Zeal ESG Insight: Understanding how “E” translates to costs in portfolio companies

Investors have increasingly recognised that environmental, social and corporate governance (ESG) factors are closely linked to companies’ growth prospects over the long term, prompting many to incorporate ESG metrics into investment analysis to improve risk-adjusted returns.

More often than not, it has been the “E” element that dominates most ESG-related discussions. But incorporating environmental considerations into investment decisions requires more than simply cutting off any exposure to polluting industries from one’s portfolio. Instead, we think it’s key to cultivate a holistic view on all of the factors at play: global energy consumption trends, government environmental policies, and how these policies disrupt polluting industries along with those situated in the upstream and downstream parts of their supply chains.

For example, global governments have set a collective target to reach net-zero emissions by 2050 to combat climate change, catalyzing reform in the auto and oil sectors.

Conventional fossil fuel vehicles, while currently one of the main contributor to greenhouse gas emissions, could well be phased out in the coming decades. Some progressive European countries such as Norway have banned the sale of fossil fuel-powered cars as soon as 2025, followed by France and UK, which will impose such a restriction by 2040[1].

These regulations will obviously bring forward, if not already accelerated, a sea change in the auto industry – traditional carmakers will need to set aside more capital in the research and development of electric vehicles or alternative fuel vehicles. Such efforts, however, will add operating costs and weigh on profits. Traditional car manufacturers are hardly the only incumbents whose status quo is being challenged. The ripple effect will also spread across the oil and gas industry, and through that, the entire chemical and processing sector indirectly.

If you have been to Singapore, in particular the west side of the city, you wouldn’t miss the unrelenting glare given off by Jurong Island, the man made island across the main coastline that is the home to some of Asia’s major refineries.

The supply chain of the oil and gas industry consists of components that span exploration and extraction, oil refining, and downstream chemical processing. A good part of the revenue comes from transportation-related demands. In the US, for example, motor gasoline accounted for nearly half of daily petroleum consumption in 2020. This hasn’t factored in the usage of residual fuel oil and jet fuel. In fact, the existing refinery as we know it is built with the objective to meet transportation’s substantial demand for oil. With chemical products making up around 20% of the overall oil demand, they are considered merely by-products in the oil refining process[2].

However, when combustion-powered vehicles are completely phased out, half of the oil sector’s revenue will be gone, likely weakening the competitiveness of oil refineries. But we think this will play out over a period long enough for the oil and chemical industries to adapt to a new operating environment.

With Asia becoming the primary growth engine globally, we won’t be surprised if western oil refineries opt to pull out of the market altogether as their refining facilities might have depreciated beyond the point at which further investments in enhancing product mix is uneconomical. But we think situations are relatively better in Asian countries. Given robust economic growth forecasts compared to the West, there remains to be room for petrochemical product demand to grow. If improvements are made to the design of new production facilities, we think Asian refineries will make a steady transition to the new operating environment. In fact, many newly built refining and chemical plants in China have substantially scaled up the production of petrochemical products.

We think understanding oil refineries’ depreciation policies is key to the ESG analysis of the petrochemical industry. When combustion-powered vehicles become a thing of the past, existing refineries may no longer be economically viable, or may even be shut down. If their depreciation periods stretch over a lengthy time frame, it’s likely that profits are overestimated. Also, given the tectonic changes the entire industry will undergo, we see little visibility in the long-term growth prospects in gross profit margin. We think a more viable approach would be to value these companies conservatively. For example, a higher discount rate may be necessary if they are being valued by discounted cash flow. Finally, all greenhouse gas emissions should be factored in the total cost. The average price of one ton of greenhouse gas now stands at about RMB50 in China[3]. As most listed companies disclose emission figures, analysts should include these costs into their valuations.

[1] Source: Beijing Business Today, as of April 2021

[2] Source: The US Energy Information Administration, as of March 2021

[3] Source: Industrial Sustainable Development Clearinghouse, as of March 2021


This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

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