Join our community of smart investors

Cleaning up

Environmental regulations are tightening, but what opportunities does this present for investors?
Cleaning up

The search for sustainable investments often comes down to renewable energy sources and the storage systems that make them commercially viable. Companies such as Ceres Power (CWR) have certainly attracted support in the market on this basis, while established entities such as SSE (SSE), formerly Scottish and Southern Energy, have rejigged their business models to take account of the prevailing zeitgeist.

You might also consider stocks whose activities reduce our impact on the planet by offering green alternatives within entrenched industries; Tesla (US:TSLA) and Beyond Meat Inc (US:BYND) readily spring to mind, although you would probably be underwhelmed by the share price performance of the latter disrupter since it joined Nasdaq in May 2019.

And those averse to stockpicking can support sustainable initiatives through a range of ‘green’ index trackers, exchange-traded funds (ETFs), bonds, or even environmentally focused investment trusts such as Greencoat UK Wind (UKW).

The point is that if you support the proposition that companies that create value for all stakeholders are more likely to succeed in the long term and deliver stronger financial returns, you now have a range of established alternatives from an environmental perspective.

On top of this, however, it may make sense to broaden your capital allocation to take account of industries that are both part of the problem and part of the solution.  

Many of the companies mentioned above have had no trouble in attracting investor interest because the sectors in which they operate generate extensive newsflow as they're considered home to leading-edge, sustainable technologies.

But there are some rather more prosaic areas of the economy that are evolving in the face of tightening environmental strictures and the dash towards net-zero. The packaging industry is one case in point. But perhaps the most under-recognised area of the economy, or at least one with an outsized impact on the environment, is the waste management industry.

 

Waste management – poacher turned gamekeeper?

It may not have the same caché as electric motoring, but the sector is having to clean up its act in accordance with emissions target levels agreed in the Paris Climate Agreement. Regulators are now implementing an enhanced, supranational framework incorporating waste management and the idea of achieving a truly circular economy – in which waste is reduced and products are reused or have their lifespans extended.

While it's certainly true that changes to the way in which we package and transport consumer goods might have a bearing on the overall volumes of waste, it’s what we do with it afterwards that could underpin an expansionary phase for the industry.

There are many themes at play here. The proliferation of organic packaging is set against rising levels of consumption that are creating yet more waste in emerging economies. And while more companies are now taking account of a product’s end of life in the early stages of the design process, waste management facilities still often rely on quick, inefficient and outdated technologies. This particular circle is clearly difficult to square.

Humanity as a species has been both literally and figuratively burying this problem for decades. But where a problem exists, so, too, does an opportunity. Forecast growth rates bear this out: according to Grand View Research, the value of the global waste management market reached $989bn (£790bn) last year, and is expected to expand at a compound annual growth rate of 6.2 per cent from 2022 to 2030. And, if anything, the long-term structural drivers of the industry are gathering steam – although there will inevitably be a certain amount of industry disruption (and market volatility) along the way.

 

A foul legacy built over decades

It’s disturbing to consider what archaeologists might think of our civilisation in, say, 400 years from now (assuming we’re still around). Anyone conducting a dig at a former 21st century landfill site would unearth a wealth of colourful microplastics, albeit degraded to varying degrees. Eventually, this may turn out to be the most common vestige of what some scientists refer to as the Anthropocene, a geological epoch dating from the commencement of significant human impact on global ecosystems.

The remnants of single-use plastic products would predominate within the find, as their use has increased exponentially since 1945, a consequence of the subsequent proliferation of throwaway consumer goods.

