Sembcorp sends wrong signals with SLB

Shareholders at Sembcorp Industries, the Singaporean energy company, this month approved what looked like a standard corporate transaction: selling some assets to reduce debt and strengthen the company's environmental, social and governance credentials.

But the firm's move to sell Sembcorp Energy India Ltd (SEIL), an independent power producer with two coal-fired plants in India, was anything but standard if you look at the fine print.

SEIL is a substantial part of Sembcorp Industries, making up 47% of its net assets. In the first half of 2022, the unit produced S$238m ($173.67) of Ebitda, 27.5% of the company's total.

Sembcorp highlighted numerous reasons for selling SEIL: it would strengthen Sembcorp’s balance sheet; preserve value for and protect the interests of shareholders; and bolster the group’s transformation of its portfolio "from brown to green" — the slogan that adorned Sembcorp's last annual report.

These are all valid points. But on page 17 of a shareholder letter sent at the end of October, ahead of an extraordinary general meeting to approve the sale, another rationale emerges.

“The option of retaining SEIL was considered, however, this could lead to a step-up in interest costs for [Sembcorp’s] sustainability-linked financing instruments,” said the letter.

Sembcorp issued a S$675m ($273m) 12 year SLB in October 2021, followed by a S$300m seven year in April. The first transaction included a S$150m investment from the International Finance Corp.

Both bonds will have a 25bp step-up in coupon from the first interest payment date on or after April 1, 2026, if the group does not meet its sustainability performance target of reducing its Scopes 1 and 2 emissions from its power generation to below 400kg of CO2 equivalent per megawatt hour by the end of 2025.

Sembcorp said that after divesting SEIL, its greenhouse gas emissions intensity would fall from 510kg CO2e/MWh to a pro forma value of 320kg this year, allowing it to meet its 2025 target well ahead of schedule.

That would ensure it did not have to pay the coupon step-up to its SLB investors.

Sembcorp also said in its letter to shareholders that if it kept SEIL, "...the investor base that would be able to invest in the securities of SCI [i.e. Sembcorp Industries] would decrease, as a significant proportion of institutional funds exclude investments in companies that have coal-related exposure. This would likely result in lower liquidity and thereby an increase in cost of capital for SCI."

Going green, in other words, is seen by the company as imperative for it to retain investor support — irrespective of the SLB.

Selling SEIL will remove no less than 60% of Sembcorp's absolute Scopes 1 and 2 emissions, according to a presentation from the company, reducing the 2021 figure from 26.2m tonnes to 10.4m, pro forma for the disposal.

Observers may argue Sembcorp was simply carrying out its strategy. As part of its ambition to change from brown to green, selling a coal-based asset is a natural step. The firm can bolster its ESG strength and prove to the market it is serious about its transition goals.

But the execution of the divestment raises concerns.

Sembcorp is selling SEIL to an Omani consortium called Tanweer — led by private equity firm Oman Investment Corp, the Ministry of Defence Pension Fund of Oman and Dar Investment, the family office of Sheikh Abdullah Al Salmi, the executive president of Oman’s Capital Market Authority.

HSBC is sole financial adviser to Sembcorp on the sale.

The acquisition, for the book value of SEIL, Rp117bn (S$2.1bn or $1.5bn), is being financed in an unusual way.

Sembcorp itself is providing the consortium with a deferred payment note (DPN), effectively a loan, for the full amount of the purchase price.

Tanweer will have between 15 and 24 years to pay back the money. The interest rate is 180bp over a base of 7.2%, the yield on 10 year Indian government bonds.

The Omani buyers can receive a 9bp cut in the interest rate for every 1% reduction in greenhouse gas emissions the power plants achieve under their ownership. In addition, Sembcorp intends to continue providing “technical advisory services” to SEIL for a fee during the life of the DPN.

Having decided that it needed to green its operations, Sembcorp had been gauging market interest to buy SEIL since 2020. That led to a more targeted sale process last year and then officially opening the process to bidders. Multiple binding offers were made.

All the bidders were offered the vendor financing package using the DPN, and all of them opted for this.

Sembcorp said it had done this because of "the limited availability of funding for coal-related projects due to ESG considerations of financial institutions globally".

In other words, Sembcorp is financing the purchase itself because it is anxious to get the asset off its books, but the buyers would have struggled to raise the money on their own, or would have had to pay more for the debt.

