Environmental, social and governance (ESG) risks are becoming increasingly important to judging the credit worthiness of electric utilities, especially as climate change makes their work more challenging.
On this episode of the Columbia Energy Exchange, host Bill Loveless talks to Jim Hempstead, a managing director in Moody’s Global Project and Infrastructure Finance Group. In his role at Moody's, one of the largest credit ratings firms in the world, Jim helps oversee the North American Regulated Utility and Power Team. He also heads Moody’s working group in charge of ESG issues in the Americas.
In the conversation with Bill, Jim makes clear that defining ESG standards is still very much a work in progress for the credit rating firms and the companies they assess for credit worthiness. Nevertheless, ESG metrics are an important means of evaluating the utility sector where shifts are occurring not only due to climate change but also from public policies, market forces, and public attitudes about how electricity is produced and used.
Jim and Bill also talk about the relevance of government policy and regulation as it relates to ESG and the power sector, including recent developments in Washington D.C. and the enactment of an historic climate law in California.
View the Transcript
Bill Loveless: An increasingly important factor for judging the credit worthiness of companies is their exposure to environmental, social and governance risks. It is especially true for electric utilities as concerns over climate change deepen and their business faces transformation. But how are those risks defined and how are they applied? Hello and welcome to the Columbia Energy Exchange. A weekly podcast from the Center on Global Energy Policy at Columbia University. From Washington, I’m Bill Loveless. Our guest today is Jim Hempstead of Moody's Investors Service. One of the largest credit ratings agency in the world. Jim is the Managing Director in Moody’s Global Project and Infrastructure finance group where he helps oversee the North American regulated utility and power team. Just as important for this conversation, he also heads Moody’s working group in charge of environmental, social and governance issues in the Americas. I reached Jim by phone at his office in New York recently to talk about environmental, social and governance risks and how such assessments are done when it comes to the U.S. electric power sector. Jim makes clear from the start that ESG standards are still very much a work in progress for the credit rating firms and others that they assess for credit worthiness. Nevertheless, they are an important means of evaluating the utility sector where changes are occurring not only in the climate but also in public policies and public attitudes shaping the way electricity is produced and used. The timing of our conversation was good as Jim was preparing for climate week in New York which took place from September 24th to the 30th. As well as just days after hurricane Florence reminded us of the dangers of torrential downpours and flooding. We also discuss government policy including an historic new climate law in California. Here is our conversation. I hope you enjoy it.
Jim Hempstead, welcome to the Columbia Energy Exchange.
Jim Hempstead: Thank you Bill and thank you very much for thinking of Moody’s to participate on your program.
Bill Loveless: Well, it’s a topic, I’ve been wanting to touch on for some time because as you know, it just touches on just about everything we talk about on this program especially when it comes with anything. I was gonna say especially when it comes to electric power, it’s really, when it comes to anything. But, you know, let’s start with simply making sure we all understand the terminology here. For credit ratings agency like Moody’s what are environmental, social and governance risks?
Jim Hempstead: Right, so ESG risks, they refer to them as ESG risks. ESG is a broad range of qualitative and quantitative considerations that we think go to the sustainability of an organization over a long term period of time. And it talks about the broader impact on society, of its businesses and its investments and its activity. And ESG considerations, ESG risks have, they affect multiple dimensions of our credit analysis and have long been incorporated into our assessments of credit. For those sectors where it’s most relevant. So you know, what are the environmental risks associated with your exposure to regulations, your exposure to rising temperatures or sea level rises and what are your exposures societal type issues of employee relations and things of that nature and then governance which is long been incorporated into our credit. How do you manage and run the organization and just as a reminder Bill, our focus at Moody’s, we look at all material credit considerations that can influence the relative risk of default. And how are the financial lawsuits triggered in the event of the default. And we look at that overall issues and all that obligations over all kinds of horizons that we can have visibility on. Whether or not they are classified as ESG considerations or not.
Bill Loveless: But Jim, is it not a commonly understood definition of environmental, social and governance risks?
Jim Hempstead: No, Bill, there is not. We are starting to see some pockets of consensus develop across the market. But in general, there are very big differences in how certain investors, certain companies, certain banks and financial advisors and regulators look at and define ESG risks. And so from a Moody’s perspective, we always want to bring everyone back to our perspective when we talk about ESG considerations from the perspective of credit which is that event of default and expected losses. And we see lots of different data providers in the marketplace right now that are talking about ESG metrics and ESG relative rankings and ESG incorporates concepts that are very complex, they are very evolving, they are multifaceted, the science continues to evolve and emerge. We see no good standardization around reporting. There is not a lot of transparency or comparability between what is being reported across the sector and notwithstanding all that, ESG considerations are highly relevant for these investors and companies and we think this is a growing trend in the marketplace that is going to continue to get a priority.
