Cargill serves the world breakfast, lunch and dinner.
The food giant puts eggs in McDonald’s’ muffins while its meats, oils, sweeteners and salts are used in kitchens across 125 countries.
These products helped Cargill to collect $177bn (£136bn) in revenue last year. This was 7% more than in the previous 12 months and highlights its growing influence over what we eat.
However, the company faces some tough headwinds, which could mean handing over more of those revenues to fund its vast operations through debt.
The issue is that Cargill, along with many others operating in the agriculture sector, carries huge environmental risks. And how sustainable a company’s practices are could impact how much it pays to be funded by debt.
The theory is that the better aligned to global temperature targets a business is the tighter its cost of capital will be. Yet it appears that some of these risks are not priced in.
Research into the impact of climate and other environmental risks on bond ratings and, ultimately, on pricing has been conducted by several organisations, including the European Central Bank, the International Monetary Fund and the Principles of Responsible Investment.
Also examining the link between sustainability and funding spreads is the Anthropocene Fixed Income Institute.
“Our core research thesis is that climate risk, and now by extension nature loss risk, is not priced into fixed income spreads,” says Josephine Richardson, the think tank’s head of research.
Cargill is an example of a corporate which could be vulnerable to a re-rating over its environmental practices. Two of the ingredients it cultivates are soy and palm oil – major culprits in the destruction of the rainforest and, therefore, biodiversity loss.
There is growing political pressure on companies to stop harming our climate and the natural world in the pursuit of profit. If, for example, such political will leads to the introduction of legislation designed to halt such practices, it could trigger mis-pricings in the credit markets.
One such event is the European Union’s new deforestation laws.
The EU Regulation on Deforestation-free products (EUDR) comes into force at the end of December, by when companies trading certain products within the bloc need to prove that their supply chains do not cause deforestation.
Although Cargill has set a target to remove all deforestation from its supply chains by 2030 the company could be vulnerable to a re-pricing in the debt markets. Indeed, the EU’s deforestation law appears to be a “significant” credit-relevant event, Richardson says.
Research published by the think tank believes the market is concerned that Cargill, which carries more than $50bn (£38bn) of debt, may not hit its deforestation target.
“Given limited underperformance in Cargill bond spreads since the regulation was announced, these supply chain-driven risks do not appear to be fully reflected in market pricing. For holders of Cargill’s bonds, this may present pricing risks as well as an opportunity for engagement,” Anthropocene’s research read.
The costs associated with that legislation could be relevant for a stock’s rating but are not priced into the fixed income market. “[EU deforestation] regulation is being enacted as we speak, so we view that as very much a near-term catalyst for repricing,” Richardson says.
The introduction of carbon taxes, for example, could be another price-altering event and should be taken seriously. “I’m not saying that regulation necessarily brings additional costs, but they tend to be a mechanism to incorporate some of the unpriced costs of lots of unsustainable practices,” Richardson says.
Not steep enough
Not all environmental risks manifest themselves in bond spreads in the near term. Some are already present but may not be considered a material risk for decades.
One example is oil and gas, a sector which carries huge transition risk. Anthropocene’s research shows that the steepness of oil and gas bond curves does not change based on production intentions. So expectations that demand for oil and coal will fall in the coming years, as renewable sources of energy become more productive and reliable are not priced in.
“Over five years the transition isn’t going to be a driver of oil and gas credit performance,” Richardson says. “But over 30 years, companies which are actively engaging in exploration have unrealistic demand and price scenarios.
“That is going to be a credit-relevant event in 30 years’ time and so that should have a steeper bond curve, but we don’t see that at all,” she adds.
Anthropocene presents this to investors as evidence that aligning portfolios to net zero is “a sensible investment decision”. “If more investors align to net zero that would deliver a differentiated cost of capital, which would drive behavioural change. That would be a key lever to some of these actors,” Richardson says.
“If oil and gas companies have to pay more for their long-dated debt, then they probably wouldn’t be drilling for oil as much,” she says, adding: “Pricing is a motivator and an incentive for change.”
A dirty business
Another issue that could trigger price moves in the debt markets is divestment. Despite engagement being the preferred route for many investors to solve environmental and social problems, some practices are firmly on the exclusion list.
One such product is oil sands, or bitumen, which produces three times more pollution than traditional fossil fuel extrac- tion and processing methods. It also creates toxic waste and poisons our drinking water.
“Now, whatever you think about oil sands, if significant pools of capital have made an algorithmic decision to exclude issuers who meet certain thresholds, there is going to be a clear negative ow on that name, so you can suggest it is going to be negative for the bonds spread,” Richardson says.
A different approach
It appears that there is a need for greater awareness of what could happen in the fixed income markets if more investors start factoring in the environmental risks corporates are carrying into their decision-making.
Unfortunately, the approach to assessing ESG risk in debt portfolios is not a standard research consideration as it is for some other asset classes.
