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KBRA ESG KNOWLEDGE HUB

Midstream Energy Companies: KBRA’s Framework for Incorporating ESG Risk Management in Credit Ratings

Oil pipeline in green landscape
Pipeline in green landscape
spooh/Getty Images

This Kroll Bond Rating Agency (KBRA) report is a follow-up to a research publication on KBRA’s general approach to incorporating environmental, social, and governance (ESG) factors in our credit rating process across corporate, financial, and government (CFG) ratings, which we describe as ESG Management. While our previous publication provided a broad overview of KBRA’s ESG Management approach (summarized below), this research report focuses on the potential influence of ESG topics on KBRA’s analysis of midstream energy companies. It is important to note that this research is not a methodology. KBRA’s cross-sector ESG methodology can be found here.

Overview of KBRA’s ESG Management Approach

  • KBRA believes that ESG issues are best examined through the lens of active risk management. Under our ESG Management framework, we seek to understand how an issuer or transaction identifies, addresses, and mitigates relevant ESG risks or capitalizes on ESG opportunities.

  • KBRA believes that credit-relevant ESG risks and opportunities are unique to every rating and issuer. Our approach to evaluating the management of ESG issues is a bespoke and dynamic process.

  • KBRA does not deploy subjective value-based ESG scoring rubrics.

  • KBRA understands that better quality ESG-related disclosure is needed to understand an issuer’s exposure to credit-relevant ESG issues.

  • Our direct dialogue with management teams enhances our understanding of credit-relevant ESG issues while also improving the quality and consistency of ESG-related disclosure.

  • Consistent with how we assess default and recovery risk, we view the management of ESG factors as a dynamic process, rather than a point-in-time judgment.

  • In addition to the unique ESG risks related to each specific debt issue or issuer, KBRA’s analysis of ESG Management typically includes a review of broadly relevant topics such as climate risk, stakeholder preferences, ESG reputational risk, and cybersecurity.\

  • We believe the risk management framework should be comprehensive, yet also dynamic and flexible enough to accommodate evolving factors, including ESG considerations.


KBRA’s ESG Management Analysis Framework for Midstream Energy Companies

Some ESG factors can have a clear, identifiable impact on credit ratings and these are incorporated in KBRA’s rating analysis. However, KBRA believes that the relative ability of issuers to identify, disclose, and address a broader array of ESG factors that may be less direct or immediate is an increasingly important credit consideration.

As part of our due diligence process, KBRA evaluates, where relevant, the overall effectiveness of the risk management framework to determine whether it adequately captures and addresses the plausible risks to which the entity is exposed. When relevant, we may analyze management teams’ awareness of existing, emerging, and potential risks, and the processes in place for identifying, assessing, and responding to relevant ESG risks and opportunities, as well as how these functions compare to peers.

KBRA defines midstream energy companies as those that principally engage in the transportation, storage, processing, and marketing of crude oil and its derivates, natural gas, and natural gas liquids. Midstream operations include, but are not limited to, gathering and processing plants that collect gas at the wellhead and prepare them for long-distance transport; long-haul pipelines that move oil and gas from the production site to a designated market area or to storage facilities; terminals that provide distribution, storage, and blending of the oil and gas products; and liquefaction and regasification plants that convert the physical state of natural gas to allow for effective transportation or commercial usage.

Environmental Factors

The impact of environmental factors on midstream companies generally varies by sector (i.e., processing, storing, transporting) and can be idiosyncratic at the company level or a systemic sector risk. The impact of environmental factors on corporate ratings can occur over the short, medium, or long term. As such, KBRA’s credit profiles consider the mitigation plans that companies have in place—or are planning—to reduce their exposure to environmental risks, as well as how their strategies manage these risks and build resilience.

