Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
- The pool of debt capital available to fund the coal sector is shrinking, driving up debt costs.
- Financial markets are moving independently and often ahead of business and policy makers, bringing fresh considerations to credit ratings.
- Any permanent cost increases will heighten rating transition risk even despite expected strong medium term demand for Australian coal.
Impact Of Australia's Coal Sector Decline
Coal is an increasingly dirty word in much of the world today and those in the industry must dig deeper to find funding for it.
Australia is the second largest coal exporter so the sector's decline will have credit implications across the value chain, in our view. Australia is also one of the world's biggest emitters on a per capita basis, according to the United Nations (UN). The UN recently called for Organization for Economic and Development countries, which includes Australia, to phase out coal by 2030.
Sources of funding will continue to change. The pool of capital available to fund the coal sector is shrinking, which is increasing the cost of that capital.
S&P Global Ratings believes these market forces will increase liquidity and refinancing risks for companies as debts mature. They could also pressure ratings if the cost of debt continues to rise and issuers do not respond by reducing leverage.
We also believe rising capital costs will cause asset owners along the coal chain to reduce investment in upgrading or enhancing physical assets to extend their operating life.
Timeframes Are Shortening
A primary issue for businesses that rely on coal is funding. Who will continue to fund them and on what terms and at what pricing?
Financial markets are working toward their own agendas and timelines. These timelines are contracting and companies, governments and policymakers know it. What were once 10-year time horizon considerations for investors are now more like five years. Adding to the pressure are the ongoing trade tensions between Australia and China.
Another risk for some entities is the potential for "financial stranding," whereby the pool of capital becomes shallower as investors exit the sector.
To Invest Or Not To Invest
Some financial organizations now exclude coal-related investment. But the question of funding is not black and white.
Many investors have a timeline for when they will exit coal-related assets. Some are shunning the relatively more polluting thermal coal used for energy but maintaining an interest in metallurgical or coking coal, a key ingredient in steelmaking. Others still have policies allowing them to invest in companies with plans to support them through the transition.
The burgeoning market for "transition bonds" is one way investors are responding to energy transition. This approach is understandable, given strong near-term cash generation. And established infrastructure should help fund the shift to more environmentally friendly activities over the medium to long term.
It also remains unclear to what extent private capital will step in to support the sector, and at what cost. Private debt capital will be attracted by the increasing returns and is less exposed to public scrutiny than public capital market and bank lenders. Even still, lower aggregate demand for these coal-related assets will mean that elevated debt costs are likely to persist.
Credit conditions are tightening. Over the past 12 months, spreads on bond issues for coal-related businesses have moved out by 50-100 basis points depending on the type of asset. Various market developments reflect both the decline in the investor demand for the sector and the requirements for a risk premium to invest. For example:
- For Australian assets on the debt side, Asian and U.S. markets are stronger sources of funding because of lower demand locally and from Europe. Environmental, social and governance (ESG) considerations are featuring in more and more investor mandates. So the question is how long Asian and U.S. markets will retain their current appetite for coal exposure.
- The big four Australian banks and most European banks now rule out investing in new coal assets and aim to exit the sector over planned timeframes. Some Asian banks are following suit.
- For the Australian coal export terminals accessing debt capital markets, the U.S. remains the primary source of capital markets funding as other debt capital markets shun coal assets. This increases the cost of debt and heightens refinancing risk.
- The Northern Australia Infrastructure Facility (NAIF) recently approved a A$175 million loan to Pembroke Resources for its new coking coal mine, Olive Downs, in central Queensland. The NAIF, which is funded by the Australian government, offers concessional funding terms and seeks to fill gaps where the private sector won't fully fund transactions. This transaction would suggest the project had difficulty securing private sector finance at attractive rates.
- Coal export terminals such as Dalrymple Bay (Dalrymple Bay Finance Pty Ltd. BBB/Stable/--), in Queensland, and the Newcastle Coal Infrastructure Group Pty Ltd (BBB/Stable/--), in New South Wales, have been accessing U.S. capital markets over the past 12 months, raising medium to long term debt at rates of between 4.5% – 5.0%. In contrast, North Queensland Export Terminal Pty Ltd (BB-/Negative/--) was unable to raise debt in the bank or capital markets and so relied on shareholders' funding to repay recent maturities.
- The recent recapitalization of Coronado Global Resources Inc. (B-/Stable/--) involved an equity raising to reduce debt and included a US$350 million tranche of senior secured five-year notes priced at 10.75% and a US$100 million asset-based loan facility.
- UniSuper recently sold equity positions in New Hope and Whitehaven Coal and IFM Investors plans to exit thermal coal-reliant assets by 2030.
Stranded Assets And Pricing Pain
The coal sector increasingly faces the problem of stranded assets. Market economics are forcing the early closure of deteriorating, inefficient or unprofitable power plants and mines.
In general, significant new capital is unlikely to go toward upgrading or enhancing older physical assets to extend their operating capability.
The most prominent example is the case of coal-fired power stations. Over the past few years, most have become unprofitable as an influx of renewable energy generation lowers the price of electricity.
Similarly, older high-cost coal mines are vulnerable to pricing cycles. They may be profitable during periods of high coal prices but suffer when prices fall. This vulnerability may make companies reluctant to continue to operate such assets or to contribute funding. On the other hand, those that stand to benefit are operators with efficient cost bases and "cleaner" coal.
Forced To Clean Up Their Act
- AGL Energy Ltd.'s coal-fired Liddell power station in NSW's Hunter Valley will close in 2023 to be replaced by a renewable solar-hydro energy power plant.
