“We will chase perfection, and we will chase it relentlessly, knowing all the while we can never attain it. But along the way, we shall catch excellence.” – Vince Lombardi
The Attempt to Push an Agenda v. The Attempt to Improve
Environmental, Social, and Governance (ESG) investment considerations have incrementally acquired notable mindshare and have gradually become a controversial debate. The epicenter of the ESG dispute within the capital markets lies in the energy sector. Many argue the necessity of ESG to support their position on eliminating fossil fuels, while others see the topic as an impediment to running an efficient business. The reality is that the material variables of ESG and the value drivers of energy investments are not mutually exclusive. Debating for the sake of promoting either agenda is counterproductive over the long term, and as the world increasingly attempts to decarbonize, both factions should find common ground. If this fails to occur, then the energy transition is destined to fail. Ultimately, the ESG “evangelists” and the stringent ESG “detractors” are equally responsible for this unfortunate dynamic.
We believe the energy transition and decarbonization strategies can be accelerated if quality long-term focused capital is awarded to management teams who marry financial performance with increased sustainability-focused transparency, improved data quality, and who have also reinstituted higher degrees of trust. For this to occur, the ESG evangelists and detractors must collectively acknowledge and objectively address the five key catalysts responsible for the issue’s current turmoil:
- The concentrated ownership of index funds adversely impacts constructive & actionable ESG evaluation
- Poor-quality ESG data is currently flowing through the global capital markets and requires substantial improvement
- Due to the complexity and nuance of the energy markets, economic considerations and reliability concerns must be pragmatically and objectively addressed
- For the foreseeable future, fossil fuels are an unequivocal necessity for any economy to function, let alone, thrive. Massive amounts of investor capital must be allocated to hydrocarbon industries as they are well positioned to execute large-scale decarbonization strategies
- Increased ESG transparency will lessen, but not eliminate, the deep lasting scars associated with the volume of wealth and capital the energy industry destroyed the prior decade
The concentrated ownership of index funds adversely impacts constructive ESG analysis
Global equities ownership is more concentrated than most realize. BlackRock, State Street, and Vanguard, i.e., “the Big Three”, are the largest shareholders in 88% of the S&P 5001. Moreover, the Big Three also account for roughly one-third of total shareholder ownership within the index2. The surge of index fund inflows over the last decade has left Vanguard positioned as the number one shareholder in 330 stocks in the S&P 500. BlackRock Institutional is a second-top owner, ranking as the number one investor in 38 S&P 500 companies3.
This degree of concentration is alarming since passive investment management, relative to active strategies, executes little to no scrutiny of the underlying forward-looking fundamentals of held equities. Instead, passive investment portfolio construction is predominantly focused on high-level, superficial characteristics such as sector, market cap, and/or region. This results in placing a disproportionate emphasis on the more trivial attributes of equities (i.e., Sector over Return). Consequently, this usually comes at the expense of forward-looking fundamental performance and forthcoming strategic directives aimed at generating future shareholder wealth.
This systematic flaw is further amplified when the influence of stewardship teams is added into the mix. Stewardship teams are generally comprised of small groups responsible for incredibly important decisions, namely proxy voting and in some cases, overall portfolio eligibility. The individuals running point on initiatives impacting global stakeholders should not be relegated to a select few. This runs counter to the democratic nature intended for the complicated realm of both asset management and proxy voting and, also contradicts the guiding principles of “stakeholder capitalism.” In other words, why would we expand the definition of “stakeholder” only to constrict the number of individuals eligible to make decisions on their behalf?
Poor-quality ESG data in current capital markets requires improvement
The adverse impacts of concentrated ownership are further intensified since stewardship teams cannot appropriately achieve a required scale when evaluating a specific set of companies. For perspective, according to Vanguard’s website, their Total World Stock Fund has 9,414 holdings4. The small size of stewardship teams, combined with the vast number of owned equities, provides solid reasoning that it is unrealistic to assume these teams analyze every material aspect of held equities. Presumably, this “gap” is most likely filled by poor ESG data provided by outside sources or third-party rating providers. We feel it is more practical to focus on the data quality conundrum since that is a relatively quicker fix than addressing passive ownership deficiencies.
