The ESG Risk Atlas
May. 13 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 Exposure (Risk Atlas: 4)
Transportation is a heterogeneous sector that includes various subsectors with different exposures to environmental risks, though most face increasing regulation of greenhouse gas (GHG) emissions. Overall, environmental risks for companies within a particular transportation subsector and region tend to be fairly uniform, with limited differentiation by company. Airlines and shipping companies are at greatest risk.
For airlines, the risk is mostly long-term because the rules agreed on by most countries under the International Civil Aviation Organization (ICAO, a United Nations-sponsored entity) apply only to international routes and can be met fairly easily using current and planned aircraft engine technology over the next several years, though this becomes more costly thereafter. The ICAO agreement seeks to limit carbon dioxide emissions beginning in 2020. With global air traffic growing faster (5%-6% annually) than ongoing efficiency improvements (1%-2%), this implies a long-term need for further technological breakthroughs such as biofuels to avoid or limit paying for carbon offsets (phased in voluntarily over 2021-2026 and mandatory thereafter). European airlines face an additional, separate emissions trading scheme to help offset emissions in that region, which has raised costs somewhat but not had a profound financial impact. The U.S. Environmental Protection Agency (EPA) during the Obama Administration had indicated an interest in pursuing GHG regulation for the U.S. domestic market following the ICAO approach, but that appears to be on hold under the Trump Administration.
Shipping companies face near-term regulations by the International Maritime Organization that mandate much lower emission of sulphur compounds as of 2020. Measures to meet this are costly (mostly either using more expensive fuel or installing "scrubbers") in a competitive industry with low margins. Accordingly, implementation of regulations could have a direct impact on credit ratings, though we believe higher shipping rates will offset most of these rising costs, since all shipping companies face the same requirements. The transition to these cleaner shipping fuels by refiners could also cause a short-term spike in the costs of all transportation fuels. Other sectors, such as railroads and trucking, face some environmental regulations but they tend not to be as impactful. Companies that provide operating leasing of transportation equipment (e.g. aircraft, marine cargo containers, rental cars) must factor environmental regulations into their decisions about which types of equipment will be attractive to users and retain residual values. Still, we see their risk as generally less than that of the transportation companies they serve. Environmental risks beyond GHG, including climate change and waste pollution, are less significant and in some cases not material.
Social Exposure (Risk Atlas: 3)
Passenger transportation companies face risk on social cohesion, as airlines are a high-profile target for terrorism and are disrupted by war, but freight transportation is relatively less affected. Passenger airlines have become more resilient, and traffic levels generally recover within a few months of an incident (though this varies, of course, depending on the severity of the incident and perceived risk of further attacks). Airlines carry insurance for potential liabilities, though particularly catastrophic attacks may exhaust it and require government backstopping of coverage. A material risk is cybersecurity, as transportation companies rely on extensive information technology (IT) systems to manage operations and collect revenue. Community opposition to expansion of transportation infrastructure (e.g. airport runways) limits growth and raises operating costs, but also allows transportation companies to raise prices by limiting capacity in the market. Human capital management represents an exposure, as many transportation companies are heavily unionized and strikes can be very costly and disruptive. Safety is also a risk, particularly for airlines, for whom accidents are highly visible and deadly (albeit rare statistically). Aircraft leasing companies are less exposed to such risks than the operating airline and, depending on the problem, the manufacturer, and leases require that the airline provide various forms of insurance.
For freight transportation companies, the safety risk relates mostly to employees or accidents that endanger others (e.g. toxic or flammable spills from rail accidents). Freight railroads, for example, are often required by law to transport commodities that may pose hazards. Other social risks, such as exposure to consumer behavior or demographic shifts, are much less of a concern; on the contrary, the spread of internet commerce has been a boon for freight transportation and global demographic trends are propelling airline traffic. Overall, we see social risks for transportation companies as moderate and somewhat less than environmental risk.
Governance factors for transportation companies are in most respects similar to those for other industries. For those subsectors in which most companies have unions (e.g. airlines, railroads), an ability to manage labor relations effectively is a plus. Many transportation subsectors are regulated to various degrees, so an awareness of the limitations this imposes and experience in dealing with government agencies is important.