- The scheduled closure of Energy Australia's 1,480-megawatt brown coal power station at Yallourn, east of Melbourne, has been brought forward to mid-2028.
- Whitehaven Coal's extension to its Vickery mine in northeastern NSW is facing approval uncertainty.
- A proposed underground coal mine of Hume Coal (a wholly owned subsidiary of Korea-based POSCO, BBB+/Positive/--) has been rejected by the NSW Independent Planning Commission.
Costs Add To Ratings Risk
Any new material and permanent cost increases will heighten rating transition risk for the sector. Both local and global signs are emerging of various extraneous costs. All the larger local insurers have enacted climate change policies. The conditions and timelines of these policies vary but in most instances they have exclusions in relation to underwriting and investing in coal.
A prominent public example is the Adani Carmichael coal mine in central Queensland, which local insurers are declining to insure. In response, the coal industry is investigating opportunities for self-insurance.
The Australian coal supply chain also faces growing costs at an international level. The European Union is set to introduce the world's first carbon border tax. As proposed, the EU Carbon Border Adjustment Mechanism will be rolled out in 2023 at the earliest before becoming fully operational in 2026. Such a mechanism, if replicated elsewhere, could impose costs on Australian coal exports in the absence of any carbon pricing mechanism on coal here.
Companies Look To Diversification To Ease The Strain
Increasingly companies are examining ways to either diversify away from coal or to manage the impact of energy transition. This is taking many forms, including mergers and acquisitions, demergers, and new business lines.
In many cases, a company's ESG considerations govern decisions on diversification. Nevertheless, it is difficult to separate those decisions from the influence of investor preferences and capital flows.
Looking At Other Options
The rapidly evolving landscape is forcing numerous businesses to reduce their coal dependency by diversifying into other areas.
- BHP Group Ltd. (A/Watch Neg/A-1) has begun to exit coal-mining activities.
- South32 Ltd (BBB+/Stable/A-2) divested its interest in South Africa Energy Coal and decided not to proceed with the Eagle Downs project.
- Aurizon Holdings Ltd. diversified into nonvolume-linked bulk service contracts, including leasing of rolling stock and crew, and recently expanded into non-container port services;
- The Port of Newcastle (Port of Newcastle Investments (Financing) Pty Ltd BBB-/Stable/--), the world's largest coal export port, has for several years been examining options for a container terminal within the port and is looking at developing other bulk trade over the next decade.
- Dalrymple Bay Coal Terminal is reportedly interested in how it might facilitate the transport of hydrogen.
- AGL is pursuing a demerger into two entities: one will contain energy generation assets; the other will contain its more environmentally friendly retail business activities.
How These Issues Affect Our Ratings
Our rating analysis considers present and emerging credit implications in several key areas:
Cost of debt. Interest margins for coal-related assets and business have risen over the past one to two years. In assessing future credit metrics we reference current and expected margins to understand and incorporate the impact of higher costs of debt in our analysis. This includes instances for coal export terminals where the current full cost of debt may exceed the cost that can be passed through to the terminal's customers.
Refinancing. Liquidity risk is a primary concern for corporates with concentrated debt maturity profiles and project financings with bullet maturities. The risks of replacing debt include the cost and degree of market appetite. And time is increasingly a factor because some debt issuances are taking longer to implement. For corporate credits we consider, among other things, an issuer's track record and relationship with banks—especially in the case of liquidity risk. We also consider to what extent new ESG related bank policies may affect future bank support. For project financings, we typically expect to see bullet maturities refinanced nine to 12 months ahead of maturity for investment-grade credits.
Leverage. To manage end-market volatility and refinancing risks, companies are reassessing what is appropriate for a through-the-cycle capital structure. Accordingly, we look to assess a company's current and future capital management plans as they adapt to their evolving operating environment.
Asset values. Written-down asset values decrease balance sheet ratios, particularly debt-to-asset ratios, which may affect adherence to debt covenants. Balance sheet covenants are generally less prevalent than cash flow/leverage covenants for our rated issuers, but we continually assess current and likely future compliance with all covenants.
Operating costs. We include in our forecast increased direct costs, where known, such as rising insurance premiums. We will also consider the impact of any material future cost changes in the industry. Carbon taxes or government subsidies, for instance, may increase the cost position of our rated issuers relative to more environmentally friendly technologies.
Rehabilitation/remediation costs. We consider various costs involved with the closure or retirement of assets at the end of their useful life or, as in increasingly the case, voluntary earlier closure. These costs can be meaningful and difficult to quantify (and hence easy to underestimate).
Business risk and competitive position. We closely consider a company's future strategy and recognize the need for corporate strategy to pivot and invest to address the long-term viability of its business model.
ESG factors are increasingly important for investors. The pace of change is faster than ever. This means challenges for business and less time to deal with them. Consequently, rating transition risk is heightened because the rate of change may defy our expectations.
Australia's highly profitable coal export sector is unlikely to dissolve overnight. However, failure to attract new capital amid rising ESG concerns will likely end the relative ease of doing business within the Australian coal sector.
As 2030 approaches, the industry will face growing scrutiny and the impact of capital market behaviour is likely to add to the uncertainty.
- Energy Transition in Asia-Pacific: A Marathon, Not A Sprint, April 19, 2021
This report does not constitute a rating action.
S&P Global Ratings Australia Pty Ltd holds Australian financial services license number 337565 under the Corporations Act 2001. S&P Global Ratings' credit ratings and related research are not intended for and must not be distributed to any person in Australia other than a wholesale client (as defined in Chapter 7 of the Corporations Act).
Article by Richard Timbs, S&P Global Ratings