At what point did society decide that smoking on airplanes was unacceptable? At what point did dog owners become afraid to go on dog walks without little plastic bags? When do societies decide to stop tolerating the social costs of environmental pollution?

The Forest Or The Trees?

Assessing environmental risk in fixed income is not a straightforward calculation of the likelihood and cost of possible environmental accidents, with a quick run through a list of fossil fuel reserves, carbon emissions, other greenhouse gas emissions and environmental fines paid. Everybody sees those trees, there is a forest too. Seeing the forest is a key to identifying environmental risk.

In developing a framework for assessing environmental risk, investors can consider two different types. There is the straightforward environmental risk associated with accidents, and there is the environmental risk associated with a change in society’s tolerance for, and recognition of, pollution.

To control and limit the risk of accidents, many societies have imposed regulations, limitations and prohibitions on businesses. In accepting these constraints, businesses have acquired a “social license to operate.” As societies debate whether or not these constraints are appropriate, the definition of what society is willing to accept may change.

Case Study: Freeport McMoRan

The copper mining firm Freeport-McMoRan’s social license to operate has, over the past 20 years, become more uncertain in a rapidly changing Indonesia.

The populist government of Indonesia has been pushing Freeport-McMoRan for years on environmental waste issues. The basic argument boils down to who exactly owns the copper in the ground, and a more practical battle over the value of the mining project.

Also, the rise of social media had given megaphones to many of those outside the traditional pillars of power or the traditional voices of authority.

Freeport-McMoRan’s CEO, Richard Adkerson, has pushed back against likely changes in the company’s legal and social licenses.

According to Mr. Adkerson, “It was always controversial, but it was a decision that was basically said you are going to develop this mine in this location or not…But you simply can’t say 20 years later we’re going to change the whole structure of what we’re doing. You can’t put the genie back in the bottle…I will tell you this, it has no impact on our view of the value of our asset.” (Freeport-McMoRan 4^th Quarter 2017 Earnings Conference Call, January 25, 2018)

The company’s stock dropped about 14 percent that day. The credit spread on the company’s 2043 bonds widened about 10 percent in the following few days as well (Bloomberg Transcript, Freeport “Q1 2018 Earnings Call”).

By increasing the environmental costs, the government of Indonesia has decreased the value of the project as it negotiates for a larger share. Each side is aware that the other side can pull out of the project and there is a balance between social costs, financial costs and jobs. Indonesia may decide that the social costs are too high, and Freeport McMoRan may decide the financial costs are too high.

A Framework For Assessing Environmental Risk

Academics have identified a useful four-pronged framework in which to think about environmental risk and social change.

• Legitimacy. Businesses must have “legitimacy,” a general acceptance by the society that the business has a right to operate.

• Legal License. Businesses must have a “legal license” which it attains by operating, or appearing to operate, within international and local laws.

• Economic License. They must also have an “economic license,” an ability to meet the demands of investors and creditors.

• Social License. Lastly, they must have a “social license,” having the support of the local community (Canadian Public Administration New Frontiers “Social License to Operate: Legitimacy by Another Name?” June 15, 2017). Or, if not support, at least a passive acceptance of its existence.

Case Study: Smithfield Foods

An example of environmental risk is the case of Smithfield Foods (SFD), which has threatened the profitability of the company, and the relative value of the firm’s Ba1, BBB- and BBB rated bonds.

On April 26, 2018, a North Carolina jury awarded 10 plaintiffs $50 million in damages in a nuisance suit against a hog-producing subsidiary of Smithfield. However, North Carolina laws passed in 2017 will significantly limit amounts plaintiffs can collect in agricultural nuisance lawsuits. The plaintiffs had argued that the smell, open waste lagoons, and truck traffic associated with hog farms had limited their access to the outdoors (New Food Economy “North Carolina Jury Fines Smithfield Foods $50 Million Nuisance Lawsuit Hog Farm Manure” Volume 60, no. 2, June 2017, pp. 293–317).

This was the first of 26 nuisance suits against Smithfield that has been decided. After a similar civil judgement of $11 million in Missouri in 2010, laws were passed to limit nuisance damages. In addition, potential lawsuits may evolve to trespassing lawsuits after recent air samples from farms neighboring manure lagoons in North Carolina found significant evidence of hog fecal bacteria (Environmental Working Group “Study: Fecal Bacteria from N.C. Hog Farms Infects Nearby Homes” May 11, 2017).

According to Moody’s “…the company would need to maintain overall earnings stability and a conservative financial policy before an upgrade would be considered.” (Moody’s Investors Service “Rating Action: Moody's upgrades Smithfield Foods' CFR to Ba1, March 6, 2018)

Smithfield Foods is owned by WH Group, a Chinese food group. A recent Rolling Stone magazine article pointed out that in China, the WH Group uses bio-gas digesters and a dry-manure process, rather than wet lagoons. The magazine quoted a former Smithfield director of corporate communications as saying, “lagoons work better for North Carolina’s warm climate… I’ve seen growers go bankrupt trying to use alternative systems.”

The apparent ability to control the environmental pollution, albeit at higher cost, appears to make this more of a margin issue than an existential issue for Smithfield. The cost of risk mitigation may delay an upgrade at Moody’s.

Not In My Back Yard

Even though many of the best examples of environmental risk arise from the natural resources sectors, investors should also keep in mind the vulnerability of consumer brands in the age of social media. A seemingly small environmental issue, even in a company’s supply chain, can turn into higher costs and a flurry of negative publicity. 

NIMBY-ism (“Not in My Back Yard”) is a reflection of the fact that sometimes social costs are concentrated on relatively few community members, rather than spread across society. If this risk concentration has fallen on the powerless and voiceless, investors should consider whether the rise of social media and the evolution of legal systems has increased the voice and power of these few. 

General Risk Types: Accidents And Societal Change

Fixed income investors assessing environmental risk will find it useful to segment two general types of risk when assessing different bond maturities from the same issuer.

1. The risk of accidents affects all of an issuer’s bonds from very short maturities to long maturities. It is not difficult to imagine unfortunate circumstances that would send an issuer’s management running into bankruptcy court right after an accident.

2. The risk of societal change in the acceptance of social costs is more likely to affect an issuer’s medium term and long-term maturities. 

We believe that fixed income analysts must consider the possibility of changes in societal attitudes, particularly when considering longer term bond maturities. Changes in societal attitudes about the environment are often championed first by thought leaders in academia, government agencies and Non-Governmental Organizations (NGOs). As these groups spread information and data on previously ignored social costs, the possibility of changes in societal attitudes increases.

To properly assess the environmental risks facing an issuer, analysts must be aware of the relevant issues being raised by thought leaders and consider how those issues impact the environmental risk facing a company.

Societies have largely decided to no longer tolerate the social costs of environmental pollution. With this in mind, investors must factor in environmental risks when assessing fixed income investments. The genie has left the bottle, likely to never be put back.

Patrick Faul is director of research at LM Capital Group.