Why we own one of the most carbon intensive stocks in our investment universe
John Bennett and Tom O’Hara, European equities portfolio managers, explain why investing in so-called high ESG risk companies can prove to be beneficial as an active manager.
- ‘ESG by avoidance’ often fails to recognise the importance of scrutinising companies which may have exposure to high levels of carbon, such as steelmaking. Instead, the managers believe that holding these companies to account is more constructive.
- The European Union’s proposed ‘carbon border adjustment’ could transform margin volatility in Europe by placing high levies on imported steel and drive a sustainable supply/demand dynamic.
- This change could impact both the ESG status and financials of the steel industry.
The steel industry has been a poor area in which to invest for over a decade with low margins, volatile earnings, chronic oversupply, cyclical demand and high carbon output. ArcelorMittal is classified as one of the most carbon intensive stock in our investment universe and Sustainalytics, an independent provider of environmental, social and governance (ESG) research and ratings, attributes an ESG risk rating of 37.7 (High Risk) to the company. So how can an investor who believes in a clear link between the cost of capital of an equity and its associated ESG risks consider such an investment for their portfolios? The answer, as is true of many of our investments, is to invest in change.
We believe that ‘ESG by avoidance’ (simply excluding high carbon stocks and industries) will increasingly look like an outdated and potentially suboptimal investment approach as it closes its eyes to the complex challenges at hand. If high carbon industries fail to gain funding from public markets they will increasingly seek private funding, where environmental scrutiny may be much lower. Instead we seek to apply our clients’ capital to those areas and companies which present a credible decarbonisation strategy, and hold them to their timeline and targets. We believe this will have a greater environmental impact in the long term, rather than exclusively offering our clients’ capital to companies that are dubbed ‘environmental winners’ simply as a result of their asset light business models.
ArcelorMittal’s path to decarbonisation
Steel is one of the most recyclable materials on earth but scrap availability cannot meet society’s yearly additions to the capital stock of steel, which is intensified by emerging market infrastructure development and the shift to steel-intensive renewable power generation. Steelmaking therefore continues to rely heavily on the conversion of iron ore, a very carbon intensive process. To illustrate, a 2011 Carbon Trust study revealed that in the UK each tonne of steel produced from iron ore generates on average around 2.3 tonnes of CO2 due to the energy required in the process.
- smart carbon – includes technologies such as carbon capture, storage and reuse and the replacement of coking coal with bioenergy sources
- green hydrogen – hydrogen from renewable energy sources used in the direct reduced iron (DRI) process.
The cost implications of these are enormous – firstly, to convert steelmaking sites, but more importantly, to establish the shared clean energy infrastructure in society that will be required to decarbonise steel, cement, heating, transport and other sources of emissions.
The European Union (EU) recognises the need for policy support to enable this complex transition and to create global decarbonisation leaders across all industries. Policymakers in the EU are looking at the prospect of a ‘carbon border adjustment’ for steel and cement, which should become established through 2021.
A steel carbon border adjustment scenario
An EU-based company imports a tonne of steel from a country that does not have an established carbon pricing mechanism such as the EU’s emissions trading system (ETS). The producer of that imported steel is at a cost advantage compared to domestic EU steelmakers who have to pay for their emissions. This is known as ‘carbon leakage’ and risks undermining the profitability of the EU’s steel industry and preventing investment in decarbonisation technologies.
Under the new system, if a tonne of steel produced creates two tonnes of CO2, the imported tonne of steel will be subject to a levy of two times the carbon price.
At a carbon price of EUR40/tonne (t), the imported tonne of steel would incur a levy of EUR80/t.*
European steel prices have averaged EUR600/t over the last decade with low and volatile EBITDA per tonne margins of around EUR25-75/t. Cheap imports, with no carbon cost incurred domestically or at the point of import, have been a major driver of the financial weakness of the industry.
Accounting for carbon could reverse the EU steel industry’s economic erosion from cheap imports over the last decade, transforming margin volatility and the industry’s ability to invest in decarbonisation.
China is also looking at its steel policy
Over the last decade, China has been the main exporter of cheap steel. However, the country is now taking action to rationalise its domestic steel industry with a series of initiatives to tackle the most polluting capacity and to make it less worthwhile to export steel. China is rightly questioning the value of producing over two tonnes of carbon locally just to export one tonne of steel, which often makes little profit. A reduction in China steel exports is another major driver for a more sustainable supply/demand dynamic in the steel industry and its ability to invest in decarbonisation. This change could affect both the ESG status and financials of the steel industry.
*desk estimations, as at May 2021.
EBITDA: Earnings before income, tax, depreciation and amortisation.