The climate threat: Will investors exit big oil?
Institutional investors are increasingly being required to factor climate change into their decision-making
UK pension schemes have for a couple of decades spoken about taking environmental, social and governance (ESG) factors into consideration in their investment decisions—and then largely proceeded to invest regardless. The movement had lacked focus, but momentum is now squarely behind efforts to use the invested trillions to help fight climate change.
UK pension scheme trustees have a fiduciary responsibility to maximise risk-adjusted returns for scheme members and, theoretically if not in reality, are personally financially responsible for losses made from unreasonable decisions. Historically, this has trumped all other considerations.
The official view now is that climate change poses a material risk to long-term pension scheme saving. By 1 October 2019, almost all UK occupational pension schemes will need to document their approach to ESG factors and stewardship in their statement of investment principles (SIP), with specific reference to climate change. Schemes must publish an implementation statement that detail how they acted on their SIP. The upshot is that risk-averse trustees that were once solely worried about their fiduciary duties will now also need to be concerned about being taken to task about their approach to climate change.
Responsible investing has anyway been a growing phenomenon over the last decade; numerous organisations have sprung up, from the UK's ShareAction to the international ClimateAction100+, which has more than 320 members that collectively control $33trn. There are now 2372 signatories to the United Nations principles of responsible investment representing assets under management (AuM) of $86.3trn (see graph).
"We are seeing a number of large institutional investors putting constraints on where they would invest, which is starting to have an impact on where capital will come from and putting pressure on traditional oil and gas companies to start adapting," says Chris Midgley, head of analytics at information firm S&P Global Platts.
Asset managers have certainly taken note. Caroline Escott, Caroline has a account investment and stewardship policy lead at the pensions and lifetime savings association (PLSA), notes that half of the exhibitors at her organisation's annual investment conference in Edinburgh chose ESG as their core message and it was the most requested topic by one-third of delegates surveyed. "Love it or loathe it… it seems clear that 2019 is the year ESG finally became mainstream," she says.
While most schemes would like to make a positive impact, implementation is far from straightforward or without cost. Depending on your point of view, plenty of FTSE 100 shares could fall foul of ethical rules, from military equipment (BAE Systems, Rolls Royce) and gambling (Flutter Entertainment) to tobacco (British American Tobacco) and alcohol (Diagio and others).
Three of the top five UK firms by market capitalisation have oil and gas interests: Shell, BP and BHP. And, particularly important for pension schemes, Shell pays the biggest dividends. Investors could not hope to maintain a balanced portfolio if they eliminate broad swathes of the economy.
Few pension schemes take the extreme position of imposing a blanket ban on investing in certain companies or sectors. "Most institutional investors have a much more sophisticated approach," says Sandra Carlisle, senior responsible investment specialist at financial services firm HSBC Global Asset Management. "Sometimes clients feel under pressure—particularly university endowments if students are up in arms about climate change—but when we explain the consequences of divestment they decide against that route. Such a limited universe of companies would result in a level of idiosyncratic [non-market] portfolio risk that would breach their fiduciary duties."
It may not even be possible to disinvest. Pension schemes have increasingly moved away from actively managed funds to lower-cost passively managed ones; as the manager robotically tracks an index it is not possible to sell a component stock. Without a credible sanction, why would management listen to a climate-concerned fund manager?
Passive managers, however, have scale. Even the largest oil major would surely engage with Blackrock or Vanguard, with AuM of $6.5trn and $5.2trn respectively. "If you say, as an owner, you are concerned that climate change is eroding returns, they will engage," says Carlisle. "They respect the fact you have capital invested. They may respectfully disagree, but it is very unusual for them to refuse."
Asset managers can also flex their muscles at company AGMs, depending on investor consents. Negative publicity, whether justified or not, can also cause substantial reputational damage and attract the brickbats of protestors—as BP found at its May AGM.
"Several years ago, oil and gas majors felt they could stonewall us with answers that were not sufficient or robust," says Carlisle. "That has changed. Climate change is real, governments are responding and consumer behaviour is changing. The climate emergency makes it much harder for companies to duck questions."
