Left behind

Friday, 01 September 2017

James Dunn photo
James Dunn

    James Dunn examines stranded assets in the context of climate change and beyond and outlines the key factors directors should be considering.

    Assets become stranded all the time in dynamic economies, especially at the moment as technological advancements foster disruption in so many markets.

    Recently the term ‘stranded assets’ has become prominent in the climate change debate. Directors have a responsibility to examine the potential for their assets to be stranded as a result of environmental factors.

    But first, it’s important to understand the connotations of the term stranded asset.

    Although the expression has become a loaded term in the climate change debate, it has other meanings. For instance, a stranded asset is an economic expression that refers to investments not able to generate a return above the cost of capital. It also refers to assets whose economic life ends prematurely because of a technology, regulatory or market change.

    Additionally, the term stranded asset is commonly used in the resources industry to describe a mineral or hydrocarbon deposit too far away from supporting infrastructure to make it economically viable. It also refers to a mining deposit or a field that might not pass muster in terms of grade, metallurgy or due to the challenging technical aspects of mining or extraction.

    In the accounting context, a stranded asset is one that has suffered an unanticipated or premature write-down or devaluation, before being fully depreciated. The asset has a market value much less than its value on the balance sheet and can even become a liability.

    Turning to its meaning in the climate change debate, the concept of environmentally stranded assets is usually mentioned in the context of companies with fossil fuel deposits that risk the value of these assets being stripped as the world moves to using more renewable resources for energy such as wind and solar.

    Bret Harper, head of research at energy and emissions market analysis firm Reputex, says resources companies are continuing to invest in looking for more reserves. But they potentially run the risk of having those assets stranded if the markets for those products evaporate.

    Moreover, in October 2016 the Centre for Policy Development and the Future Business Council published a legal opinion by Noel Hutley SC and Sebastian Hartford Davis that concluded Australian company directors who fail to consider climate change risks could be found liable for breaching their duty of care and diligence.

    This effectively puts company directors in the resources and energy sectors on notice regarding stranded assets.

    The environment is central

    At the crux of the stranded asset issue is the Paris Agreement on climate change. Signatories, which include Australia, promise to take steps to keep average global temperatures from rising by any more than two degrees Celsius above pre-industrial era global temperatures.

    This effectively requires countries that are signatory to the agreement to transition to a lower carbon economy, which is likely to mean these countries will move to being less reliant on fossil fuel sources of energy such as coal. As a result, there’s likely to be less demand for fossil fuels.

    This is an issue for directors of businesses with fossil fuel assets to consider. Boards must ensure their assets are not stranded as the market for renewable energy sources grows and demand for fossil fuels decreases.

    High-cost, long-life thermal coal or liquefied natural gas (LNG) investments could be at risk. The businesses and sectors such as railways and ports that support those fossil fuel industries could also be in jeopardy.

    This poses many potential challenges for directors. As a first port of call, Citi senior analyst Elaine Prior points directors to the work being done by the Task Force on Climate-related Financial Disclosures (TCFD). It’s developing ways for companies to disclose climate change risks and its work should help boards understand what investors expect around this.

    Prior also urges companies to consider different scenarios to the two-degree global warming situation at the heart of the Paris Agreement. For instance, the International Energy Agency’s middle proposition, A New Policies Scenario, assumes higher global warming than two degrees and higher fossil fuel demand.

    “Companies should be looking into different scenarios alongside the two-degrees scenario, exploring how robust their projects and investment decisions are under different potential outcomes,” she says.

    Prior says when it comes to disclosure to investors, they want to understand how companies are making decisions on whether shareholder money is being spent wisely given the transition to a low-carbon world.

    “Investors would like to understand how boards are positioning their companies. It should be a normal part of doing business,” she says.

    Beyond climate change

    Stranded assets are not just a problem for resource, mining and energy businesses. As Sinclair Davidson, professor of economics at RMIT University, notes, assets become stranded in all sorts of industries.

    For instance, Davidson argues assets such as desalination plants may be examples of stranded assets. He says the term stranded asset is used in a very deliberate way in the fossil fuels debate.

