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ESG Initiatives in the Steel Sector

Steel is one of the most sustainable materials in the world; however, decarbonizing remains a challenge because the steel industry is accounting for approximately 8% of total greenhouse gas (GHG) emissions. Investors are supporting the efforts to limit global warming to well below 2°C above pre-industrial levels in order to deliver the goals of the Paris Agreement. The three types of climate transition risks relevant to the steel sector are policy risk, technology risk and market risk. 

Policy Risk

Companies with production in markets where the introduction of carbon prices is likely (or existing carbon prices are likely to increase), will be exposed to additional costs unless such costs can be passed on to customers. The steel sector could see profits fall by 80% if higher carbon prices emerge.

Technology Risk

The type of production facilities owned by steel companies is an additional consideration of relevance in assessing exposure to climate-related financial risk, given that the two main types of steel production differ substantially in their energy intensity. 

  • Basic oxygen furnace, accounting for around 70% of global production, produces new steel from iron ore and is highly carbon intensive because of the fuels required.
  • Electronic arc furnace uses electricity to heat scrap steel to create new products and is 36% less emission-intensive than the basic oxygen furnace.

Steel companies mainly reliant on basic oxygen furnaces for production will therefore be more exposed to costs related to carbon pricing, or other policy interventions, than those whose production is mainly via the electric arc furnace.

Market Risk

Financial risk may also come from new or competing products driven by the changes in customer preferences for materials supporting the energy transition; for example, auto manufacturers may shift from heavier materials (e.g., steel) to lighter-weight materials (e.g., carbon fiber). This means that steel producers with a diversified range of end-use products are likely to be most resilient to climate-related market risks.

Given the constraint of scrap availability, R&D programs on innovative primary steel production routes should be intensified to accelerate the transition to a fully decarbonized iron and steel sector new steelmaking technologies that would result in substantially reduced carbon intensity are in early phases of development, lack either commercial or technical viability, and are unlikely to gain widespread adoption in the next 10 years.

In the ESG initiatives in the steel sector, investors’ expectations are generally on the governance transition plans and disclosures:

• Governance expectation: Clearly define board and management governance processes to ensure adequate oversight of climate-related risk and the strategic implications of planning for a transition consistent with 2°C and efforts to pursue 1.5°C.

• Transition-plan expectation: Take action to reduce GHG emissions across the value chain, consistent with the Paris Agreement’s goal of limiting global average temperature increase to well below 2°C compared to pre-industrial levels.

• Disclosure expectation: Provide enhanced corporate disclosure in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) to enable investors to test the robustness of the company’s business plans against a range of climate scenarios, including well below 2°C, and improve investment decision-making.

For steelmakers, five key actions can help guide the sustainable transition: 

  • Assess and adopt clean technologies, promoting a balance of risk, capital cost and quality. Some of the emerging technologies to reduce emissions include carbon capture, innovations in product mix, hydrogen and alternative smelting reduction processes
  • Increase production of sustainable steel to capitalize on growing demand
  • Improve ESG performance to meet shareholder expectations
  • Embrace digitization to unlock value
  • Collaborate with all stakeholders to accelerate the transition to improve output quality

Steel Companies’ Sustainability Initiatives in the United States

Iconic United States Steel (NYSE: X), industry giant Nucor (NYSE: NUE), consolidator Cleveland-Cliffs (NYSE: CLF) and upstart Steel Dynamics (NASDAQ: STLD) are sizable steel companies in the US. The biggest thing separating these companies is the way they make steel. While steel is always a cyclical industry, with performance tending to rise and fall along with economic activity, US Steel’s earnings are much more volatile than those of Nucor and Steel Dynamics.