She notes that regulation is increasingly mandating action and initiatives such as the task force on climate-related financial disclosures (TCFD) provide a reporting framework.
"It is absolutely changing oil firms," says Midgley. "There is no doubt that they are making many more investments in, and statements about, sustainability. Shell's Ben van Beurden committed his salary to making reductions in carbon—this would have been partly due to investor pressure. Companies are shedding high carbon intensity processes and assets, such as oil sands, and focusing on low-intensity processes."
Passive money can no longer be taken for granted as exclusion is becoming much easier. On 3 July the London Stock Exchange changed its classification system: oil and gas producers became non-renewable energy and alternative energy became renewable energy. A subtle change perhaps, but one that shifts the perception of what is considered mainstream and facilitates exclusion—regardless of the subtleties of a company's energy mix-by ticking a box. These classifications also inform institutional investment decisions—such as which companies will be hit by the 2017 decision of $1tn Norges Bank to disinvest oil and gas stocks (made for non-environmental reasons).
Another problem for investors is correctly identifying targets. Industrial processes of any kind inevitably impact the environment. Oil and gas companies may be responsible for extracting resources, but airlines, cement manufacturers and consumers driving cars and warming houses make the final decision to release the CO2.
Moreover, carbon-intensive hydrocarbon production tends not go away even if a large oil firm opts out—just to another company and one that is perhaps not under the same level of pressure or scrutiny. "There is a waterbed effect—it pops out where there is lowest level of governance," says Midgley. "We need to be careful about unintended consequences. It makes sense to see control of these assets under larger oil and gas companies that are held accountable to high standards and have the best technology."
Legal and General Investment Management (LGIM), with AuM exceeding £1trn, launched a new approach in 2016 in response to the COP21 Paris agreement and reported its second annual findings in June. It identified six sectors for special attention: oil and gas, mining, electric utilities, automakers and, perhaps more surprisingly, food retailers and financials.
It recognises that these are essential sectors and is not attempting to damage or disinvest from them. It is not interested in making moral judgements on total CO2 emissions, instead it uses its clout to push for transparency, highlight wasteful processes and disseminate best practice. Divestment is a last resort and dialogue continues even after it happens.
"We call it engagement with consequences, that has results and impact," says Meryam Omi, head of sustainability and responsible investment strategy at LGIM. "We are not [interested in] having a dialogue forever. This is a massive problem that requires urgent action—we do not have 10 or 20 years."
LGIM's process resulted this year in ExxonMobil becoming an exclusion candidate, as it did not meet LGIM's key minimum requirements on emissions reporting and targets. It would not commit to company-wide targets for so-called scope 1 and 2 emissions (from direct activities and products sold) or disclose scope 3 emissions (indirect emissions from up- and downstream activities). Four other new companies were divested: Hormel Foods, Korean Electric Power Corporation, Kroger and Metlife joined China Construction Bank, Rosneft, Japan Post Holdings, Subaru, Loblaw and Sysco Corporation.
US independent Occidental was reinstated to its investment list after improvements, at first sight surprisingly considering its huge acquisition of Anadarko and its shale resources. It regained favour by a "step-change in engagement, backed by tangible actions" and because it will both disclose scope 3 and announce targets for scope 1 and 2. Fellow US indie Dominion was also reinstated.
"Energy intensity will be one of the biggest things companies are measured on," says Platts' Midgley. "The world recognises that we need hydrocarbons—the point is to show you are producing as responsibly as you can. BP and Equinor stand out by committing to produce the lowest energy intensity barrels. Equinor has talked about cutting the intensity of its production by 50pc. That will be the key metric that investors and activists will be looking for."
HSBC's Carlisle agrees that active managers' ability to disinvest means they have more impact. "The ability to have real influence is greater. Active investors can drill down into the business much more as they know much more operational detail."