Bill Loveless: But it sounds like it’s quite a challenge for ratings agency like Moody’s especially now given the increasing attention this is receiving not only from investors who are concerned about climate change for example, you know, and the potential for clean energy but the public at large. It just, how challenging is this to arrive at some sort of comfortable assessment of risk?
Jim Hempstead: Well, it’s very challenging and that’s why what we are doing here at Moody’s is trying to create a common language and a common platform to talk about these risks from a credit perspective. So this week, Bill, we published a rating methodology. It’s actually a request for comment for the public to talk about the general principles of how we think about ESG risks in our credit analysis and you will see us continue to do research and continue to develop tools that are consistent with those general principles that are published in that methodology. So that we can create a future where we have more quantitative tools to work side by side with our qualitative assessments on what ESG is all about. You’ll also see us put out next week during climate week hopefully some additional work on our use of environmental risks across all sectors, globally and you’ll see us work on additional tools and assessments with all three component of ESG, environmental, carbon transition assessment tool, social and government assessment tool.
Bill Loveless: Let’s talk about the U.S. electric power sector. It’s a sector that you’re particularly veriest given your background there at Moody’s and previously in your career. How are ES and G risks particularly relevant for the U.S. electric power sector?
Jim Hempstead: Well, they are very relevant for the U.S. electric power sector and I’ll talk about regulated electric and gas utilities and because they tend to represent a large, it’s a sector that represents a large component of the carbon dioxide emissions that was facing. The sector gets a lot of attention from regulators and from policy issues. And so, the sector is doing very well actually and they are doing very well on two fronts Bill. Number one, carbon dioxide emissions that have been produced from electricity generation are already 28% below the levels that were produced in 2005. This is according to the EIA data. And when we think about the amounts reductions of coal fired power plants that are coming over the next few years, we are calculating that the U.S. power industry is going to meet the clean power plant target of 30% reduction below 05 by 2023. Seven years in advance. And that’s a nice statistic. And then secondly, we see the sector through the electric, the Edison Electric Institution creating the framework to provide better transparency, that’s verifiable and comparable across the sector with what they are doing on their [00:09:13] work and we see them pulling in the American Gas Association as well. So we see the sector doing very well in this front.
Bill Loveless: A year ago, Moody’s assigned a stable outlook to regulated utilities in the United States for 2018. Going forward, is that likely to remain the case?
Jim Hempstead: That is no longer the case actually, Bill. Earlier this year in 2018, we changed our outlook to negative for the regulatory. And we changed that outlook to negative because of primarily because of the degradation in their financial coverage metric. So on average, the ratio of cash flow from operation for the sector have been hovering around 20% for 2010 to say 2015 or 16. It started to go down in part because of large uses of debt for acquisition purposes. But in 20, at the end of last year, with the tax reform, there is a significant cash leakage for regulated utility associated with tax reform and so we see that ratio falling down to the 15% range probably by 2019. So that’s why we assigned that negative outlook earlier.
Bill Loveless: So Jim then the change wasn’t due to environmental and social and governance risks.
Jim Hempstead: No, the principle change, so this is a Moody’s sector outlook and principle reason behind that change was financially driven.
Bill Loveless: Right. But still I, you know, we talk a lot about outlooks in a very specific meanings to a ratings agency. But, you know, when I look out on the electric power sector, there seems to be the potential for considerable disruption given the introduction of renewables, the interest in micro grids, the potential of storage, not to mention the ever promise of new technology and consumer demands for change in the way electric is delivered and is used. How do you counter that? I mean, how do you counter the potential for disruption over the long run when it comes to these ES and G issues?
