Revisiting ‘Conventional Wisdom’: Energy & Sustainability

Revisiting ‘Conventional Wisdom’: Energy & Sustainability

In an effort to stimulate conversation around complex topics within sustainability… Over the last 3-5 years, it’s increasingly felt like the finance community broadly recommended sustainability funds broadly exclude O&G investments. Given the events of the last 12 months (Russia/Ukraine, inflation, political backlash to ESG in the US), it feels that investors and firms are taking a more granular view on exclusion policies, how they define sustainable investments, and what they are engaging on/for at energy companies. It appears that there’s less of a focus on exclusion and divestment (see related research: EDF: Transferred Emissions―How Risks in Oil and Gas M&A Could Hamper the Energy Transition) and now is transitioning to a model focused on responsible production and encouraging companies to deploy capital into transition opportunities where it is accretive to returns, either because companies have unique expertise or there is sufficient regulatory support to scale the technologies (renewables, hydrogen, alternative fuels, carbon capture, etc.). In conversations with multiple companies across the energy sector, it is increasingly becoming clear many investors are now focused on companies striving to have the lowest cost, lowest emissions barrels versus shutting down production altogether to ensure a responsibly managed transition. Leaders within the energy sector are focused on reducing flaring volumes, electrifying field operations, leveraging e-frac equipment, and driving efficiency gains from longer laterals and simultaneous fracking, while also investing in more nascent energy transition opportunities including but not limited to hydrogen, carbon capture, storage, and utilization, and biofuels.

Throughout the year, the world has been grappling with Russia’s invasion of Ukraine, which has set off cascading impacts to the global economy, including shocks to global energy and food prices resulting in elevated inflation and heightened recession risks. Compared to a few years ago, there’s a broader recognition that fossil fuels are not only needed today and as we transition but demand for these products may persist longer and higher than what climate transition scenarios have modeled (e.g., no new O&G development approved beyond 2021 in IEA Net Zero by 2050[1]). One need not look further than most European markets where high energy prices and energy shortages are highlighting the immense financial, social, and environmental costs to a mismanaged energy transition with European countries struggling to find alternative sources (and turning to a much dirtier fuel, coal, in some cases – ex: Coal imports to Antwerp-Rotterdam-Amsterdam region in 1H22 rose +35% YoY[2]) to fill in the gaps caused by not receiving Russian oil and gas supplies. I highlighted some of the recent developments/backsliding on climate commitments at both country and corporate levels by using the G-7 summit and the Food & Beverage sector as examples in a recent post: Net Zero: Transition from Exhaustive Targets to Feasibleness?.

The divergence between energy markets and economy-wide financial markets can be observed through the asymmetric relationship between YTD returns with the S&P500 down -18% YTD while the S&P500 Energy index is +31%[3].

Given that most sustainability-focused funds have traditionally excluded or been underweight energy as a default policy, this period of underperformance has also impacted sustainability managers. This trend might be changing as recent survey data of institutional ESG investors from June 2022 suggests that up to 32% of managers, up from 15% in March 2022, are increasing their fossil fuel exposure on the back of the Russia/Ukraine conflict[4]. This comes at a time where simultaneously the EU parliament backs labelling gas and nuclear investments as green.

Below I outline some simple, select arguments for and against whether energy companies have a place in sustainability funds.

• Arguments For: There is wider recognition that global sustainability strategies are undergoing a style drift where mainstream assumptions such as the effectiveness of exclusion are being revisited and investors are increasingly comfortable with the idea that multiple philosophies within sustainable investing can co-exist (e.g., exclusionary, best-in-class leaders, ESG improvers). In addition, to drive real world changes in the global net zero transition, investors will need to own and engage with carbon-intensive sectors to help influence their transition in financially productive manner instead of avoiding them entirely. Many investors recognize this as an analysis of 43 large asset managers committed to the Net Zero Asset Mangers Initiative showed only 3 firms (~7%) did not invest in fossil fuel companies at all and an analysis of ESG funds found that one-third of them have some exposure to Oil and Gas[5]. There’s also the fact that traditional energy incumbents will be early partners, investors, and customers of nascent but necessary transition technologies such as carbon capture and removal, hydrogen, and biofuels. As an example, I would point to Oxy’s announcements on their long-term plans around DAC as discussed in this period post: Occidental Petroleum selling carbon credits to Airbus from is Direct Air Capture Project.

• Arguments Against: Developments in the regulatory landscape around definition of sustainability funds (e.g., SFDR in Europe, recent SEC guidelines on ESG funds, etc.) may limit investment mangers’ ability to redefine their investable universes. Additionally, it may be difficult for investors to change their existing exclusionary policies or to modify existing fund investment objectives. Further, many sustainability funds focus on carbon intensity relative to a benchmark index as a measure of sustainability while many other mangers pledged to the Net Zero Asset Managers Initiative plan to reduce weighted average carbon intensity through 2030. In either of those cases, the carbon intensity metrics would get materially worse when including previously excluded energy companies that often have some of the most carbon-intensive footprints across all corporates. There’s also the argument that while there’s a role for energy companies in the world, that role does not necessarily need to be in sustainability-focused funds – e.g., applying an exclusion policy on Energy or similar can be viewed to be no different than style preferences with inherent biases (e.g., sector-focused funds, growth vs. value, etc.)

While Energy is often the proverbial punching bag in this debate, I’d note you can replace ‘Energy’ with ‘Metals & Mining’ to make the same point. The global energy transition will impact every facet of resource extraction (ex: EV adoption driving up demand for mined commodities).

• BNEF: “In 2021, the price of lithium, nickel and cobalt have all increased over the past year due to the rapid growth in battery demand, a lack of metals supply, inflation compounded by the invasion of Ukraine and subsequent sanctions on Russia, and the repercussions of China’s Covid Zero policy. These have led to significantly higher raw material prices, putting pressure on battery prices”[6].
• Mining Firms’ Cautious Spending Threatens Shift to Green Energy: “Metals prices are up, but mining companies aren’t spending. Their restraint could keep supplies tight and magnify shortages of raw materials such as copper and zinc that are critical for the transition away from fossil fuels. Project spending by 10 large mining companies, including Rio Tinto PLC, BHP Group Ltd. and Glencore PLC, is expected to stay at roughly $40 billion this year and next year, according to figures compiled by Bank of America Corp. That would put capital expenditures well below a 2012 peak close to $80 billion, the bank’s figures show. Much like the oil industry, mining companies are responding to pressure from investors to give priority to dividends and share buybacks, rather than heavy spending. A recent push to limit the sector’s environmental damage also pinched spending.”

At the end of the day, evaluation of sustainability should incorporate competing priorities such as the negative financial, social, and environmental impacts of high energy prices against the need to rapidly decarbonize the global economy in a responsible manner. I see tremendous value in meticulous research of and engagement with companies that are effectively balancing short-term market pressures with long-term, structural climate-related opportunities and risks.

Supporting Sources:

1. IEA Net Zero by 2050 published May 2021.
2. Europe Snaps Up Coal From Abroad to Fill Gap Left by Russia (7/5/22).
3. Bloomberg data as of 7/7/22.
4. AllianceBernstein Global ESG Research: How has ESG investing evolved given geopolitical uncertainties? Published June 15, 2022.
5. Credit Suisse Global ESG Research: What ESG investors tell us is on their minds. Published June 23, 2022.
6. BNEF 1H 2022 Battery Metals Outlook. Published July 5, 2022.