The overreliance on ESG data and ratings exists particularly within the index funds. Ironically, this “solution” is triggering detrimental market deficiencies due to the skewed nature of ratings. To be fair, many stewardship teams utilize a variety of different data sets, but given the low correlation of ratings, it is reasonable to assume that rating providers prioritize commercial differentiation and market share over empirical integrity5.
Further, empirical evidence showcases that ESG ratings are biased6. The more notable biases include sector, size, geographic and algorithmic. Low score correlation combined with biased retrospective data utilized by small teams who cannot produce scale does not present an adequate infrastructure for efficiently or accurately examining the forward-looking directives of companies.
ESG Rating comparison: Correlations
Image Courtesy of BDO USA, LLP
The typical correlation between influential ESG raters generally ranges between 35% and 50%, Source7
Sector designation is typically based on the historical profile of a company instead of its future directives. Apart from the Information Technology space, high-level classifications commonly discount the degree of innovation within a given industry. Moreover, first-level industry classifications are incredibly complicated for the hydrocarbon energy industry when it comes to ESG considerations. “Oil and Gas Producer” may define many current revenues, but it commonly masks that these companies are active sponsors of the energy transition and are responsible for a substantial proportion of functional green technology8.
The emergence of carbon technologies among Talos Energy, Denbury Resources, and California Resources Corporation, the Louisiana Oil & Gas Association stating “we are all for wind energy”9 and the variety of emerging technologies currently tested by Chevron10 are just some of the many examples showcasing how the oil industry is progressing. Legacy energy’s inherent dilemma is not necessarily focused on the conceptual or idealistic importance, merit, or worthiness of the energy transition. Instead, their dispute typically centers on the capability of earning an attractive and responsible return on investment in an environment where the scarcity value of investor capital is continually increasing.
As with any company operating in any sector, adhering to stringent fiduciary responsibilities entails first understanding how the sources of project funding will result in a corresponding return on investment. This is non-negotiable. Quality capital is already scarce and management teams, especially those in energy, must showcase a high degree of capital allocation discipline. Such concerns become increasingly more complex for legacy energy management teams given the immense efforts to restrict quality capital from the hydrocarbon industries. Ironically, efforts to restrict hydrocarbon funding result in a decreased effort to fund decarbonization strategies since such endeavors dramatically raise the opportunity cost of said investment. Regardless, as the chart below highlights, if we proxy commitment to green technology by the number of green patents issued, then legacy energy and power have already established a leadership presence.
Energy and Power companies create more green patents than Renewables companies, Chart Source11
Shockingly, MSCI, one of the most influential ESG raters, does not even account for green technology within Oil and Gas weightings. “Opportunities in Renewable Energy” and “Opportunities in Clean Technology,” are categories that exist within their respective scoring methodology, yet they receive ZERO weight for Oil and Gas companies12. This runs counter to the observed data highlighting the swift and aggressive emergence of energy transition-focused investment and technology within the legacy energy space13.
We feel this evidence further reinforces that rating firms (and to a certain extent certain reporting frameworks as well) are more concerned with promoting the divestment mantra as opposed to pinpointing specific weaknesses investors can constructively engage on. In their current form, both the utility and impact of ESG ratings are counterproductive – advocating divestment ultimately stands to increase the cost of capital for legacy energy and inherently diminishes the economic incentive to invest in the energy transition. Given the immense expertise and technological potential of legacy energy, this dynamic represents a massive global disservice, especially to the more vulnerable stakeholder.