Nucor and Steel Dynamics use electric arc furnaces. Also integral to the steel-making process is scrap metal, with both Nucor and Steel Dynamics operating sizable scrap businesses. Electric arc mills tend to be smaller and more flexible than blast furnaces, allowing them to adjust more quickly to changes in demand. They can remain profitable even during periods of relatively weak overall demand. Electric arc mills are more consistent performers over time. This adds up to a better long-term performance for investors. That consistency of performance translates into other benefits for shareholders. Nucor has increased its dividend annually for 47 consecutive years. Steel Dynamics has increased its dividend each year for a decade. Most long-term investors would be better off sticking with Nucor and Steel Dynamics, both of which have more consistent core businesses built on electric arc mills. It’s an advantage that may not seem important today, but when the sector turns lower, it will be.

A meaningful portion of CLF’s successes is attributable to its prudent operational strategy implemented in recent years, including an increased focus on ESG. CLF is currently leading the steelmaking industry in decarbonizing operations. The company has spent more than US$1 billion to date in modernizing its production facilities and methodologies to reduce emissions. The investments have also made CLF more economically competitive within the steelmaking industry by protecting the company from pricing risks, increasing overall yield, and attracting new demand arising from the need for carbon-friendly steel. This makes CLF an attractive investment from a business standpoint, which effectively differentiates it from being a mere commodity-linked stock.

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US Purchasing Power, Inflation and Unemployment

US consumers powered the recovery following the pandemic but high gasoline and energy prices and food and housing costs have eroded their purchasing power. Real consumption spending accelerated to 7.9% in 2021 but may ease to 2% in 2022, and then to 1% in 2023.

There are already signs of an economic slowdown globally; other the other hand, household finances are robust, corporate balance sheets are strong, and the global financial system does not seem particularly vulnerable to asset-price bubbles.

Monetary policy is tightening rapidly around the world and will soon move into restrictive territory, in which rates will be above neutral. Monetary policy works with a lag, and it is likely that the global economy is only now beginning to feel the impact of the rapid rate increases of the past few quarters. Higher rates and tighter financial conditions mean the outlook is increasingly gloomy, with recessions a very real possibility in most major economies.

With inflation still rampant and central banks raising rates aggressively throughout the economy, the odds of a significant economic slowdown have increased. Normally, deteriorating growth would lead policymakers to pivot and stimulate the economy rather than continue to tighten policy. In financial markets, higher interest rates, lower equity prices and wider credit spreads are part of the solution to the inflation problem. Near-term, inflation will remain elevated.

Financial-market turbulence has been a necessary part of the tightening of financial conditions engendered by central banks this year. As policymakers begin to slow the pace of tightening and ultimately pause, the pace of market declines is likely to slow and eventually stop. The most likely outcome for markets is a reduction in volatility rather than a significant change of direction.

High prices plus rising mortgage rates are eroding demand in the housing market. Ultra-low inventories will underpin the sector. Housing starts will decline from 1.56 million in 2022 to 1.25 million in 2023 then hover at this level.

The “jobfull recession” has been fueled by record declines in productivity. Payroll job growth of 3.8% in 2022 will turn negative in 2023 as the “jobfull recession” transitions with job growth falling. Two million job openings will provide a shock absorber for the impact of the recession on the labor market. The headline unemployment rate is expected to rise from 3.8% in 2022 to 6.6% late in 2024 before beginning a gradual decline in 2025.

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Collective Investment Trusts 

A collective investment trust (CIT), also known as a collective investment fund, is a group of pooled accounts held by a bank or trust company. CITs operate like other pooled investments in that multiple investors with similar objectives combine their assets into a single portfolio, and investors in CITs assume the same investment risk, with no guarantee from the bank, trust company or any regulatory authority such as the FDIC.

CITs continue to be an attractive vehicle for plan sponsors to add to their retirement plan offerings. In 2021, 78% of defined contribution (DC) plans featured a CIT, making CITs the second-most common type of investment vehicle offered by retirement plans, after mutual funds.

