Both Chinese and international policy makers are emphasizing the importance of stress testing environmental risks for investment, including the use of scenario analysis. Yet, it is unclear to investors how these potential environmental impacts may translate into financial costs, and more importantly, how these risks could be incorporated into existing financial analysis to potentially improve risk management.
This research presents a possible assessment framework to measure the hidden costs from various regulatory and physical risks under key scenarios, and illustrates how investors might integrate this into existing risk and financial analysis using the coal-to-chemical sector as an example.
How Do Environmental Risks Translate Into Financial Risks?
Environmental risks build upon the physical impacts businesses have on the environment, which then translate into financial risks for business and investors via risk factors. The risk factors included in the analysis are compliance with energy and water standards, environmental tax, water resource tax, the national carbon emissions trading scheme (ETS), the pollutant emission trading system, and water stress. Based on China-specific life cycle assessment (LCA) data (Wernet, G. et al., 2016), policy research and stakeholder consultation, Trucost estimates the potential costs for each risk factor under various plausible pathways for seven key coal-to-chemical products. These pathways are then analysed using likelihood scoring matrices and categorized into three key scenarios – most likely, likely, and less likely.
Environmental Compliance and Water-related Risks are the Most Prominent
Trucost’s findings show that environmental risks could lead to a financial cost of about 35 – 64% of the unit price of these products on average in the three scenarios. For most of the coal-to-chemical products, potential costs from environmental risks increase significantly towards the less likely scenarios. This illustrates that while the costs for some products may be limited at present, they could be subject to disruptive rises in future, bringing greater uncertainty for investors.
Potential loss of production from regulatory compliance accounts for the largest share of environmental risks for most products – over 90% of total cost on average (see the blue portion of the bars shown in the graph above). With the dominance of risks from environmental compliance, stringent and ongoing due diligence may help investors to mitigate a significant share of these potential costs.
The Overlaps of Risks and Industry Growth
Water appears to be the most prominent environmental impact driving these risks, as about 45% of total environmental risks is related to water use. It is also a key factor for regional variations in risks. As shown in the map below, the higher risk intensity is in the north-eastern provinces, overlapping with regions where the greatest coal-to-chemical production capacity is located.
The overlap between risks and production may further expand with the industry growth target set out in the 13th Five-Year Plan (FYP) by China for coal to oil and coal to gas. Using coal to oil as an example, the map indicates the potential growth in capacity would likely concentrate mostly in higher risk regions and thereby increase the exposure of environmental risks for this sector as well as investors.
If the capacity growth is realized for both products, the environmental risks could account for 2 -6% of the projects’ investment, potentially increasing to 8% in future.
Case Studies Show Significant Impacts on Profitability
To illustrate how these environmental risks could have financial implications for projects, Trucost selected two projects as case studies – one was coal to oil and the other was coal to gas. Taking environmental risks into account, the internal rate of return (IRR) of both projects is estimated to be positive (3-5%) while still far from reaching their weighted average cost of capital (WACC) (the two companies have their reported long-term WACC at 8-9%).
Trucost’s sensitivity analysis also shows that the breakeven threshold for both projects becomes significantly more stringent as environmental risks increase. They require much higher diesel and gas prices while relying on a low coal price in order to break even (see the graph below for results under the “most likely scenario”).
This analysis demonstrates the importance of integrating environmental risks in investment analysis and how this could help investors better understand the risk-adjusted profitability of their investment. Factoring in the potential costs of environmental risks could enhance risk management to avoid projects that could become stranded in the future when environmental risks become much more significant.
Integrating Environmental Risks into Investment
The results demonstrate that environmental risks could have profound impacts on project profitability. The potential scale and uncertainty of future environmental changes emphasize the importance of incorporating environmental risks into financial analysis for investment decision making.
Trucost posits that policy makers could address these financial risks through robust and consistent regulation and enforcement to encourage sustainable business decision making. This could provide a clear and effective incentive for businesses to consider environmental impacts in the management of their operations.
Investors could consider integrating in-depth assessment of environmental risks into their current financial analysis. Investors should also recognize that conducting due diligence before and after investment is also vital to increase the resilience of portfolios to environmental risks.
This blog was first published in China Water Risk