Environmental, social, and governance (ESG) considerations are not always as black and white as many anticipate. Take, for example, the recent trend of large extractive companies selling off carbon-intensive assets, partially in an effort to “decarbonize” their portfolios.
Such actions may look like progress towards addressing investor concerns about the economic impacts of a warming planet. But capital markets need relevant, reliable data to assess these transactions, and since the purchasers of these assets are often private entities, that information can be hard to obtain. As such, developing a robust understanding of where and how climate risks are embedded in a diversified portfolio — hint: nearly everywhere — and which companies are managing them effectively is critical.
ESG considerations have enjoyed a strong tailwind of late. Regulatory and market forces have played significant roles in that growth, particularly in the extractives sector. Governments have introduced stricter regulations to accelerate the transition to a low-carbon economy. This has heightened risks associated with certain business activities and created potential opportunities for others. Meanwhile, the economics of alternative energy sources, including wind and solar, have grown more competitive relative to fossil fuels and coal in particular.
The financial implications are already being felt. For example, Repsol and Chevron announced large asset write downs in 2019 due to, in part, the transition from fossil fuels to renewables, and many energy companies have established emissions reduction targets, with BP aiming for net zero by 2050, for example.
Regulators around the world are exploring and even requiring climate-related financial disclosures to facilitate more efficient pricing of risk and smooth the transition to a more sustainable economy. The G7 finance ministers and central bank governors have expressed support for mandatory corporate reporting in line with the Task Force on Climate-related Financial Disclosures (TCFD)’s recommendations. For investors that have been working with incomplete and inconsistent information on climate-related risks, this is welcome progress.
Transition Now or Transition Later
With so much of the ESG spotlight on large public companies, it may come as a surprise that five of the top 10 methane emitters in the United States are small, relatively unknown oil and gas producers. Many of these acquired their assets from larger public entities. The consultancy Wood Mackenzie estimates that $140 billion in oil and gas assets are up for sale. Major companies rarely shed their lowest-cost or cleanest-emitting assets.
This underscores the growing disconnect between capital markets and the real economy and the importance of addressing climate change as a systematic risk. Large corporations sell assets as part of a transition strategy, yet overall emissions — and the associated risks — are unchanged or perhaps even rise, as new owners take over.
Nothing is gained when risky assets in your portfolio simply change hands. So how can financial markets better assess corporate risks and strategies to ensure companies, investors, and society effectively navigate the fraught but imminent economic transformation?
Managing climate risk often boils down to “gray area” decisions. These are rarely as simple as offloading “dirty” assets or simply shutting down facilities. Companies must balance the need to maintain their business’s resilience against climate risks while also generating funds for new business activities. Governments have their own objectives amid the transition, such as ensuring access to traditional energy until sufficient low- or zero-emission options are available. Meanwhile, investors have different investment strategies and time horizons that influence capital allocation decisions.
Ultimately, the combination of market forces, government action, and corporate transparency should help determine the optimal path.
Information Remains a Valuable Asset
Once sold by major public firms, fossil fuel assets don’t disappear. Neither does the need for relevant, reliable risk disclosure. Often the entities that buy them need third-party financing, from commercial banks, bond markets, private equity, pension funds, etc. These capital providers need data to assess and manage the risks and opportunities in their portfolios and align with their investment objectives. In addition, banks and investors both face greater scrutiny as to their own climate- and ESG-related activities.
Over time, government regulation, changing consumer demand, and business pressure from technology and falling renewable energy costs may present an existential challenge to legacy oil, gas, and mining assets.
Companies and their investors will have complex decisions to make and they will need useful, actionable information to make them.
Coal: The Canary in the Mine?
The coal industry’s predicament is instructive in this regard. Cheaper and cleaner alternatives such as natural gas and renewables have put tremendous pressure on the coal sector. Bankruptcies and closures have abounded. According to the Beyond Coal Sierra Club initiative, 345 US coal facilities have been retired, leaving 185 active plants. Last year, coal extraction’s high costs, anticipation of the new Joseph Biden administration, and the larger transition to alternative energy led to record bankruptcies and increased levels of distressed debt in the industry.
Disclosure standards can help firms navigate these sorts of transitions. Those developed by the Value Reporting Foundation’s Sustainability Accounting Standards Board (SASB) reveal tangible data on the operating activities that drive emissions and on broader corporate strategy. This can inform investment decision making and serve as the basis to engage with and potentially influence corporate management. As such, SASB Standards are already in wide use in both public and private markets.