Advantages of CITs

1) Lower overall expenses:

  • CITs are not registered with the Securities and Exchange Commission (SEC), eliminating costly registration-, legal-, board- and compliance-related fees. 
  • Since CITs may accept investments from only certain retirement plans or other eligible investors to maintain their securities and tax law exemptions, CITs require lower marketing and distribution costs compared to other vehicles. 

2) Quicker to launch:

  • Contributing to the generally lower cost profile, CITs may be quicker and less expensive to launch. CITs are traded through the National Securities Clearing Corporation (NSCC) to mirror mutual-fund structure.

3) Enhanced risk management:

  • By pooling assets, sponsors of CITs may take advantage of economies of scale to offer enhanced risk management for the participating investors than such investors could achieve by investing these assets in separate portfolios. 
  • CIT trustees serve as Employee Retirement Income Security Act (ERISA) fiduciaries to the plan assets invested in CITs. ERISA fiduciary standards require the bank, as trustee, and any sub‐advisers it may employ to assist in the management of the CIT, to act solely in the best interests of plan participants and their beneficiaries as a whole, thereby avoiding potential conflicts of interest.
  • Plan sponsors appreciate that CIT trustees are subject to ERISA fiduciary standards with respect to ERISA plan assets invested in CITs. 

4) Diverse and innovative investment opportunities:

  • By pooling assets, sponsors of CITs may also take advantage of economies of scale to more diverse and innovative investment opportunities for the participating investors. CIT providers are developing more CIT products to compete with mutual funds, despite the CIT space was dominated by indexed and stable-value investment strategies historically.

5) Targeted marketing and distribution efforts:

  • CITs accept investments from certain retirement plans or other eligible investors only. As such, CITs’ marketing and distribution efforts are more targeted than other pooled investment vehicles. 

6) Flexible pricing:

  • Banking regulators allow CITs to offer variations in pricing to different investors, provided that the fees are reasonable and commensurate with the level of services provided. CIT fees are sometimes more negotiable than fees available in other regulated pooled investment vehicles. CIT trustees recognize that ERISA plan fiduciaries have a fiduciary duty to ensure that the fees charged for a plan investment option are reasonably related to the services provided.

7) No disclosure requirements

  • CITs are not registered with the SEC, eliminating extensive public disclosure requirements

8) Reduced investment minimums

  • CIT Providers are waiving or reducing investment minimums for sponsor participation. In the past, an investment minimum of $100 million or $150 million or $200 million in assets could be a barrier.

9) Management flexibility

  • CITs allow for greater management flexibility, such as customizing underlying investments, negotiating fees, adding or subtracting managers.

10) Compatibility

  • CITs are now more comparable to NSCC Fund/SERV®.

11) Improved reporting and transparency

  • CITs have improved reporting and transparency as a result of compliance with Department of Labor (DOL) disclosure requirements under the ERISA. Historically, the lack of detailed expense information posed a headwind to the broader use of CITs, while plan sponsors now benefit from greater transparency on pricing practices in the DC market as a result of several DOL regulations governing fee disclosures to plan sponsors and participants.
  • CITs enable easy access to information on recordkeeper websites, quarterly statements and fact sheets. Some CITs now have ticker symbols.

Key Buying Factors

1) Investment expense/cost of trust services:

  • Investment expense is generally the largest single expense associated with a retirement plan. Lower-cost CITs provide plan sponsors and participants with the potential for considerable savings as the industry becomes more focused on driving down plan costs to enhance performance.

2) Investment strategies available:

  • The range of investment strategies available in CITs rivals that of any other type of vehicle, at generally comparable (if not lower) costs.

As a best practice, plan sponsors and their advisors should generally choose the strategy first and then select the most appropriate investment vehicle. Other key factors to consider include providers’ onboarding process, brand recognition, distribution mechanisms and style, operations and technology usage and CIT governance. The plan sponsor is always the plan fiduciary, but CITs can help sponsors fulfill their fiduciary duty to offer reasonable, cost-efficient investment options since CITs typically cost less than their mutual-fund counterparts.