Jim Hempstead: Well, disruption is a getting a lot of attention here at Moody’s. We have spent a considerable amount of time on those types of issues with technology developments and the amazing fall in cost associated with renewable energy that we are seeing. Changing customer demands and customer expectation is a big part of it. And the whole thing about integrating the grid and make it more efficient, you know, two way communication and things of that nature. We were a little bit diverted earlier this year because of the large impact of the tax reform. But we’re swinging back around to disruption now and the way we look at it is we take a long term view. We always take a long term view in our credit analysis. But what we are looking at with these utility companies is what is the financial resources that they have to deal with these considerations and these risks and it comes back a lot to regulation and we see utilities having very good regulatory relationship with the state regulators. There is a common objective between the state and the elected officials and the regulators and the companies to invest in the infrastructure to make it more resilient and quite frankly Bill there is not a lot of substitution risk right now for electricity and so we think that at the end of the day, there might be a lot of disruption and changes around parts of the infrastructure. But as a critical infrastructure asset, these companies tend to perform very well over time. And one thing, I would like, I highlighted is that you know, when we talk about default, when we look at ten year average default rates for corporate infrastructure securities which are primarily utilities. The ten year average default rate is around 3.4% based on one of our big default studies that we published. And that compares to non-financial corporates that have a ten year average default rate of 14 and a half of that. There is a much lower risk business.
Bill Loveless: Yeah, you know, I worry that utilities will begin to disappear at some point.
Jim Hempstead: We don’t subscribe to that issue at least over the foreseeable future that we can see that, that’s vital concept, I think that you’re starting to head at. We’re not incorporating that into now?
Bill Loveless: So what’s Moody’s point of view on climate change and how difficult is it to assess the risks of climate change, you know, given the incremental nature of the phenomenon?
Jim Hempstead: Climate change is, you know, climate change is talked about and incorporated into our bigger broader topic of environmental risks. So when we talk about environmental risks, we talk about five thing. Air pollution, soil and water pollution and land use restriction. We have carbon regulations in there, water shortages and then natural and man made disasters. So two thing. One, we carve carbon regulations out from air pollution because it’s such a very a focus and it has wide ranging credit risk. We’re looking at the impact of current and future policy that are coming. When we think about climate change, we’re looking at the natural and man made disaster and so we think about these environmental risks, basically in two categories Bill. The first one is the consequences of regulatory and policy initiatives that seek to reduce or prevent environmental trends and hazards. Right, so that’s, you know, what are the climate trends and what are the climate hazards and the second one is the adverse effects of the direct environmental or climate change impacts such as hurricanes or droughts or natural or human caused disasters and when we think about this, what we try to do is put everything on a relative ranking basis and so we talk about sectors that are most exposed, that they have elevated exposure where there is clear risk and that risk is already being reflected in their credit analysis or the most elevated sectors where we look at unregulated power. We look at the auto sector and oil and gas exploration and production. And then we look at sectors that have moderate risk. This is where the risk seems to be emerging over the next five years or so and that’s where the regulated utilities would reside. Where the credit pressure is coming but there is lots of mitigation time. And then the low risk category. This is where the big developed sovereigns would exist and the financial institutions would exist. That’s where there is a modest exposure to this where the consequences are not material.
Bill Loveless: Well, you know, I was reading through Moody’s report that acknowledges climate change will be reflected in severe heat changes in precipitation patterns, rise in sea levels. Much of what we have seen in the hurricane that just ravaged North Carolina and South Carolina, what does something, what does someone like you learn from the hurricane Florence?
Jim Hempstead: So, hurricane Florence has got a lot of attention right now. We’re very focused on the what will the impact be. I think the lessons learnt that we can expect out of hurricane Florence are still coming. What we learnt with this is always what are those lessons learnt. And so when we think about hurricane Florence, we look back to two years ago in the Carolina when we had hurricane Matthew. We look back at the other hurricanes that have affected things and what we see is the ability to get smarter when these storms are coming. So you have the benefit of seeing them come. So we see in hurricane Florence case companies put, they pre-position a lot of assets. They pre-position a lot of resources and that accelerates the recovery period which is a good thing. What we also see is for example in the Carolinas after hurricane Matthew came through, there was a need to invest heavily in much of the critical infrastructure to make it more resilient to these issues. But because hurricane Matthew was viewed to be a hundred year storm, a lot of those investments hadn’t happened yet. And here we are three years later with another hundred year storm. So perhaps we will see an acceleration of the priority to ways substations and food pipe, some of these critical assets are a little bit more. But we will see needs things happen.
Bill Loveless: I get the impression from your comments on the utilities in the United States and the treatment they receive from Moody’s and other agencies that you feel utilities are in fact responding with means to make the grid resilient whereas there is a, you know, there is a public discussion right now whether or not in fact the grid is resilient enough. But is that a fair assessment of your point of view?
Jim Hempstead: It’s fair assessment to say that there is an awful lot of capital investment going into the grid to make it more resilient, to make it more smarter and more efficient, absolutely.
Bill Loveless: You know government policy, we talked about that and you said that’s something that Moody’s certainly takes into consideration when doing these sorts of assessments. The government policy can change substantially as we’ve seen in Washington where the Trump administration has reversed planet policies of the Obama administration. What bearing does policy change like that have on ES and G determinations?