This crafty funding package should make ESG investors, including those in the SLBs, uncomfortable.

Questions have long been raised about whether it should be acceptable for SLB-market issuers to meet decarbonisation targets by simply selling high-emitting assets, rather than closing them down.

Sembcorp's SLB certainly falls into the territory where this debate applies.

Critics argue that just selling an asset could mean there is no actual decrease in emissions, merely a change of ownership. If that is the case, has any real impact been achieved?

On the other hand, the reality of corporate finance is that deals concern one company at a time. If a business wants to exit a particular activity, the usual way is to sell it. Everyone considers that as removing exposure to that activity from both the company and its investors.

A company's carbon footprint is agreed to be based on its current activities, not all the assets it once owned — even if a few companies such as Microsoft have tried to count up and offset all their historic emissions since they were founded.

From this point of view, although SLB investors are right to be wary of issuers meeting targets by selling assets, and sceptical of the impact achieved, such strategies are probably not breaking any fundamental norms of corporate or investor behaviour.

A second vulnerable point of Sembcorp's transaction is that its shareholder letter indicates that it least considered keeping the coal plants, presumably because finding a buyer was not easy when it first tried in 2020. But it sold the plants to avoid the coupon step-up.

This behaviour in the face of potential financial loss does not speak of a company methodically executing a well-planned decarbonisation stategy. Investors are bound to ask whether Sembcorp is as seriously committed to greening its business as it claims.

But the third and most concerning aspect of this is the vendor financing Sembcorp is providing to the Omani buyers.

Investors may not realistically expect carbon-heavy companies to leave money on the table and virtuously close polluting assets when they could sell them.

But when an old economy asset is hard to sell — especially if this is because the wider capital market has turned away from coal power — to prop up the sale value by providing financing looks like going too far.

The Anthropocene Fixed Income Institute, a Swedish think-tank that campaigns on climate issues in the capital markets, wrote in a report that investors should not consider the coal generation and carbon footprint of SEIL as deconsolidated from Sembcorp’s until the assets have been fully paid for.

“The key argument for this is that Sembcorp is simply shifting operation emissions into financed emissions through the transaction structure, with minimal real emissions reductions," the AFII wrote. "In this deal, a physical asset simply shifts to become a financial asset on the balance sheet.”

It added that the financing structure makes Sembcorp a “lender of last resort for the coal assets, with recourse”.

Sembcorp officially responded to media reports about this on November 9, suggesting its emissions reporting would continue to be prepared in line with the Greenhouse Gas Protocol and be verified by a third party auditor.

Its annual reporting on key performance indicators under its sustainable financing framework will also be verified by a qualified third party.

Sembcorp reiterated its strategy of brown to green transformation and the role of the Indian sale in achieving its ambitions.

"The structure of the proposed sale was developed in the best interests of multiple stakeholders... and is, in its opinion, a responsible way to progress its brown to green transition in accordance to the strategic commitments that Sembcorp has... made to its stakeholders," it wrote.

On paper, the structure of the SEIL sale helps Sembcorp further its transition strategy.

But Sembcorp has not really separated itself from SEIL. According to its presentation, of the S$238m of six monthly Ebitda, based on first half 2022 figures, that it will give up with the transfer, it will get S$95m back through interest on the DPN.

As for post-tax profits, it will retain S$79m out of the S$101m given up.

Holders of Sembcorp shares and bonds will still be making nearly as much money as before out of those Indian coal plants, even if Sembcorp's reported emissions fall 60%.

The Omani consortium may be able to pay off the DPN quickly. But the terms allow it to take 15 to 24 years.

Fifteen years from now is 2037, way past the date at which the SLB's target is tested and even past 2030, by when Sembcorp has said it will cut its absolute emissions to 2.7m tonnes, 90% lower than in 2020.

Divesting emissions to a buyer financed by yourself hardly seems in the spirit of giving investors, either in Sembcorp's shares or SLBs, a genuine "brown to green" transition.

It also sets a bad precedent for the SLB market, especially in Asia.

Other companies could easily follow its example and shift emitting assets from their own balance sheets to off balance sheet related entities — especially if they are worried about missing performance targets.

This sequence of events has put Asia’s ESG debt market on the back foot. Investors should beware.