The global shift toward a lower-carbon economy and changing stakeholder preferences toward investments with a positive environmental impact may lead to the capital markets becoming less receptive to the midstream energy industry due to its reliance on fossil fuels and high level of greenhouse gas (GHG) emissions. However, some midstream assets may be viewed more favorably given their role in procuring and delivering natural gas, which is increasingly replacing coal as a cleaner source of electricity production and will likely be crucial in the early stages of a low-carbon transition. Further, if the global response to climate change continues to push technological developments in the capture and storage of carbon dioxide, midstream assets may play a role in the long-term transition plan. Though it is unclear how midstream assets will be viewed over the longer term, KBRA sees the management of stakeholder preferences around environmental issues as crucial for any midstream entity. Stakeholder preferences are described in more detail in the social section of this report.

Other key environmental factors that may influence a midstream company’s credit ratings include climate change, land use and natural resource allocation, and pollution, which we describe below.

Climate Change

Where relevant, KBRA analysts examine both physical and transition risks related to climate change. Physical risks such as extreme weather, sea-level rise, or drought, directly impact assets or business operations. In contrast, transition risks are indirect and relate to an entity’s ability to shift to a lower-carbon economy including potential changes to environmental regulations, supply and demand changes, and/or increased reputational risk.

Regarding physical risks, KBRA analysts will often request an issuer’s analysis of the potential impact of climate change on its physical or financial assets such as operating facilities, revenue generating assets, or financial assets (e.g., insurance policies, business loans, etc.). As climate change intensifies, natural disasters and extreme weather events such as earthquakes, flooding, wildfires, and drought are projected to increase in frequency and severity. Consequently, the risk of technological accidents triggered by natural disasters (natech) are expected to increase, which can cause damage to some midstream assets and the downstream facilities that rely on their services. However, climate change is likely to affect different assets in various ways, creating opportunities for some issuers and risks for others. Some companies may benefit as weather patterns change, while others could experience a reduction in operations and productivity. For instance, climate change-driven water shortages and droughts could make it more difficult for some power generating facilities to operate. Although drought conditions will likely affect many industries, it could be beneficial for certain assets as the demand to store and transport water may increase over time. This dynamic illustrates the critical need to understand how management teams identify, prepare, and adapt to climate-related risks and opportunities and their response to natech events. It also shows how unique these can be for a specific issuer or asset, which is why KBRA’s bespoke approach to credit analysis is so important.

In addition, when appropriate, KBRA seeks to understand the process through which an issuer determines its exposure. Though there are exceptions, KBRA believes this line of inquiry is increasingly relevant across most CFG issuer and issue types. In addition to the obvious importance of any insight into the potential timing and costs of mitigation efforts, KBRA also believes the process an issuer uses to analyze its exposure to climate change is credit-relevant because it provides insight into the robustness of its risk management practices.

KBRA considers transition risk to be material for midstream companies as there likely will be increased emissions regulation that may result in reduced demand for downstream products, which could have an immediate effect on the need for and profitability of midstream services. As the global economy shifts to cleaner energy sources to combat climate change, the demand for oil and gas pipelines is expected to fall. While this dynamic is likely to affect some crude oil pipelines, KBRA believes the demand for natural gas transportation networks will continue over the medium term. At present, natural gas accounts for 40% of all power generation in the U.S. Although this percentage is likely to decrease as renewable energy continues to expand in the country, it is unlikely that natural gas production will be eliminated over the short and medium term. Furthermore, the planned expansion of liquefied natural gas (LNG) export facilities will potentially result in additional demand for some pipeline systems.

KBRA favorably views companies that are actively invested in reducing their exposure to climate change risk and natural disasters. Those without capable management teams that are not planning for future ESG risks will likely face decreases in productivity, reductions in operations, increased capital costs, and in some severe cases, the complete loss of assets. While hurricanes often garner the most attention, landslides, floods, and lightning can cause the most damage for some pipeline systems and it is important for at-risk companies to have business continuity plans in place to combat this exposure.