Jim Hempstead: So, it depends. In order to be mean for credit, the policy considerations that change really need to affect the likelihood of the fall and cut our losses. And so when we think about policy, we’re looking for a near term policies that have already been implemented that have the clearest impact on credit versus the longer term policy initiatives that seem to be coming down the pipe that may have less clarity or maybe some what unclear. One of the things that we look for versus when we are evaluating policy and how that affects a company’s cashflows or revenues or liquidity or investment needs. We look at what are the consequences of not adhering to the policy or not meeting those policies. So if you have something that says, you have to have a 100% renewable by a certain year, what the consequence of not meeting that policy are nothing. And it really doesn’t affect the credit quality of the company. And so and we try to make those differentiating factors.
Bill Loveless: But does it matter that you have a situation where one administration, the Obama administration proposes a clean power plant for example and the next administration, the Trump administration negates that and comes up with its own policy for emissions of electric power plants. Does that, you know, dramatic shift in policy approach has any practical impact when you and when Moody’s looks at these utilities and the risk for these utilities?
Jim Hempstead: Not… So with respect to what you’re referring to with these environmental policies from one administration to the next, the answer is not real. We see the market well ahead of the regulations when it comes to the carbon reduction initiatives that are going on across country on a state by state basis. And so when the Trump administration reversed course on the Obama administration efforts on the clean power plant and on Paris, we published reports that said, this is really not a credit driver for regulated utilities because they are already moving in that direction and as we mentioned a moment ago, we’re gonna probably need be 30% reduction off by 2005 carbon emissions by 2023. That’s a technological and a market driven response. So in that instance, it really didn’t affect that. Now, it does create some uncertainty for those companies that are affected by that because they are, especially in their regulated utility sector, these are very capital intensive, long life assets that they are trying to invest and make decisions on and so they need to really look through all of the other policy considerations to make their investment.
Bill Loveless: And I suppose, you don’t necessarily dwell on hypotheticals and I raise that probably because I’m thinking, proposal by the U.S. department of energy in May to acquire regional operators of the grid like PJM to buy power from coal and nuclear plants that agency dream strategic generation reserves. That would be done over two years while daily further studies of vulnerability of the grid. Does this draw business to any attention for people like you?
Jim Hempstead: Absolutely get the attention from us. We’ve written a fair amount on that. We pay close attention to that. It is a hypothetical at this point and so we are examining okay, if that particular policy was implemented and put into place what is the effect on the regulated utilities, on the customers and PJM’s transmission utility. So therefore we also look at the generator. So how does that affect the generator. And that intervention from the government is the credit risk. The fact that the government can step in and have that kind of intervention on a market that has been, you know, running on its own so to speak for quite some time. That’s the credit risk factor that we have to zero in on to see how that might go another way with another administration and so we think about these things, we talk a lot about them and the nice thing about our credit deliberation is we have an opportunity to talk to all these differentiators and parties that are involved in this to get their views and then we try to come up with our own view as an informed view as possible. But we definitely talk a lot and think about some of these issues. It may not be reflected in further analysis.
Bill Loveless: Right, right. I mean, that’s an issue that’s received quite a bit of attention here in Washington. I mean, how big of a risk do you think, it might be.
Jim Hempstead: How big of a risk, it could… Well, it depends on what the costs will be. You know, for that particular issue, what is the cost on the consumers to compensate those particular generators. Those are also, those power plants that you’re talking about are not the most economic power plants that are available and so therefore you push other stuff aside and so, I think you would see a response by a lot of consumer advocates in terms of you know, what that burden would be like on customers.
Bill Loveless: We’re talking about things going on in Washington but we look across the country to California, we see where they just adopted a sweeping new policy that called for total reliance on clean energy by 2045. What do you like?
Jim Hempstead: So that was interesting in California. The legislation, it was clearly credit positive for the environment and for the people who want to see carbon dioxide emissions go down further. But from a credit perspective, it was credit negative for some of the generators in that region and for the regulated utilities in the state. And its credit negative because of the potential costs that are associated with meeting that particular plan based on what we know today. So we are non-incorporating the significant cost reductions from technology development that could take place over the next period of years. But what we see here is a need to meet that goal is going to require more gas fired generation and so we some pressure on the California independent system operator and what we see them reacting is they’ve recently contracted for about 850 megawatts of gas power as a backup as part of their procurement process. So that they can ensure grid reliability. And so we look at that. Renewable energy currently contributes a little over 30%, I believe in California’s energy consumption and so in order to reach that 100% target, the states are gonna have to contract for some more gas capacity or it’s gonna need to replace something else and presumably that will be battery storage and renewables where the costs are still a little higher. So we do have 27 years to go, to get there. And we think that will happen. New technologies could develop and the cost of battery storage could continue to decline and so we will continue to do that.