    “Activists use stranded asset to mean ‘a development I would like to see stopped’. They’re trying to use the dry language of economics to sound more sophisticated, when they are simply saying that they do not want these developments to go ahead.

    “These groups use the term to warn investors such as insurance companies and super funds not to invest in coal, and they are trying to tell banks not to fund coal. They say, ‘gee, you may have a stranded asset’ – and then try to act in such a way as to make that asset not economically viable,” he says.

    If an asset becomes genuinely stranded, and the company can’t divest it, it is obliged to write the asset down in value, says Gavin Wendt, principal at independent resources analysis firm MineLife.

    “The non-government organisations and the environmental, social and governance analysts are telling Australian fossil-fuel companies that they have stranded assets, but I don’t think there are any that are genuinely stranded – unless you’re taking an ideological view.”

    Wendt says Australia is fundamentally an excellent resources jurisdiction. “If you find something, you can develop it, as long as it makes economic sense – with the exception of uranium, where government policy and changes of state governments can strand assets.”

    He says a number of the large energy providers have started to explore renewable investments. But they are unlikely to walk away from planned fossil fuel investments, in effect stranding them.

    “The only way it could happen would be if the federal government said ‘we’re not allowing you to develop any further resource projects in this country’, and that’s not going to happen.”

    Wendt says it’s unlikely activists will have widespread success stranding resources assets.

    “The term stranded assets certainly gets people’s attention. But I don’t think the companies take this seriously, or feel that they might need to reassess their asset inventory,” he says.

    Nevertheless, there are already bans in place on certain fossil fuel activities. For instance, the Victorian government introduced a bill in 2016 to permanently ban hydraulic fracking (a process to extract natural gas using water, sand and chemicals to break up rock) and coal seam gas (CSG) exploration.

    Tasmania banned fracking for five years in 2015, while New South Wales and the Northern Territory have moratoriums in place.

    Under pressure from environment groups in NSW, the state government has balked at approvals for CSG projects.

    “All of the shale or CSG in New South Wales is effectively stranded because the government refuses to let anyone drill a hole anywhere,” says Peter Strachan, independent analyst and publisher of StockAnalysis.com.au.

    “The activists have combined with farmers on whose land drills were proposed. You have groups like Lock the Gate [an anti-fracking alliance], and all of a sudden, you’ve got the appearance of a big corporate trying to trample the little person. When that happens, no one’s interested in the technical arguments. That situation can strand an asset,” he says.

    The Carmichael coal mine in the Galilee Basin of central Queensland is another potentially stranded asset. Private Indian company Adani proposes a $16.5 billion project built around it. The project will see the mine and an associated railway line built to transport coal to the Abbot Point port, and then to India, to supply power stations.

    The Queensland government granted the development preliminary approval in May 2014, followed five months later by federal government approval. But Adani has postponed its final investment decision due questions surrounding its funding.

    Adani’s project has borne concerted attack from activist groups and ESG analysts on the basis that its coal will exacerbate climate change and harm the iconic Great Barrier Reef – both directly through dredging near Abbot Point and indirectly through climate change. Ultimately, however, economics will determine whether it is a stranded asset, says Wendt.

    “There’s always been a broader question mark over the Carmichael project’s financial viability, simply in terms of what it costs to produce a tonne of coal from that operation, and get it to market. There is going to be a market for the coal in India. The problem is that it’s so far from the coast [that] the railway costs, the shipping costs are enormous,” Wendt says.

    The Carmichael project only makes economic sense in a strong thermal coal price environment, says Wendt. “That was the case when the project was being strongly pushed, back in 2011. You’d probably need a thermal coal price above US$100 a tonne to make Carmichael viable,” he says. At time of writing thermal coal was trading at around US$85 a tonne.

    However, Adani is a private company and therefore doesn’t necessarily have the same short-term profit considerations as public companies do, which means that the development may still make sense for the business.

    Nevertheless Wendt says the Carmichael project is probably is stranded at this point because Adani does not have financing complete.

