Tom Lyons, Head of Climate Investment Research and Senior Investment Analyst with Wells Fargo Asset Management, discusses climate change as it relates to the utilities sector and the Climate Change Working Group’s framework for assessing individual firms.
Laurie King: I’m Laurie King and you are listening to On the Trading Desk®. Today our discussion features highlights from a recent Investment Perspectives created by Wells Fargo Asset Management. It’s called Resilience: Global utilities in the time of coronavirus, oil crisis, and climate change.
I’m talking with one of the papers’ authors, Tom Lyons, Head of Climate Investment Research and Senior Investment Analyst with Wells Fargo Asset Management. He’s been our guest earlier this year on the program when our discussion was about the auto industry and climate change. Welcome back to the program, Tom.
Tom Lyons: Thanks, Laurie. It’s great to be back.
Laurie: To kick off today, let’s start by talking about utility stocks and bonds, particularly their market performance. Usually utilities are seen as a defensive sector, but since the coronavirus shutdowns have occurred, this hasn’t been the case. What’s your reaction to that?
Tom: Yeah, I was quite surprised to see the way that both utility stocks and bonds responded to coronavirus.
For example, in February and March of this year, when coronavirus really caused the market to start to sell off, you saw both utility stocks and bonds track much more closely to the market in general than they have in previous economic downturns.
In the past, utilities’ financially strong and regulated nature, and the stability that this allows for cash flow, let utility securities really prove much more resilient and less sensitive to economic downturn than other parts of the market. Or to say it another way, utility securities were able to be more defensive. But in the current downturn, this hasn’t been the case, at least initially. It appears that coronavirus’ unpurgeable nature, combined with the coincident over supply of oil has just caused investors to see more risk in utilities. But in our note, we show that neither coronavirus nor oil market weakness really should do any lasting damage to utility fundamentals in Europe or the United States.
We think about this effect between coronavirus, oil, and utilities in two basic categories, that is volume risk and margin risk.
With respect to volume, shelter-in-place clearly did have a negative impact on volumes, especially in the first quarter of this year, but those volumes did recover relatively quickly, and they’re not back yet to where that have been historically, but they’re making quick progress.
Away from volume dynamics, we also see regulatory and electricity price tariff structures that help insulate many utilities from the impact of change in volume.
So the dual effect of relatively resilient demand for electricity and protective regulation has prevented, and should continue to prevent, volumetric risk from really hurting utilities.
Margins, too, were not severely impacted for utilities, both due to regulation and due to the way competitive electricity markets work. Oil prices are often seen to be correlated to electricity prices, but there’s really not much of a fundamental connection there despite that. Most electricity markets that are deregulated and are subject to natural market forces tend to see their prices set either by natural gas or coal fire station, which operate near where the supply and demand curves intersect, so oil doesn’t have any direct feed into power markets except for very exceptional moments when demand is extremely high.
So both volumes and margins were relatively well protected. They have started recover already, and we think over the long-term should continue to support the utility investment case.
Laurie: So now let’s return to the broader picture of the overall utility industry and longer-term trends that are likely to affect it. You wrote about them in your Investment Perspective that we highlighted at the beginning. Can you bring to life some of the findings from this report?
Tom: I’d be happy to. When the Climate Change Working Group set out to assess the physical, technology, and policy effects of climate change on the utility space globally, we had a long debate about the nature of the utility value chain and how those various physical, policy, and technology secular trends would impact that value chain and competitive landscape in the decades to come.
What we found is that the fundamental impacts on utilities and, therefore, the impacts on their security values in the credit and equity markets, boiled down into four primary categories.
The first category is the physical effect of climate change and, of course, we see quite a bit of concern about climate change’s physical effects worldwide. The concern is well-founded. Effects like increasingly severe weather, about more frequent drought and heat waves in various parts of the world. These effects are increasingly tangible. Their impact has been increasingly expensive, and further they’re more and more unpredictable as they relate to when they’re going to occur and how they’re going to impact markets.
Away from that, decarbonization investments are increasingly common. We’ve seen the EU, different parts of Asia, including China, and various other parts of the world announce stimulus programs which focus on green investments and all of these investments are ultimately motivated by the physical concerns we’ve just outlined. So physical effects and how they’re driving investment across countries is the first and most important effect that we look at when we think about how climate change affects utility stocks and bonds.
The second example that we look at is the regulatory response to the physical effects of climate change. That is, when we read about the European Union [EU], the state of California, different countries in Asia and Latin America announcing decarbonization policies to drive their admissions closer to net zero by midcentury, the effect on various industries is profound. So regulation and policy are the second example that we look at.
Third, technology innovation is closely related and extremely important. Whether it’s the increasing cost competitiveness of renewable power generation, increasingly affordable electricity storage, more reliable power grids, or any other of the various innovations we’ve seen in electric motors, these really have an impact throughout the economy, and we have to pay close attention to them when we assess the value of a security.