 

Global Circular Options
 TIDMPrice (p unless stated)PCHG 1-yr (%)PCHG 5-yr (%)Ebitda CAGR - 5yr (%)PEDYPEGEV/EbitdaP/SalesMarket-cap (£mn)
BiffaBIFF338.625.978.9-5.1na0.77.210.20.81,036
FerrovialES:FER€24.393.444.0-8.715.12.4na38.32.615,308
GFL Environmental CA:GFLC$37.01-7.8na53.1na0.21.515.42.49,756
RenewiRWI67035.4-31.622.021.5na0.84.50.3536
Republic ServicesUS:RSG$130.3319.21069.532.31.42.812.13.733,254
Severn TrentSVT3,09826.030.60.528.63.32.816.44.07,754
SSESSE1,86527.731.0-7.220.64.43.813.72.619,912
Veolia FR:VIE€27.198.551.65.440.03.70.77.20.616,236
Waste ConnectionsCA:WCNC$163.518.293.312.953.10.72.620.95.533,975
Waste ManagementUS:WM$158.6412.01166.135.01.62.515.23.653,228
Source: FactSet          

 

It’s a far cry from Sutton Hoo, and it’s sobering to consider that every piece of plastic ever produced still exists in one form or another. But it’s not just about polymers; it has been estimated that glass bottles can take up to one million years to break down completely, while electronics waste linked to the digital economy is responsible for the lion’s share of toxic chemicals such as lead, cadmium and mercury that end up in landfill sites (and the water table). Very often, this is at the expense of populations in emerging and frontier economies, where around 80 per cent of waste is still disposed in open air dumps and landfill sites, resulting in hazardous levels of pollution within air, soil and groundwater.

The disposable age in which we live has forced a rethink, not only in the way that we impact the natural world, but also on its impact on human health. Consequently, China, India and other major Asian economies have started to clamp down on waste import volumes to protect their own ecosystems. Since the implementation of China’s ‘National Sword’ policy in 2018, which banned the importation of several categories of solid waste, other countries including Thailand, Malaysia and Vietnam have followed suit. You could say this provides another example of truncating supply chains, but the reality is that waste management is no longer a responsibility that advanced western economies can blithely dump in somebody else’s lap.

 

The unfortunate link between effluence and affluence

While the developed economies produce the most waste, this is truly a global issue. A strong correlation has been demonstrated between waste volumes and changes in gross domestic product. The World Bank predicts that lower middle-income countries are likely to experience the greatest growth in waste production, most notably those located in Sub-Saharan Africa and South Asia.

It could be argued, however, that increases in regulatory oversight and environmental awareness are generating new commercial opportunities. The waste management industry is being forced to innovate, not only in response to policy initiatives such as the European Union (EU) Packaging and Packaging Waste Directive, but also because the by-products of waste management are becoming a more valuable proposition.

By some estimates, the energy derived from high-temperature incineration generates a net CO2 emissions reduction compared with power generation through fossil fuels. This is because about half of the non-recyclable waste we generate is produced by living organisms. Proponents of energy-from-waste (EfW) technologies argue that it is, in effect, a low-carbon substitute, limiting the build-up of methane from landfill sources. This is significant in that methane is a far more damaging greenhouse gas than CO2, perhaps 25 times as potent at trapping heat in the atmosphere.

Beyond energy generation, other by-products from this process are also now being used within the construction industry and roadbuilding. The Ellen MacArthur Foundation, an international charity that promotes the circular economy, estimates that the circular economy could produce net savings of $340bn-$630bn in raw material procurement in Europe – admittedly a rather wide spread, but an estimate that nonetheless underlines the commercial opportunities on offer.

 

Waste energy versus landfill

Predictably, however, EfW remains contentious from the urban development perspective – not many homeowners would want to live in sight of an EfW facility. Some industry analysts maintain that technological improvements have rendered previous objections to high-temperature incineration redundant, although debate still rages over the true level of dioxin emissions.

Additionally, there is a clear trend towards the development of smaller-scale plants in the UK, as municipal bodies seek added benefits linked to costs and emissions. It’s well established that this type of ‘localism’ is an important factor to consider in the dash towards net-zero – unfortunately, governmental support is far from assured.

It’s also worth noting that the plastic component of waste volumes – a product of the petrochemical industry – is ideally suited to high-temperature incineration due to its high calorific content. The UK is building waste-fuelled power generation capacity, but for the moment it still relies on available spare capacity in Europe.