Trends of the CIT Market

The potential advantages that CITs offer when compared to other investment vehicles may continue to translate into greater demand. CITs also continue to grow for recordkeeper acceptance and consultant familiarity. Technological advances, regulatory reforms and other changes in the retirement plan investment landscape have also helped to increase the popularity of CITs. Long a popular choice of defined-benefit plans, in recent years, CITs increasingly have become a choice of DC plan sponsors. The CIT universe today covers a much broader array of investment strategies to meet client demands. 

Meanwhile, widespread sharing of CIT information with database vendors has been limited, both in terms of the number of CITs publishing data and the breadth of the published data, although data aggregators, such as Morningstar and NASDAQ, provide coverage of CITs and continue to expand and improve their institutional subscription databases in collaboration with CIT sponsors.

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Investment in Carbon Capture and Storage

Although carbon emissions occupy a relatively small space on the spectrum of environmental, social and governance issues, as more and more countries and companies commit to Net Zero, they are steadily gaining attention from investors. Companies have relied on offsets to help avoid or reduce emissions for decades. Long associated with the “cap and trade” market, they are traded globally in two ways: (a) as allowances among companies to comply with mandatory emissions caps or (b) as part of various abatement initiatives in the voluntary markets. Offsets are generated through carbon-reduction activities across two broad categories: industrial and nature-based. Carbon capture and storage, for instance, are examples of industrial initiatives to remove carbon emissions.

Moral justifications are supporting the decisions to make strategic investments in carbon dioxide capture and storage. Investing in carbon capture and storage plays a significant role in a portfolio of global solutions to climate change in response to The Paris Agreement targets. Drawing on moral claims about protecting economic and energy access, carbon capture and storage capacity should be available to the regions with hard-to-decarbonize infrastructure.

The key question is, where to pursue the strategic investment? There are near-term and long-term considerations when investing in carbon capture and storage projects. Near-term global distributive justice and undermining legitimate expectations, which we favor investing in developing regions, especially in Asia. We also consider long-term climate impacts and the best uses of resources, and so we favor investing in the relatively wealthy regions that have the best prospects for successful storage development.

The investment risks of carbon capture and storage projects include (a) the risks directly associated with the operational activities of carbon capture and storage; and (b) the planning risks inherent in an over-reliance on large-scale, future deployment of carbon capture and storage. As such, generally, the investment risks of these projects are two aspects: general project risk or mitigable risks and hard-to-reduce risks, which refer to the risks that cannot be mitigated in the same way by private-sector actors. The hard-to-reduce risks can only be addressed by governments. 

Financing Models for Carbon Capture and Storage Projects

During the early stages of deploying carbon capture and storage projects, financial support from governments is necessary to mobilize private capital for these projects. In addition to government and public funding, private funding can come from a wide range of investors, especially banks, as they are experts in funding infrastructure projects. There are corporate-finance models and project-finance models: 

  • Corporate-finance model: the corporate-finance model involves a single corporation that develops the project and finances all of its costs. The corporation may choose to implement the project through a subsidiary, which would then be consolidated into the corporate’s financial accounts. Since it has full ownership of the subsidiary, the corporation reaps all the benefits of the project. Still, it is also exposed to all of the risks and liabilities, which can be significant should the project not perform as expected. Such an arrangement makes it possible to raise debt at the corporate level, with the lenders having recourse to all the corporate’s assets in the event the project should not perform. This significantly reduces the interest rate applied to debt, making the latter relatively cheaper. Also, since the project management is internalized, this makes the entire corporate-finance process attractive in terms of cost of capital and speed of implementation. 
  • Project-finance model: a more scalable funding model is project finance. It allows multiple equity investors to participate in a single project. Debt provided through project finance is referred to as non-recourse debt, and it is for this reason that this form of debt is charged at higher interest rates than corporate debt. Under project finance, the project is set up through a special purpose vehicle, with each investor having an equity stake. Capital for the project is raised based on future cashflows, so both equity and debt investors are exposed to any uncertainty in the performance of the project, thereby increasing the investment risk and subsequently the cost of debt. The ratio of debt to equity can vary significantly and will be dependent on the project specifics, availability of capital and the risk profile of the project owners. Some projects may have a very high gearing of up to 85% debt, whilst others will be much lower, at approximately 50% debt.