Finally, and last but not least, stakeholders, and by stakeholders we mean investors, customers, and governments, are unlikely to backtrack on their demands for utility leadership in responding to climate change. Coronavirus rightly has occupied the attention of all parts of the market in recent months, but we don’t think that means there’s going to be any less pressure from any stakeholder on the utility sector to really help lead decarbonization and hardening of critical infrastructure. So we’re seeing that pressure continue to pop up not only in the U.S. but in the European Union, as well. And that stakeholder pressure is having a growing impact in the way companies run their businesses.
So those are the four items that we pay most attention to.
Laurie: And what I found striking and optimistic within your paper is the idea that financially robust and climate-resilient utilities can help the economy, but also can help with health and safety. Can you talk more about that?
Tom: Yeah, of course. I think that utilities are unique compared to other parts of the economy because of the role they play in society. And society needs a financially strong, robust, reliable utility sector to not only lead decarbonization, which provides essential services to people.
So one of the benefits of having exposure to utilities in a portfolio is that there’s an alignment, at least when companies are well-managed, between what’s good for society and what’s good for these companies.
With that, tends to follow regulatory structures that are ultimately quite supportive of utility fundamental strength. So I think there’s a virtuous circle, you can say, between what’s good for the public, what’s good for the companies, and by extension, what’s good for investors in these firms.
Laurie: At the heart of what you do is evaluate the competitive advantages that are most important to managing climate change within an industry, utilities in this case. Could you please explain the Climate Change Working Group’s analytical framework for assessing individual firms? And I’d also like to know—and I think our listeners would—was it difficult to agree on the focus of a new framework for evaluating climate change?
Tom: That’s an interesting question. When we formed the Climate Change Working Group two years ago, the overriding objective was to pull together portfolio managers, analysts, sustainability experts from around WFAM [Wells Fargo Asset Management] to focus on one question, which is how does climate change affect security value and portfolio risk? That’s what our investors were asking us to come back with better answers around, and that’s what all the managers of risk within the firm were keenly interested in exploring.
So with that single question in mind, we started by looking into the most basic tenets of any fundamental analysis we do in any investment team and then breaking them down to think about the different ways that the physical effects of climate change, related policy and technology responses, and related responses from stakeholders really fed into the way we do fundamental analysis,
And here there’s really six examples that we focus on mainly as a part of that exercise:
- Competitive strategy.
- Asset position—that is the cost competitiveness, regulatory landscape, carbon price exposure of the various assets that a company might own.
- The physical risk exposure. For example, is a company located in an area that’s prone to flooding? Will it be particularly vulnerable to rising sea levels? Is it in the path of extreme weather patterns?
- Operational expertise around renewables, energy efficiency, and other important areas.
- Financial profiles—the strength of the balance sheet and cash generation.
- Stakeholder strategy. Is the firm good at engaging with governments, with investors, with customers? Building consensus around its client strategy and then using that consensus to really propel forward the company’s business strategy.
So six is a big number when it comes to a conversation like this, but those six factors are important not only for climate risk analysis, but for any kind of risk analysis. We look at them in detail with the help of our sector experts on the various investment teams and we then respond to those investment teams with specific examples of how the value of a stock or bond might be affected or the level of risk in a portfolio might be affected, as well.
So to come back and answer your original question, Laurie, I’d say that there was an awful lot of thinking and debate that went into the framework we applied to climate risk analysis, but I think we really came away with a stronger overall fundamental platform and a better overall ability to evaluate securities.
Laurie: Now that you and your group have done an in-depth dive into autos and, most recently now, the utilities industries, can you tell our listeners what’s next for the Climate Change Working Group?
Tom: Of course. Our group is growing. We have representatives from about a dozen different teams around Wells Fargo Asset Management.
I think the consensus in the group is the financial sectors are where we need to focus next. We’ve done a fairly thorough job in the industrials, having covered and published on autos, utilities, and various integrated energy producers.
Insurance and investment banking firms are very likely going to be our next focus. They require unique analysis because of how global and complex and diversified they are. But they are quite sensitive to climate change through exposure in their loan book and exposure through a broad range of different regulatory constructs that demand that some of the banks and insurance companies report more thoroughly around the resilience of their balance sheets in the face of climate change. So that complexity and those issues will be what we focus on our next analysis.
Laurie: Well, we’ll look forward to hearing about it. This has been a very interesting conversation and we really appreciate the time that you’ve taken to provide a perspective on climate change and an important industry—global utilities—that matters to many of our listeners, both from a personal health and safety aspect, as well as from an investment one. Thank you again for joining us On the Trading Desk, Tom.
Tom: It’s been my pleasure. Thanks again, Laurie.
Laurie: For our listeners, you can find our Investment Perspectives about climate change and sustainable investing by visiting wellsfargoassetmanagement.com. Until next time, I’m Laurie King; take care.
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