ESG and Access to Capital
ESG factors are increasingly influencing capital allocation decisions across the spectrum of sources of funds. These interconnected indirect pressures may result in calls for greater transparency into the financing of legacy oil and gas asset acquisitions.
For example, credit rating agencies are explicitly integrating ESG considerations into fixed-income ratings. Asset managers face mounting regulatory interest in how they market “green” investment vehicles. Asset owners are making formal ESG commitments to the Principles for Responsible Investment (PRI). The risks associated with climate exposure in bank lending portfolios are drawing scrutiny from investors and regulators.
These factors could present growing challenges to prospective buyers of large extractives company assets as they seek capital through these channels.
Credit Markets
S&P reduced credit ratings on Exxon Mobil, Chevron, and ConocoPhillips in February 2021, in part citing “growing risk from energy transition due to climate change and carbon/GHG emissions.” This followed an earlier, broader warning that the industry faces “significant challenges and uncertainties engendered by the energy transition.” Other leading credit rating agencies have also integrated ESG factors into their credit analyses.
A business seeking to finance an oil and gas purchase with rated public debt might confront similar considerations in any rating assessment and, consequently, higher borrowing costs.
Conversely, rising interest in ESG has led to significant growth and more favorable credit costs for green and sustainability-linked bonds. Many such loans are indexed to specific metrics.
The SASB Standard for Oil & Gas Exploration & Production, for example, has a metric that asks companies to discuss “long and short term strategy or plan to manage Scope 1 emissions, emissions reduction targets and an analysis of performance against those targets.” Such corporate disclosures can help investors better assess the risks associated with different transition strategies.
Bank Debt
Sixty of the largest commercial and investment banks funded nearly $4 trillion in fossil fuels since the signing of the Paris Accord, according to “Banking on Climate Chaos 2021.” This indicates a continued source of capital to finance acquisitions in the extractives industry. However, added demands for transparency, in conjunction with the underlying fundamentals, could spark change.
Global central banks have concerns about climate risks embedded in bank loan portfolios. Near-term this means they are mostly gauging the problem and compiling data. But many central banks appear to be trying to guide their financial systems towards green energy. As such, their policies could exact a toll from US firms with overseas operations.
Banks are responding. “We acknowledge we are connected with many carbon-intensive sectors,” Val Smith, Citi’s chief sustainability officer, wrote. “Our work to achieve net zero emissions by 2050 therefore makes it imperative that we work with our clients, including fossil fuel clients to help them and the energy systems that we all rely on to transition to a net-zero economy.”
Indeed, as “Banking on Climate Chaos 2021,” noted, while overall lending continues, UBS, among other banks, has reduced fossil fuel related activity by nearly 75% over the period.
Investor-led initiatives could also focus more scrutiny on access to bank capital. In January, 15 institutional investors representing nearly $2.5 trillion in assets filed a resolution coordinated by ShareAction requesting HSBC “publish a strategy and targets to reduce its exposure to fossil fuel assets, starting with coal, on a timeline consistent with the Paris climate goals.” In June 2020, a Chinese bank walked away from financing a $3 billion coal plant in Zimbabwe. In fact, more recently China has pledged to stop building coal facilities abroad.
The SASB Standards include climate and ESG topics and metrics that reflect the potential financial impacts of loans and investments to industries exposed to transition risk, including several financials industries. The SASB Commercial Bank Standard, for example, asks companies to disclose a breakdown of credit exposure by industry and for a “description of approach to incorporation of environmental, social and governance factors into credit analysis.”
Private Equity
Private equity (PE)-backed ventures have purchased assets from oil and gas majors. These PE firms are not immune to ESG considerations. More and more PE limited partners are embedding ESG into their capital allocation processes. Several have committed to the PRI and markets are increasingly holding firms accountable to these pledges. Furthermore, the Institutional Limited Partners Association industry trade group has incorporated ESG as a core focus.
Separating ESG from fundamental financial considerations is becoming harder and harder. PE funds are directing capital to such fast-growing sectors as solar, carbon capture, and battery storage. Indeed, renewable energy asset funds are raising about 25 times more capital than their fossil fuel counterparts. Some observers have suggested the supply of capital to the traditional energy sector could be drying up.
SASB and other reporting standards reflect these mounting and related needs and are being put to widespread use across private markets. Several case studies have demonstrated how these markets have employed SASB Standards.
Asset Owners and Investors
Many asset owners and managers have signed on to PRI. Given such long-term obligations, pension fund investors, among others, may prefer to avoid transition-exposed assets and gravitate to companies they perceive as better positioned for the energy transition.