 

Three circular options
 PPrice change 1-yr (%)Price change 5-yr (%)Ebitda CAGR - 5yr (%)PEDYPEGEV/EbitdaP/SalesMarket-cap (£mn)
BIFFA338.625.978.9-5.1na0.657.210.20.81,036
RENEWI67035.4-31.622.021.5na0.84.50.3536
VEOLIA 27.198.551.65.4403.680.77.20.616,236
Source: FactSet

 

Nevertheless, it’s easy to appreciate why domestic energy generation is an increasingly attractive option for the waste management industry. For a start, the UK has committed to cut the share of landfill volumes to 10 per cent of all municipal waste generated by 2035. And aside from the fact that the UK is fast running out of landfill options, operators of recycling plants are also being saddled with increased disposal costs for their residual waste. Incineration taxes in Sweden, Germany and the Netherlands, which currently offer spare capacity, are also on the rise, so the commercial imperative for domestic generation is growing.

It might be a stretch to describe EfW as being a mainstay of the circular economy, but even if its net impact on climate change remains open to debate, the energy transition could present new commercial opportunities. In 2020, the technology accounted for 2.5 per cent of total net UK power generation, but this is predicted to reach 7-8 per cent by 2030. It means that continued private sector funding will be required to narrow the residual waste treatment capacity gap, potentially providing investment opportunities along the way.

Some opposed to EfW believe that the EU’s primary focus on reuse and recycling means that the fuel source should be next on the chopping block, at least once coal-fired power is phased out. However, recent experience in energy markets suggests that national governments might be reluctant to ditch a reliable source of power generation, particularly as its net environmental impact is far from clear – negative or otherwise. It’s a headache for government policymakers, particularly as it may fall under the sub-category of ‘least-worst option’.

It’s significant that incineration of solid waste in the EU more than doubled between 1995 and 2017, and a recent study conducted by research organisations Prognos and CE Delft posits that the successful achievement of recycling and landfill targets in EU member states (and the UK) by 2035 will play a significant role in fulfilling objectives set out within the Paris Climate Agreement. Clearly, many environmental lobby groups would take issue with that conclusion.

It’s worth remembering, however, that EU mandarins recently pushed to get natural gas reclassified as a renewable source of energy, despite internal disagreement over whether the fuel source genuinely qualifies as a sustainable option. It would not be too surprising, therefore, if they supported another compromise along the road towards net zero. It may even be unavoidable given an implicit trade-off between EfW expansion and the prospect of more landfill. All of which begs the question of which listed companies stand to benefit.

 

Biffa: Tapping into demand for “refuse derived fuel”

Even if inward investment is stymied due to the global economic slowdown, the refinement of EfW technologies should ensure that growth in this corner of the market outstrips that of the wider waste management industry. If so, it should enhance the investment case for Biffa (BIFF), one of the UK’s largest producers of what it terms “refuse derived fuel”. Group management believes that the development of residual waste treatment capacity “goes hand in hand with recycling”, implying that investors are not being presented with a binary 'either/or' proposition.

Biffa is one of the larger UK public companies operating in the sector, and the scale of the business increased in August 2021 when it paid £126mn to complete a deal to acquire the collections business and certain recycling assets from Viridor Waste Management. The purchase meant that net debt increased to a level equivalent to 139 per cent of shareholder funds, although cash flows were constricted due to recurrent disruption brought about by the pandemic.

This was felt particularly acutely in the industrial and commercial division as shuttered businesses significantly reduced demand. The group was also forced to take a £25mn write-off associated with the purchase of surplus food redistributor Company Shop Group, although subsequent trading gives cause for encouragement. Ahead of the release of its full-year figures on 16 June, Biffa confirmed that trading in the second half of the year had continued to plan, with revenues through to February 35 per cent up on FY2021, and 20 per cent ahead of FY2020, helped along by acquisitions.

