Nicer for the Nordics

25 July 2016



Nicer for the Nordics


Nicer for the Nordics

Moody’s vice-president, Scott Phillips, writes about the environmental strategies of leading European paper companies. The article comes from a broader report on the overall European paper market, which cites Nordic companies as having better access to certified virgin fibre than their peers as a result of their geographical position. These companies are also less dependent on the grid for electricity and have lower carbon emissions; however, there are areas where their peers perform better.

The rated global paper industry encompasses 60 companies, representing approximately $75 billion of rated debt. Previously, we have stated that the paper and forest products sector faces emerging, moderate environmental risks, but over a five-year time horizon, or maybe even longer than that. At the same time, we also acknowledged that while these risks could negatively affect credit ratings, there is sufficient time for companies to adapt.

 

The activities of the paper industry involve elements of environmental risk. Logging activities can contribute to increased carbon levels because trees act as carbon sinks, manufacturing processes typically consume large quantities of energy and water, and many of the chemicals cannot be recycled and must be sent to landfill sites, which potentially contributes to soil and water pollution. Although many companies have taken steps to mitigate their environmental footprint, there is still a large variance in performance.

 

Where these environmental risks are material, and are key drivers of credit ratings, we score companies in the sub-factors described in our ‘Global Paper and Forest Products Industry’ methodology and discuss their exposure in research. Many environmental risks are relatively longer-term in nature, which makes it harder to assess the possible financial impact. In such instances, these risks are unlikely to be material drivers of credit rating outcomes.

 

We consider six forest product companies: Metsa, UPM, Stora Enso, Sappi, Mondi and SKG against a number of KPIs designed specifically for this research. The KPIs were designed by considering the targets set by companies when monitoring their own environmental performance; and the sustainability disclosure identified by the Sustainability Accounting Standards Board (SASB) for the Pulp & Paper Products industry (published in July 2015). While we include Metsa as unrated in our analysis, we do rate a subsidiary of the larger group – Metsa Board Corporation.

 

 

Fibre and location strategy

As the graph shows, among the six analysed forest product companies, we believe that, overall, the Nordic companies – UPM, Stora Enso and Metsa – are better placed to weather the negative effects of long-term environmental risks than other companies in this peer group and score best against our KPIs.

 

This strong position of the three Nordic companies reflects two key, but related, factors: their location and their fibre-sourcing strategy. The Nordic companies have ready access to large amounts of virgin fibre, which is more likely to be certified by independent forest management programmes. Location also means the Nordic companies have a higher propensity to generate energy using biomass, which decreases their dependency on external electricity purchases and reduces their carbon emissions because the use of biomass is generally classed as “carbon neutral”, and means they score well on these KPIs.

 

However, the energy intensity of these three companies does vary, which reflects their product mix and means there is some differentiation in relative risk. Overall, Metsa is a little better positioned than UPM and Stora Enso, as reflected in its KPIs.

 

Smurfit Kappa Group (SKG) appears the weakest on some KPIs but the strongest on others, which reflects the same fundamental driver: a reliance on recycled materials for fibre. While recycled materials require less energy to produce their products, it also means lower amounts of biomass residues are available to generate energy and abate carbon emissions. As a result, SKG scores well on energy intensity, but weakly on energy self-sufficiency, carbon intensity and waste-to-landfill. We do recognise, however, that a high use of recycled materials potentially reduces other types of risk for SKG compared with the other peer companies, for example, reputational risks associated with large-scale tree-felling, although we have not captured this specifically in our analysis.

 

While Mondi and Sappi score relatively poorly against our KPIs, this does not capture the positive financial impact from the companies’ strategy. For both companies, a large presence in South Africa is positive for profitability, but higher use of coal for energy generation means carbon emissions are higher than peers.

 

 Volatile energy costs are a credit risk

The forest products industry is considered to be “energy intensive” because it consumes significant amounts of electricity and heat during manufacturing, and accounts for around 10% of companies’ operating costs. Therefore, fluctuations in the price of energy can adversely affect the financial performance of more exposed companies. The paper industry accounts for around 15% of all industrial electricity consumption in the EU.

 

While energy is used throughout the paper, pulp and packaging production process, several applications are particularly intensive: mechanical virgin wood pulping consumes large quantities of electricity (owing to the use of electric motors), whereas chemical/kraft pulping and the drying of paper consume heat.

 

In response to the challenge of volatile energy costs, companies continue to invest to reduce net energy consumption. These investments are typically in electricity production through combined heat and power (CHP) assets, but also include energy efficiency measures and even financial investments in utility companies.

 

We believe there are two main considerations with respect to energy costs. Companies that either have a higher level of energy self-sufficiency or lower energy intensity (consumed energy per ton of saleable product) will be less exposed to volatile input costs and will exhibit more stable earnings and cash flow over time.

 

In our methodology for the paper and forest products industry, we capture self-sufficiency directly. Rated companies that score high on this sub-factor will generally cover all of their own energy needs and will sell surplus volumes to third parties. In contrast, rated companies that score poorly will be more dependent on energy purchases.

 

According to our research, Metsa meets the highest proportion of its energy requirements from internal sources, but has no score assigned to it because we don’t rate this company. Of the rated issuers, UPM has the highest proportion of its energy requirements met from internal sources, reflecting its investments in CHP as well as its 44% stake in Finnish utility group

PVO. In conjunction with its high fuel source diversity (nuclear, hydro, biomass, coal and gas), this justifies its higher A-scoring in the methodology.

 

SKG’s self-sufficiency, at around 40%, is the lowest among its peers, scoring it a B in the industry methodology. We believe this low score reflects SKG’s strategy to maximise the contribution of recycled materials in its fibre sourcing compared with virgin wood. SKG’s use of virgin wood is lower than the other companies. As a consequence of this strategy, SKG will produce fewer biomass residues (bark chippings and black liquor), which can be combusted for energy generation and means a higher dependence on external purchases.

 

The positive flipside of greater use of recycled materials is that the electricity intensity of SKG is lower than its peers, which is why the company is ranked the highest on this KPI. This reduces its energy consumption because it decreases the need for chemical or mechanical pulping. In contrast, the electricity intensity of UPM is higher, which reflects its bias towards high-quality printing paper, a very energy-intensive product.

 

Waste disposal performance

The manufacturing of paper, pulp and packaging has the potential to generate large quantities of waste, some of which is hazardous and cannot be readily reused or recycled. Typical products include green liquor and other chemical sludges, which have few alternative uses and, in many cases, must be sent to landfill. For some companies, however, the use of landfill may reflect local infrastructure constraints, and is particularly the case in less developed countries.

 

While the environmental consequences of landfilling include soil and water pollution, there are also negative financial consequences for more exposed companies. Indeed, in many countries within the EU there exists a landfill tax that is levied on companies when depositing waste. As the attached graph shows, we believe that SKG and Sappi are the more exposed companies to any increase in landfill taxation with relatively more of their waste being sent to landfill when compared with peers. In contrast, the three Nordic companies perform strongly on this KPI, realising very high recycling rates.

 

Moody's full report, ‘Paper: Europe Nordic Players Are Well Positioned to Weather Long-term Environmental Risks’, is available on www.moodys.com.



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