    Not drowning, waving

    Jason Ireland, partner at McGrathNicol Advisory, says boards should be looking at assets at the level before they become stranded.

    Anything that is exposed to material technological change could be in this category.

    “Factories could be in this category. They could become much smaller as technology matures and automation becomes more prevalent. We may not need enormous manufacturing assets. That doesn’t make factories obsolete, but it changes their value,” he advises.

    Ireland notes asset values are under extreme pressure the world-over as a result of technological disruption, and directors must be across this.

    “In the current environment, boards should be focused on sustainability and risk exposure around assets. Directors also have a responsibility to look at the value of assets on their balance sheet on a regular basis. They should have a policy for considering whether an asset is stranded,” he advises.

    This involves sophisticated financial modelling skills that calculate asset values under certain scenarios. “Directors need accurate forecasts and to be running what-if scenarios all the time; that’s just good risk management and forward planning,” Ireland notes.

    He says this is a hugely important governance challenge. “Financial modelling of asset values must be paramount if you’re in an industry that’s under technological pressure. You also need to keep a watch on listing rules to ensure you stay inside disclosure requirements if an asset has to be substantially written-down.”

    Advice for boards

    Aside from business-as-usual asset assessments, every board must conduct strategic asset reviews on a periodic basis to ensure they are optimising the return and benefit of their investments to the organisation. This process should identify assets whose revenue may be compromised in the future.

    According to Nicholas Guest, partner assurance and corporate advisory with accountants and financial advisers HLB Mann Judd, it may suit a business to divest assets that are not core to the company before they are at risk of being stranded.

    “Divestment may be appropriate if the asset is not aligned with the current strategic focus of the organisation. This may be due to the asset’s underperformance, location or drain on management time and resource,” he says.

    Guest says there are a number of divestment options directors can consider. One path is the public auction or sale of an asset.

    “This would require early disclosure to the market and the associated speculation [around the reason for the sale] but could result in cash proceeds in a timely manner,” he says.

    A carve out is another option. This would create a separate legal entity for the asset that is self-supporting, with a view to selling it as a going concern, or separately listing it on the stock market to generate cash for the business.

    A spin-off is a third option, says Guest. “This would create a separate legal entity that is self-supporting. Shares in the new entity can be distributed to the existing shareholders, with no inflow of new cash.”

    Finally, directors may choose to wind up and liquidate an asset. This may be the right choice if a business unit is not profitable. “In this circumstance it may be appropriate to explore a liquidation and realisation of individual assets,” he says.

    According to Guest, under any of these circumstances, the board should ensure full and considered communication of the transaction to the internal and external stakeholders to minimise negative interpretations. This will also allow the business to capitalise on the positive outcomes of a divestment to the wider organisation.

    “This may not be just the monetary proceeds received but allowing the board and management to focus on the core strategies of the organisation,” he says.

    While stranded asset may be a term purloined by interested parties for their own purposes, all directors must regularly review their asset base and assess risks to their investments on an ongoing basis.

    This will help reduce the risk the business is holding – and being distracted by – non-performing assets and allow the board to focus on the investments that help the company grow.

    The Divestment Path

    Divesting a potentially stranded asset is an option for many businesses.

    Nicholas Guest, partner assurance and corporate advisory with HLB Mann Judd, says a detailed feasibility review and cost/ benefit analysis is required prior to committing to any divestment. Guest advises directors to make the following important considerations:

    1. Will the overall enterprise be conserved, created or destroyed by any divestment?
    2. Is the asset saleable? If so at what price?
    3. What will be the net financial benefit to the organisation post divestment?
    4. Are there unrecorded liabilities or obligations that may be crystallised by a divestment?
    5. What resources are needed to prepare and maximise a return on the asset?
    6. Will the disposal impact on internal synergies and the way the organisation delivers its products and services?
    7. How will external stakeholders view the divestment? Could there be negative perceptions?

    Latest news

    This is of of your complimentary pieces of content

    This is exclusive content.

    You have reached your limit for guest contents. The content you are trying to access is exclusive for AICD members. Please become a member for unlimited access.