“The materiality of what credit investors care about is different to what equity investors care about,” Richardson says, pointing out that stewardship and responsible investment is often focused on equities.
Bondholders may not have a say on who sits in a corporate’s boardroom like shareholders do, but they can still catch the attention of companies that they believe need to change.
The people investors with sustainable strategies are trying to influence are frequently funded by debt. This typically means heavy infrastructure, energy, sovereigns and state-owned entities. So debt is a way to engage with ‘dirty’ companies and industries to help create impactful change.
A big opportunity here is refinancing. Lenders may not get a vote at the AGM, but issuers come back to the market every five years or so to ask for more money. This gives lenders some influence. If companies don’t make progress on any requested changes, they should be considered a higher-risk investment and therefore have to pay more for the debt or not be offered it at all.
But for Anthropocene, this is about targeting those who are not running sustainable mandates. It is about making this approach to risk management a mainstream consideration. “We can work harder on the nancial arguments of why these things aren’t necessarily about promoting sustainability, just about promoting good businesses that are going to be longer and stronger credits over the long term,” Richardson says.
“Our theory of change is around supporting the relationship between cost of capital and sustainability. If better sustainability gets you a better cost of capital, then people will be more sustainable. We are not necessarily directly trying to make people be more sustainable,” she adds. “We are trying to support sustainability being correlated with cost of capital, and then that will make people be more sustainable.”
Trillion-dollar market
It is not just those investing in conventional forms of debt who need to be aware of the environmental risks’ issuers carry.
Investing in a bond that has a sustainable label – those named green, blue, social or sustainable – does not necessarily mean you are not exposed to ESG risks.
And it seems that investors will have plenty to consider from companies wanting to improve their environmental and social performance given that the market for sustainably labelled bonds could breach $1trn (£770bn) this year for only the second time, S&P Global Ratings believes. This comes after it came within touching distance of the landmark last year at $980bn (£754bn).
If this prediction of the market this year proves to be accurate, it could mean that bonds designed to make the world greener or to reduce inequality would be 14% of the global debt market.
In another positive development, S&P reports that sustainable debt’s growth trajectory will now mirror that of conventional debt after outpacing it for some years.
This is a sign that the sustainable debt market is maturing, believes David Oelker, a director and head of ESG investment in EMEA within global fixed income at BlackRock. “Even now we are hearing in the US that their treasury borrowing committee has discussed potentially issuing green treasury bonds,” he says. “That shows you how far into the mainstream this asset class has gone,” he says.
Closing the gap
If the $1trn worth of sustainable bonds hits the market this year as expected and is used to fund additional green investments, then “that has to be moving things in the right direction”, Richardson says.
“Unfortunately, it is well researched and reported that the funding gap, especially in emerging markets, is still huge. So it’s great, but more is needed,” she adds.
Indeed, to achieve net zero, $7.3trn (£5.6trn) of investment is needed annually by 2050, according to research from law rm A&O Shearman. “The extent of the capital needed is still significant,” Richardson says.
Most sustainable-labelled debt focuses on use-of-proceeds, so if you lend them money they could use it to buy a wind farm. “Unfortunately, there is still a challenge around the overall pricing of this debt,” Richardson says. “Some people say it has a ‘greenium’, but does it? I’m not sure.
“And it is hard to justify that those bonds should have a tighter spread, because they are, from a credit point of view, the same. Why would you, if you are an investor, and you believe in the transition of a company which is building a wind farm, accept debt that notionally is used to fund the wind farm, rather than the total debt when you have no superior claim over that asset? So it is quite hard from a pricing point of view,” she adds.
But what impact will this year’s expected level of sustainable debt issuance have on decarbonising the global economy?
Oelker finds it difficult to put a figure on this until the market achieves greater scale. “This is an asset class that is growing through regulatory support and through focused investment from funds,” Oelker says.
“We need to have a broadening out of that, to get to a stage where you can put numbers against the impact that you are funding,” he adds. “We are still building the infrastructure for that. Until you get to that point, it is difficult to put a number on it.”
This asset class is diverse, which could help it reach the scale needed. It is not only about use-of-proceeds bonds. There are also sustainability-linked bonds, which don’t function at project level, but where the issuer sets certain KPIs within these bond frameworks. So, for example, chemical or cement companies will work to reduce their emissions to an agreed level in a bid to secure the capital.
“There are parts of the green bond market that are financing greater renewable energy capacity or grid improvements, and that is fantastic. We want to nance that,” Oelker says. “That is important provided that these projects put the issuer onto the right path.
“So the issuer doesn’t have to be green, but the projects have to be genuine,” he adds. “They can’t have a negative environmental impact.”
Looking for the substance behind the label is important to make sure that the risk is suitably priced. “We do not consider every bond self-labelled green to be a green bond,” Oelker says. “And we have processes to assess a bond’s shade of green.”
It is clear that pricing in the debt markets, be it for traditional forms or specialised areas, is not considering all the risks and that investors should remain vigilant.
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