Investors and asset owners are not homogeneous. Each has their own strategies, benchmarks, and portfolio needs. While some may steer clear of “dirty” assets, others might see upside to acquiring equity in “ESG laggards” that can improve their performance, engaging with management to identify and execute on business opportunities, or investing with a shorter time horizon in oil and gas markets.
Anglo American, for example, spun off its South African coal mines into a separate company rather than sell it outright. The firm’s leadership recognized that its shareholders had differing perspectives on coal. By executing a spin, Anglo afforded investors the option to hold, divest, or grow positions according to their own investment priorities.
Asset owners need transparency and data to assess these decisions. Even when a company exits certain oil and gas assets, it may retain financial liabilities. A US federal judge recently ruled a bankrupt privately held energy company could pass on environmental liabilities from aging wells. BP and Exxon could each face $300 to 400 million in costs to decommission these wells and insurers could be liable for more than $1 billion. Given the potential financial exposure associated with legacy / sold liabilities, investors might want to engage with management to better understand their asset disposal strategy and how they might contain such risks.
The Reserves Valuation & Capital Expenditure topic in the SASB Oil & Gas Exploration and Production Standard can help investors understand these exposures. This topic asks companies to discuss the sensitivity of hydrocarbon reserves to potential future carbon price scenarios as well as investments in renewable energy and how price and demand for hydrocarbons and climate regulation could influence their capital expenditure strategy.
Insurance
Access to insurance may pose another hurdle for buyers of legacy oil, gas, and mining assets as the financial system acclimates to the transition. Some have speculated that the insurance industry could be the downfall of fossil fuels given climate change–related issues and how the switch from carbon to renewable energy could affect portfolios. This speculation is not idle: Some insurers, including Lloyd’s of London, have committed to no longer sell insurance for some fossil fuels.
In the mining sector, an Australian mine faced challenges securing insurance; BMD Group was among more than a dozen firms that warned that lack of financing because of ESG considerations could destroy Australia’s $20 billion coal export sector.
SASB’s Insurance Industry Standard can help assess such scenarios. Metrics under the topic Environmental Risk Exposure ask companies how they incorporate environmental risks into their underwriting process and their management of firm level risks and capital adequacy. The Insurance Standard also includes metrics related to the incorporation of ESG considerations into investment management.
Nowhere to Hide
As governments worldwide ramp up their efforts to address climate change, legislation, regulation, and oversight could impact businesses dramatically, both to the upside and downside, and affect the relative value of legacy oil, gas, and mining assets. Investors need to consider the potential implications of:
Carbon Taxes and Caps
The EU and China, among other jurisdictions, have implemented carbon trading systems. Businesses covered by such rules may face uncertain and escalating costs. Credits in Europe reached record high costs this year. Such regulations are likely to ramp up. A recent EU proposal could lower the overall emission cap and phase out free emission allowances for some industries. Such regulations could put upward pressure on carbon credit pricing and raise costs in affected industries. The EU and to a lesser extent the United States are also contemplating taxing imports from high-emissions regions.
Mandates and Regulation
New government rules could force the closure of certain assets, establish rigorous emissions standards with costly compliance costs, and drive shifts to new technologies. More governments have adopted mandates to phase out internal combustion engines in favor of zero-emissions vehicles over the next 10 to 15 years. That will decrease demand for the associated fuels and affect the oilfields and refineries that extract and process them. This trend isn’t limited to automobiles. The UN agencies that govern international aviation and marine transport have enacted emissions limits. This may catalyze a shift towards newer, more efficient planes and ships, and alternative, low/no emissions vehicles
Governments could change the permitting processes for materials extraction or for building the infrastructure to move these goods to market. For example, the Biden administration recently cancelled the permit for the proposed Keystone pipeline. They can also incentivize business decisions with subsidies and favorable tax considerations, as the US government has done with tax credits for electric vehicles.
Underlying Markets / Economics
The cost of renewable power generation has plunged. Continued focus and potentially supportive government policy and future technical advances in, for example, energy storage might accelerate this trend.
A potential buyer of long-term oil, gas, and mining assets or a provider of capital to such acquisitions will need to factor these three potential areas of concern into their analysis. All of them could have value-related consequences. And again, understanding how these developments might impact corporate operations and financial performance requires the right information. ESG data can help. Corporate reporting to a global standard will yield consistent and comparable information for the financial markets to trade on.
The nature of ESG considerations rarely make for simple choices. But with more reliable and accessible ESG data, investors and other providers of financial capital — across public and private markets — will have a stronger foundation on which to base theirs amid the transition to a low-carbon economy.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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