Analysts and investors, however, will be looking closely at the degree to which rising cost pressures have constrained margins. But if you’re looking to gain further exposure to EfW (or the sector in general) the shares aren’t prohibitively priced based on a 17 per cent discount to the FactSet broker consensus estimate, although other metrics, most notably its price/earnings growth (PEG) ratio, suggest otherwise.

 

Renewi: Primed to benefit from decarbonising supply chains

Later this month, another homegrown alternative, Benelux-focused Renewi (RWI), is also due to lodge its own results for its March year-end. That is no doubt a keenly anticipated staging post given the waste-to-products specialist enjoyed a relatively successful pandemic, as prices for a range of recycled industrial inputs increased markedly.

Renewi is engaged in the decontamination and reuse of materials, including soil, sludge, water, bottom and fly ash, and packed chemical waste, while producing secondary raw materials for the construction industry. The business model ties in nicely with the push towards the circular economy, not least because companies are increasingly looking to utilise recycled materials to decarbonise supply chains.

However, like Biffa, Renewi has taken on uncomfortable levels of debt as capital is given over to building capacity to exploit increasing recycling demand, particularly given its sizeable presence in Belgium and the Netherlands – two countries with some of the highest recycling rates in Europe. Sales growth relies to a large extent on the continuing implementation of tighter environmental regulation, and there is certainly further scope to improve plastic recycling volumes across the continent.

As a quasi-utility, the business also benefits from decent visibility on revenues due to the long-dated nature of its contractual arrangements. And although there is no universal standard, a PEG ratio of 0.8 in a nominally lower-growth sub-sector helps to explain why the market value has increased by a third over the past 12 months. Taking account of net debt, the enterprise/cash profit multiple is well down on its historical average, so it is difficult to say whether the current share price represents a viable entry point.

 

Veolia - Scale matters in the circular economy

Short of investing in an environmentally focused mutual fund, one of the better lower-risk options to capture the growth of the circular economy is by gaining exposure to France’s Veolia Environnement SA (FR:VIE). To the typical UK resident, the company is best-known as the operator of refuse collections for a range of local authorities. Yet it is a multinational heavyweight with prominent global positions in water management, waste management and energy services – the holy trinity from an environmental perspective.

By most measures, Veolia would certainly be on the radar for value investors, but doubly so since it completed a somewhat acrimonious €12.9bn (£10.9bn) acquisition of Suez, a long-time rival in the domestic water market, to create what is being touted as 'the French world champion of ecological transformation'. That may border on hyperbole, but it is true that the group’s divisional structure enables it to take an integrated approach to waste management, while operational benefits accrue from the sheer scale of Veolia’s global operations. It remains one of the five largest recycling companies in the world. It is also developing renewable and recovered energy sources (biomass, biogas) and transforming waste into compost or energy.

As with all the companies we have highlighted, leverage remains a key consideration for investors. Following on from the Suez deal, Fitch Ratings has affirmed Veolia's long-term issuer default rating at 'BBB' with a stable outlook, an indication that expectations of default risk remain low – even though a quick ratio of 0.9 might normally imply dependency on inventory and/or other current assets to liquidate short-term debt. Again, the predictability of its long-term contractual arrangements works in its favour, and the Suez deal will drive operating cash flow significantly, with consensus forecasts pointing to a 21 per cent increase between December 2022 and the end of 2024.

Meanwhile, an enterprise/cash profit multiple of 5.2 is below its long-term average – not surprising given its market value has increased by 80 per cent since its two-year trough at the end of October 2020. French stocks are usually more prone to volatility than their UK counterparts, but investors might still be tempted by a FactSet consensus forward dividend yield of 4 per cent. Whether the stock falls under the 'buy-and-hold' category is open to question; both Goldman Sachs and Morgan Stanley recently initiated coverage, ascribing respective 'buy' and 'equal weight' ratings. On balance, and in particular over the long term, we would lean towards the former designation.