Bill Loveless: I chuckle because you say we’ve got some time to get there but boy, it seems like things happened, we’ve changed so much, just in recent years when you look at the grid, you’ve been in this business for a long time as a student, evaluator of the power grid in the United States. I mean, does it leave your head spinning at times?
Jim Hempstead: Sometimes absolutely. And when I say sometimes, I mean almost every day. But the technology advances have been coming fast and furious. You know, the people at the electric power research institute are all over this from a technology area and we have seen the cost of renewable energy fall much faster than we had originally expected, you know, three to five years ago. And the cost of battery storage following this happening much faster. We believe the capital cost of having those batteries in California, it could be a $100 billion and that assumes that the installed cost of batteries could drop to a $100 per KW. But as capacity of storage capacity. You know, it’s happening faster than we had expected it to happen. And so that is the technology component of credit analysis that is most difficult to _____ [00:29:15].
Bill Loveless: Yeah, I mean, how do you deal with that? I was gonna, you know, I know in my own reporting, it seems, it’s difficult to keep up with all of the changes taking place in technology development, not to mention many other things going on. How do you grapple with that? Is this something that you just learn it yourself and your staff is putting much more time into or resources into?
Jim Hempstead: We have been putting a lot of resources into energy technologies for a number of years now. We have an energy technology briefing here at our offices that we host every year. We’ve done that for the last three years now. And we get over a hundred people appending bankers and investors, companies and things of that nature. So we have been, we have dedicated resources that are focused on these emerging technology. We work very closely with our colleagues and our other departments that cover the companies for the sectors that are involved in these technologies. So for example, we work very closely with our colleague in the auto sector in terms of electric vehicle. Electric vehicles being rolled out, we work very closely with our colleagues in the energy team about what’s happening on the fuel side. And we work very closely with our academia team where a lot of these technology developments are coming from. And we work also very closely with the regulators who often get an early look at this as well. So we try to be close to _____ [00:30:50] as possible. So that we can maintain our relationship with them.
Bill Loveless: Sure, that’s the national association of regulatory utility commissions. And speaking of the need for information data, you have enough. There is a bill that’s been introduced just recently by senator Elizabeth Lauren that would require public companies to disclose more information about their exposure to risks stemming from climate change that would require the securities and exchange commission to issue rules requiring each public company disclose both its direct and indirect greenhouse gas emissions and its total portfolio of fossil fuel related assets. Of course, it’s a bill, it’s not gonna pass any time soon. But you know, it’s likely to come up given Senator _____ [00:31:42] is considered to be a likely presidential candidate with democratic party. And they come up again. Other democrats who are considered presidential candidate timber, to build. But just putting the politics aside, it does a bill like that just requiring more public information of that sort helpful to this effort on ES and G?
Jim Hempstead: So the answer to the question is absolutely. Of course, the proof will be in the details in terms of what we are talking about. But we here at Moody’s. We’re committed to be more transparent about how we incorporate ESG iterations into our credit analysis. And we support more disclosure especially when that disclosure is verifiable and transferable across asset classes and transferable across regions and things of that nature. We are signatory to the U.N. sponsored principles of responsible investing, the PRI and we are actively engaged with the task force for climate related financial disclosure, that’s the TCFD and the sustainability accounting standards board, SASB. And so we like more disclosure. We don’t advocate what should or should not be disclosed, that’s not our role here at Moody’s. But we do think that for us being more transparent is a good thing.
Bill Loveless: Well, it’s a topic that we’re certainly be hearing a lot more about as time goes on. It applies as we’ve discussed is just about every aspect of the electric power industry not to mention the energy industry and industry and society really as a whole. Jim Hempstead, thanks for joining us on the Columbia Energy Exchange.
Jim Hempstead: Thank you Bill. This has been a lot of fun.
Bill Loveless: As always, thanks to you our listeners. Let us know what you think of the Columbia Energy Exchange by giving us a rating on your preferred podcast platform. And stay in touch with us too on the web at Energypolicy.Columbia.edu. and on Twitter at Columbiauenergy. For the Columbia Energy Exchange, I’m Bill Loveless. We’ll be back again next week with another conversation.