Evaluating individual infrastructure projects from an environmental, social and governance (ESG) point of view is common practice for lenders. Yet providing an ESG evaluation of whole infrastructure sectors and their related risks is a much more challenging task, according to Frédéric Blanc-Brude, director of the infrastructure institute at business school EDHEC. Efforts to correct this are now being made, however.
Banks face a great deal of pressure to ensure infrastructure is sustainable; for example, through the fourth revision of the Equator Principles – providing a risk management framework to deal with environmental and social factors in project finance – which is due to be finalised by the end of 2019. It is set to include climate change provisions following the 2015 Paris Agreement and the recommendations of the Taskforce for Climate-related Financial Disclosures (TCFD).
The Equator Principles revision will also look to tighten social requirements after the uproar over the Dakota Access Pipeline in the US in 2017. The project risked poisoning the water supply of nearby Native American communities, yet was financed by more than a dozen banks that had signed up to the principles.
There is also a push from within banks, as their own sustainability frameworks permeate business lines. “[We spend] months with originators to assess when a deal is green or brown; I’m not going to say there are no discussions [about this],” says one banker.
Investor concern
Investors in infrastructure projects – which banks aim to attract to the deals they structure – are also increasingly aware of ESG factors, with large institutional investors examining how to reduce the climate impact of their exposures. For instance, the world’s largest pension fund, Japan’s Government Pension Investment Fund (GPIF), has calculated that the contribution to rising temperatures from assets it holds is in line with a 3.5 degree Celsius rise in average global temperatures scenario, as Bank of England governor Mark Carney noted in a speech in October. Mr Carney was addressing the inaugural summit in Tokyo of the TCFD, which he chairs.
GPIF held $2.7bn in infrastructure investments as of March 2019, an increase of 50% on its March 2018 figure. Similarly, French insurer Axa’s estimate is consistent with a 3.7 degree Celsius rise, as is Germany’s Allianz, which has committed to move towards a 1.5 degree Celsius path by 2050.
Mr Carney has long warned of the financial implications of climate change risks, and other central bankers have now followed, grouping under the Network for Greening the Financial System. Infrastructure lenders are expected to understand and report publicly on the ESG risks their projects face.
Disclosure is not just on an industry-led and voluntary basis, such as in the case of the TCFD, however, but also comes from regulation. The EU is requesting greater transparency when it comes to sustainable finance, and is creating a green taxonomy.
Making preparations
Bankers, meanwhile, are preparing for such requests. “We are expecting an evolution from a regulatory perspective,” says Orith Auzoulay, Natixis’ global head of green and sustainability. “We want to anticipate this.” And Hugues Delafon, a managing director in Crédit Agricole’s sustainable banking team, says: “What we've been doing, and most banks are now starting to do, is preparing for the next regulatory wave that’s coming from the EU in particular, so that we record and are able to consult the relevant ESG information in our internal systems.”
On an individual project basis, that information is already available, according to Matthew Norman, Crédit Agricole’s global head of infrastructure. “When you create an asset from scratch, on a non-recourse basis, you understand what you’re financing from day one,” he says. “You perform a very detailed set of due diligence and structuring to enable the creation of that asset and to monetise it, and you have a very good understanding of environmental and social factors embedded in that asset.”
Others, apart from project financiers, have access to non-public information on individual projects, for example, rating agencies, according to Swami Venkataraman, manager of Moody’s ESG analytics and integration arm. What is missing, he adds, is a sector-wide analysis.
Analysing infrastructure
Mr Blanc-Brude’s infrastructure team at EDHEC has set out to bring greater clarity to the infrastructure asset class. The subject of its work is infrastructure companies around the world and the ESG risks they face on a sector-by-sector basis. It calculates these mostly by using a combination of data sources that do not rely solely on individual project companies’ disclosure. This avoids relying on the willingness and ability of companies to disclose such information in a meaningful way.
In fact, self-reported results vary depending on the size and resources of the company – to the paradoxical extent that large industrial conglomerates that operate roads and airports may have a higher sustainability score than wind farms, according to Mr Blanc-Brude. The case for providing analysis that does not rely solely on corporate disclosures appears even stronger considering the rebalancing of both equity and debt financing towards project companies set up in the renewable energy sector, which may be smaller in terms of staff and resources than others operating in more established sectors.
Volumes of debt products to companies carrying out renewable energy projects went from representing 1.71% of total infrastructure financing at the end of March 2000 to 12.17% at the end of September 2019, according to EDHECinfra, the infrastructure research arm of EDHEC. This data is based on a sample of 948 individual senior debt instruments with a value of more than $106bn extended to 279 borrowers around the world.
Even more striking is the reduction of non-renewable power generation debt financing over the same period, from 61.49% to 6.06%. Furthermore, social infrastructure project financing grew from just over 2% of the global infrastructure financing figure at the end of 2000 to 16.78% at the end of September 2019.
The big picture
As greater financing and investment in renewable energy and social infrastructure grows, a better understanding of the ESG risks these sectors face becomes all the more important. Interestingly, greater interest has been matched by greater financial returns as the risk-weighted returns on debt to renewable energy project companies have outperformed, on average, the rates on non-renewable power debt. Risk, in this case, does not include ESG factors. In fact, so far no positive correlation has been found between ESG and infrastructure returns, something EDHEC is continuing to investigate.
To quantify these ESG risks, EDHEC is looking to capture data, ranging from geolocations to satellite imaging to natural language processing of newspaper articles and court filings. For example, according to Mr Blanc-Brude, an airport’s proximity to the coast, its altitude and its position in relation to the equator (and therefore exposure to extreme temperatures) can help determine the risk of flooding. Aerial pictures of runways can flag up risks of overheating thanks to the different shade of asphalt and concrete, two materials used to coat the ground. (Asphalt softens at high temperatures and risks rendering runways inoperable until the ground cools off.)
Similarly, for energy plants, cross-referencing the geographical location those that use water-intensive technology with information about areas suffering from water scarcity because of climate change will quickly reveal any risks. And the processing of newspaper articles, social media feeds and government audits can flag up changing public sentiment towards a certain type of infrastructure, across a multitude of countries.
“The game here is to find the information that is relevant and match it [to establish new relationships between data],” says Mr Blanc-Brude “[We process] this information that today exists in dribs and drabs everywhere [from various data sources] and, using machine learning, put it all together to get the big picture, to see what a sector looks like.”
Anne-Christine Champion, global head of real assets at Natixis, which has partnered with EDHEC on the project, says artificial intelligence can help turn a corner when analysing ESG risks to infrastructure. The plan is to release first a social acceptance index in Organisation for Economic Co-operation and Development countries by the end of 2020, while climate-related threats to infrastructure analysis would be ready in 2021.
Nipped in the bud?
Infrastructure experts insist that major issues around environmental and social concerns are dealt with at the conceptual stages of a project. Moody’s Mr Venkataraman says key elements such as land acquisition, which may have both consequences for residents and nature, would need to be resolved before a project comes to life – though the Dakota Access Pipeline case shows this does not always happen.
Tighter standards might help. But while project financiers, as well as investors, review their ESG guidelines and pledge to stay clear of unsuitable ventures, a sector-wide analysis in order to convey ESG risks more clearly will be welcomed by many.
