technology. As a result, steel and aluminum companies will continue to devote a sizable portion of their annual capital spending to improve their energy efficiency and gas emissions.
Coal-fired power plants are heavy air polluters, and governments are increasingly limiting them and incentivizing greener forms of energy. The United Nations' Paris Agreement, which the EU and other developed economies signed, aims at reducing greenhouse gas (GHG) emissions by at least 40% by 2030 compared to 1990 levels.
Chinese coal miners and steel makers rank at the top in the list of issuers exposed to environmental credit risk, due to their government's decision to reduce air pollution, which so far has led to the closure of more than 150 million tons of steel capacity there.
Social Exposure (Risk Atlas: 5)
The social risks for metals and mining entities mainly stem from the sector's exposure to safety management and social cohesion. Safety management is a key risk given the heavy use of large and dangerous equipment as well as the fact that some mining sites are located in remote and sometimes hostile environments. Typically, companies in the sector track and manage to incidents and have specific programs in place to educate its work force. Over the years we saw a clear trend of improvement in the lost time injury frequency rate (LTIFR). For example, the average rate for the steel industry in 2017 was 0.97x compared to 4.55x in 2006.
Social cohesion refers specifically to social license to operate, given the land use and disruptions that mining sites can create for the local communities in proximity. Governments around the globe are increasingly demanding social infrastructure and other forms of social responsibility from miners. Poor management of these factors typically leads to reputational issues, license suspension/termination, adverse litigation, staffing issues, and unrest.
Given that natural resources are also national resources, we note that governments can seek to renegotiate or change tax and royalty agreements, particularly at times of rising prices. Companies will tend to be pragmatic and reach an amicable solution. However, in some situations, the companies may stop some operations or investments, translating into tensions with the local communities.
Governance risks in metals and mining are largely driven by the entities' risk culture, degree of complexity, and location of businesses. Long-term business continuity is key, as it ensures alignment between stockholders and stakeholders. Poorer governance tends to be more recurrent among junior mining companies whose financial strength is generally weaker, and who do businesses in riskier jurisdictions and are more focused on short-term gains.
Some large, state-owned mining companies are more focused on long-term sustainability than some privately owned companies, and usually there's a high barrier to entry to the industry in their home countries. Family owned businesses are also fairly common in mining, especially in emerging countries, and they usually pursue long-term growth strategies and have longstanding presences. Some large groups started out as mining companies and grew in size and diversification, strengthening governance standards as they became multisector entities.