Innovative financing for carbon capture and storage projects includes sustainability-linked loans and green bonds. Sustainability-linked loans are particularly popular despite their recent emergence. Whilst green bonds have supported the deployment of other sustainable infrastructure projects, such as offshore wind and solar farms, issuances of green bonds have accelerated over the past decade and yields of green bonds are now often less than conventional debt. Green Climate Funds and their agencies can provide concessional financing to support the capital needed.

Typically, large companies, such as utilities, will find that corporate finance suits their needs better than project finance. This is because large corporations have two distinct advantages: their ability to use cash flows from other operating activities and use their general creditworthiness to borrow money to fund projects. Smaller companies, which do not have the large balance sheets of corporations will find the project finance structure to be the more attractive and accessible option for funding these projects. Key to their participation in the project finance model will be their capacity to partner up with other investors. Project owners will need to form consortia to raise equity, whereas lenders will come together to provide syndicated project loans on the debt side.

Investor Considerations

Unlike conventional private investments, a material value is placed on carbon capture and storage projects. This can be in the form of a carbon price or a financial reward for carbon dioxide storage. For investors, this value must be sufficient to incentivize investment in carbon capture and storage. Or the value placed on the carbon dioxide captured, transported and stored needs to exceed the cost of the carbon capture and storage projects.

Rather than a quantifiable IRR, the only way to maintain an acceptable return on investment is by reducing the capital required from investors. Also, there are trillions of dollars currently locked up in the private sector across financial markets, capital markets as well as other sources of funding such as sovereign wealth funds. So liquidity is another criterion to consider. 

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Positioning Portfolios for An Environment of High Inflation

Investors should adopt inflation protection as inflation shows few signs of moderating anytime soon and central banks are tightening monetary policy aggressively. Treasury Inflation-Protected Securities (TIPS) can help position portfolios for an environment of higher inflation and lower growth. TIPS protect against inflation in two ways. First, the principal value of TIPS is indexed to inflation. When inflation increased by 7.5% in 2021, so did the principal value of TIPS. Second, the coupon payments of TIPS are also inflation adjusted, with payments based on the inflation-adjusted principal value of the TIPS multiplied by the coupon rate. TIPS also maintain the defensive components of Treasuries, should growth expectations decline.

In addition to allocating to TIPS, investors also need more yield to help protect from diminishing purchasing power, given the negative real yield starting point of TIPS. One solution is to replace the Treasury allocation in a multi-sector bond portfolio with TIPS. The multi-sector portfolio provides a more appealing risk-return profile, in addition to a yield cushion. Corporate bonds and securitized debt boost portfolio yields and are less sensitive to interest-rate risk. The interplay between yields, volatility and the shape of the yield curve could create investment opportunities in rate markets and among securitized assets. Investors should also build protection into their strategic asset allocations, which pertains to the long term.

Moreover, a blend of assets and hedges can overcome these drawbacks and prove worthwhile for inflation-sensitive investors because different asset classes outperform in different macro regimes. Such assets include stocks with pricing power, inflation-protected bonds, inflation swaps, floating rate debt, and real assets like commodity futures, real estate, infrastructure and commodity-linked stocks. A balanced allocation to these assets can increase the robustness and resilience of portfolios and allow investors to successfully navigate the hostile markets inflation may cause. I also recommend considering high-yielding bonds and broadening the horizon. Inflation is higher globally but it varies by region and country. In brief, active management is key in this environment because only active investors can respond nimbly to fluctuations and navigate shifting trends.

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