Carlisle is reluctant to "chuck companies out of the portfolio" as "we do not have a crystal ball" to predict how the low carbon transition is going to take place. "Every scenario we have modeled says do not go down the divestment/exclusion route as it is very hard to predict the winners and losers. You may want to invest in a heavy emitter if it is cheap and has interesting assets that could be transitioned to being more sustainable—there would be a value opportunity to capture."
Asset managers and investors are not typically pushing oil and gas majors towards renewable energy. LGIM stated that "it does not necessarily mean such companies should reinvent themselves as renewable energy companies". Instead, it "would welcome a strategy of disciplined capital allocation that is suited to the ex-growth era".
"There seems to be a presumption that big oil should be leading the transition away from hydrocarbons," says David Hewitt, oil & gas research analyst at bank Macquarie. "I challenge that. I am not convinced that big oil is the right vehicle to be leading the charge."
For diversification to be successful, he argues that both the board and senior management need to include representatives of the new business. For example, an upstream company with a board dominated by geologists and geophysicists (or a downstream firm by chemical engineers) is unlikely to dedicate enough attention to solar or wind to make it successful. Big oil's attempts to diversify away from hydrocarbons have not been very successful, he adds. "The history of diversification is rather poor."
Hewitt says that the oil skillset can easily be applied to gas but not renewables. "I am not convinced you should be moving beyond gas. I can understand [participating in power] to capture upstream rent and stimulate new LNG markets—the integrated value chain approach of Shell, BP and Total. But I just do not think oil to wind or solar is a logical move."
Macquarie found that the average unleveraged return in North America onshore oil is 33pc, pre-FID conventional 21pc and downstream chemicals 15pc (financial engineering boosts these figures by varying amounts). By comparison, solar photovoltaics (PV) and wind—on or offshore and in developed or emerging markets—produces returns between 5pc and 8.7pc. "If you believe these numbers," he says, "big oil should be staying [in oil and petrochemicals]."
Macquarie has been conducting investor roadshows and found a wide divergence of opinion. "America is not interested in the transition," says Hewitt. "In Europe, there is a big split between those who think it should be a license to operate issue and those that believe it is a societal requirement of these companies to lead the charge."
Its analysis produces a very different result to LGIM's. It has an outperform outlook for ExxonMobil, Shell, Total, OMV, Galp and Repsol and a neutral outlook for BP, Chevron, Eni, Equinor and Petrobras.
Platts' Midgley is more convinced about oil majors' suitability for renewables. "IOCs and NOCs come from a position of strength—they have strong retail experience, so they can adapt to selling power. Are electrons really that different from hydrocarbon molecules? It involves transmission rather than shipping, but other elements are very similar such as trading and aggregating supply and demand.
He adds that second generation biofuels will need technology such as hydrolysis, oil refineries can be converted into biorefineries, and hydrogen production from gas will need carbon capture utilization, and storage. "A lot of this will leverage the engineers and technology oil and gas companies already have. Investors that think making lots of little investments is frivolous may prefer Exxon. One that prefers a company that demonstrates it is looking at all the options and is thinking about the transition may reward Total or Shell," says Midgley.
Oil and gas majors also have the power of their balance sheets. "That should never be underestimated," he says. "The sector is unique as it has the power to do multi-billion-dollar projects, take significant risks and manage them over the cashflow cycle. Today there are lots of small projects but eventually the future of renewables is going to be about scale and aggregation."
Most oil and gas companies are investing between 5pc and 10pc of capex in renewables and the vast majority in traditional activities. "Some of this is just good business, some is a result of investor pressure," says Midgley. "One may not see that as a good thing as renewables are making very low profits and reducing shareholder returns. But it takes time to develop healthy levels of return and you must invest to achieve scale. It feels logical—they are not betting everything on it but starting small and building up capabilities."
Macquarie's alternative energy analyst Keegan Kruger suggests a big-bang approach may be better. "The scale issue is stopping oil and gas majors—it is just not big enough. If an oil and gas major is serious about offshore wind and wants scale it should just build a 10GW project in the middle of the North Sea… and showcase its ability to manage construction risk. They clearly know how to do so. That would be the way to gain entry to the sector."