Land Use and Natural Resource Allocation

Natural resource allocation and land use can be critical credit considerations in the rating analysis when the effective management of these factors is required to maintain sustainability and efficiency of business operations. KBRA recognizes that land use and its effect on a midstream company can vary depending on the resource being utilized, and the geographical footprint of assets. KBRA’s evaluation of land use and natural resource allocation includes the sustainability of finite resources, the extent of dependency on natural resources, vulnerability to resource price volatility, and the efficiency of resource exploitation. Land use evaluation may be important when a company is particularly dependent on a globally traded commodity, such as oil, especially if the retrieval of that commodity requires mining or other invasive processes that may affect the surrounding environment and potentially increase reputational risk for the company. Notably, corporates that rely on finite natural resources during their production process may experience declining revenue as the resource begins to deplete. This could be the case for some midstream companies, especially those operating in the storage and transportation sectors.

Environmental Pollution

Environmental pollution can be important credit considerations in the evaluation of midstream companies. Forms of pollution include nuclear plant leaks, oil spills, toxic waste, smog, and soot. Companies with pipeline systems that leak oil or other foreign substances into inland water bodies or land may have to pay fines or fees associated with remediation and civil penalties, and, will likely face some reputational risk. These companies will also likely experience revenue declines as the asset typically needs to be taken offline for corrective maintenance and preventive measures after a spill.

Air pollution is also a concern as many assets release GHG and other contaminants. New regulations that limit or provide financial penalties to assets that exceed a predetermined threshold could impact the financial performance of some midstream companies. KBRA believes that management teams that proactively plan for these events will likely have a competitive advantage over companies that are not actively planning for such cases. Companies that do not invest in innovative monitoring and mitigation technologies are vulnerable to regulatory changes that may reduce the value proposition of some of their assets.

KBRA believes that a responsible operator with a proven track record of managing midstream assets can reduce some of this risk exposure. An assessment of a company’s historical performance coupled with its maintenance strategy and community engagement can provide insight into the likelihood of declining financial performance due to pollution. While it is possible that effective management could mitigate some of these risks, others (e.g., regulatory changes) can be out of a company’s control. For example, midstream companies that deliver fuel to power plants may experience revenue shortfalls if new environmental regulations prompt some facilities to be retired.

Typical guiding questions to understand a midstream energy company’s environmental exposure may include:

  • Does the issuer have climate-related goals or targets in place? If yes, what are they? If no, why not?

  • How do they measure progress toward their stated goals?

  • What level of exposure does the issuer have to physical climate risks (hurricanes, floods, droughts, wildfires, etc.) that could potentially have a financial impact? What risks have they identified?

  • What level of exposure does the issuer have to transition risks that could potentially have a financial impact, including potential regional and federal regulatory changes? What risks have they identified?

  • What is the entity’s exposure to stranded asset risk?

  • What is the entity’s exposure to a potential international carbon tax, cap and trade program, or other regulated carbon pricing scheme?

  • Does the issuer calculate GHG emissions? If so, what were their annual Scope 1, 2, and/or 3 GHG emissions levels and how did they calculate them? If they did not calculate them, why not?

  • Does a third party verify their emissions reporting?

  • Are there any self-initiated or third-party required plans to reduce them?


Social Factors

In the midstream energy space, social issues are most likely to be incorporated in KBRA’s analysis of stakeholder preferences. KBRA believes it is important for issuers to demonstrate awareness of and disclose the ESG preferences of their key stakeholders, and how these preferences may impact the issuer’s operating, capital, and financial strategies. Labor management, employee health and safety, and community relations (among other potential stakeholder issues) can affect a company’s reputation—and therefore, its revenues.

Stakeholder views on a company’s board composition, executive compensation policies, supply chain management, tax strategy, or cybersecurity systems, have the potential to affect a company’s reputation and its ability to access capital, which is a key credit risk. An issuer that ignores relevant ESG factors deemed a priority by society, such as its contribution to climate change (which is especially relevant for midstream companies), could face backlash from its stakeholders, which can negatively affect creditworthiness.

For example, community opposition to oil and gas pipelines has been a common occurrence in recent years and can delay or even halt project development for some midstream companies. Surrounding communities have raised concerns about the negative ecological impact pipelines may have on water quality, wildlife, and the outer environment. In the event of significant community backlash, KBRA believes it is critical for corporate management teams to interact with the community and have clear plans in place to manage their concerns and mitigate any potential adverse risks. For many companies, effective communication and ongoing community engagement may be needed for long-term project success. Likewise, proactive labor management that prioritizes emergency preparedness and the health and safety of employees is important for midstream companies, given the heightened industry risk.

Typical guiding questions include:

  • Who are the issuer’s key stakeholders? What risks or opportunities do these stakeholders pose to their business?

  • Do the preferences of their key stakeholder groups pose risks to long-term operational and/or financial stability?

  • Has the entity been involved in any ESG-related controversies, litigation, misconduct, penalties, incidents, or cybersecurity attacks that may have implications on stakeholder/reputational risk?

  • What were the ramifications? What were the lessons learned?



Governance Factors

Governance issues have historically been important considerations in credit analysis as good governance practices are frequently drivers of financial stability and creditworthiness across sectors. For KBRA, a capable management team that can plan for and mitigate the unique challenges (ESG-related and otherwise) it faces is crucial for financial stability.

KBRA’s evaluation of governance includes a review of its management policies, potential regulatory changes, and cybersecurity plans. An issuer’s business model, ownership structure, and management profile, as well as its strategy and internal policies, are important factors KBRA typically considers in the ratings process. It is also increasingly important to understand how midstream energy companies prioritize ESG issues into its long-term operational and financial plan. KBRA may also look to a company’s risk management procedures, financial flexibility, and its accountability and transparency related to ESG issues. Poor governance can damage a company’s reputation, result in fines and lawsuits, and can increase regulation and debt repayment risk, which may be reflected in KBRA’s analysis.

Cybersecurity

Cyberattack risk continues to increase as most companies have become more reliant on technology. However, the impact of these attacks varies greatly across industries and some of the most at-risk companies are in the energy sector. A cyberattack focused on the manipulation of a pipeline network or gathering system could result in explosions and environmental damage, endangering civilian lives and potentially causing billions of dollars in damages.

KBRA believes that an effective management team should, at a minimum, have an effective security response plan that can quickly identify breaches to its internal networks. The ability for midstream companies to swiftly adapt to security lapses is critical, considering the impact that technological breaches could have on the operations and financial performance of a midstream company. Management teams that do not spend a substantial amount of time and resources on a comprehensive cybersecurity plan and infrastructure are exposing the company to significant risks. In some cases, these risks could have a severe, negative impact on operations. Without proper cybersecurity systems in place, KBRA believes these risks increase the probability of default, and in turn, will likely have a negative impact on creditworthiness.

While the analytical assessment of governance risks can vary depending on the nature of a company’s operations, typical topics may include:

  • When and how do ESG-related risks and opportunities influence the issuer’s strategy and/or financial planning?

  • Describe the issuer’s process for identifying, assessing, and responding to ESG-related risks and opportunities.

  • How does the organization report ESG-related information?

  • Describe how the business is preparing for anticipated social, technological, and other demographic changes associated with the shift toward a lower carbon economy.

  • Do these changes present potential risks or opportunities for them?

  • Does the entity have a cyber risk management program?

  • Do they assess their threats and vulnerabilities and determine acceptable risk thresholds?

  • Do they manage risk by prioritizing and structuring their information security program based on the cyber threats most relevant to them?


Conclusion

ESG factors are complex and dynamic, and some are likely to become more relevant to credit over time. As the world moves toward a lower-carbon economy, ESG issues will continue to evolve as shifts in public sentiment and regulatory action influence changes in supply and demand. As we develop and advance our understanding of these complex topics, KBRA aims to understand, identify, and disclose an issuer’s unique ESG risk exposure and its relevance to credit. We will continue to communicate these findings in our rating, surveillance, and research reports as we gather data on relevant ESG considerations for our rated universe .

Contacts

Shane Olaleye, CFA, Senior Director

+1 (646) 731-2432

shane.olaleye@kbra.com

Andrew Giudici, Senior Managing Director

+1 (646) 731-2372

andrew.giudici@kbra.com

William Cox, Senior Managing Director

+1 (646) 731-2472

william.cox@kbra.com

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