MSCI ESG ratings for E&Ps do NOT include Opportunities in Renewable Energy or Clean Tech14
The chart above highlights how Mega-Cap Oil & Gas companies are acting as green technology-focused investors
This is an incredibly crucial point.The objective of ESG analysis is to provide investors with visibility into corporate behavior and to incent progress around commonly held goals, like reducing emissions, waste, spills, etc. However, there exists a lasting discrepancy on behalf of rating agencies (which influence portfolio construction) to acknowledge the forward-looking directives of any company. Frankly, this is also an issue with a notable number of global investors as well. Nonetheless, by introducing structural biases into sector analysis, investors (especially on the retail side) could be fooled into thinking that investing in Tesla is “clean” while owning Antero is “dirty”, yet that conclusion is both empirically and categorically false.
Sector classification does not reflect the forward-looking ESG realities or strategic directives of a management team, yet ratings are typically influenced by various sector-specific characteristics. For example, Bloomberg classifies Amazon as an “Online Marketplace.” This classification provides marginal credit at best for their overall footprint, evolution, and success. More importantly, this shortcoming is also reflected in Amazon’s respective ESG ratings.
If Amazon is indeed considered an “Internet Retailer,” then the respective carbon emissions weighting within their overall ESG score is 0.9%. That same weighting “jumps” to 5.0% if Amazon is deemed an “Internet Services” company. For context, Oil and Gas E&P’s carbon emissions weighting within MSCI’s methodology is nearly 20%15. Presumably, “Internet Services” does not accurately account for fulfillment centers or transportation logistics, which represent a substantial proportion of Amazon’s respective emissions profile. The critical point here is not to posit or argue the accuracy of the numerical weighting. Instead, the example of Amazon displays how the shortfalls associated with sector classification can adversely skew any company’s ESG rating.
Sector bias intensifies size bias, which highlights the misleading assumption that all market caps have access to the same number of resources. The Russell 3000 represents roughly 97% of the investable U.S. market16 and the median market cap of a Russell 3000 constituent is $2.2B, meaning SMID cap companies comprise a substantial percentage of the index17. Given the average IPO size in 2020 was approximately $350M, it is also fair to assume most private companies resemble more of a SMID-cap profile as well18. Intuitively, to presume small, mid-cap, or private companies can afford to allocate ESG-directed resources in a similar fashion to a large or mega-cap company is unfair, unrealistic, and potentially detrimental to long-term value creation. Several studies and recommended policies focus on the fact that “one-size fits all” ESG mentalities result in a variety of distorted perspectives and misinformed ESG-related conclusions19.
Algorithmic bias derives from the mass data explosion the capital markets have experienced over the last few years further amplifies the ratings dilemma. Global spending on financial market data and news continued its decade-long growth streak with revenues jumping 7.4% to a record $35.6 billion in 202120. This immense tidal wave of data can be attributed to the increased utility and reliance on algorithms, as S&P Global highlights:
“Artificial intelligence (AI) allows investors to collect and analyze more information than ever before when accounting for environmental, social, and governance risks and opportunities. AI can help sustainable investors process mountains of data that hold essential information for ESG investing. Computer algorithms that have been trained to find and analyze tone and content can digest all the information available about a company, which can be a massive task for human employees to do at a reasonable speed. Popularized programs that measure the tone of the text, like Sentiment Analysis, automate tasks that would have been impossibly labor-intensive even a few years ago21.”
Algorithms theoretically provide a more efficient means of pure data capture and aggregation, but the “rules” dictating how they aggregate are designed by people – most of whom derive from outside of the energy space. Algorithms are programmed to search for very specific pre-defined language disclosed in specific locations. Because of the specificity, it is easy for an algorithm to miss a unique, material disclosure or pull in the wrong data point. If ESG data is littered with biases and inaccuracies but remains an influential variable and input within ESG evaluation, it is fair to assume that the biases existing in AI are intensified by this shortcoming22.
In terms of solutions, energy companies must counter poor existing third-party data with the proactive conveyance of objective data they track and measure on their own. It is also important to note this conveyance should align with more of a generalist profile and should aim to educate the audience as well. In other words, we feel the likelihood of a methodology change on behalf of a ratings provider is small. As painful as it might seem now, the most effective remedy long-term lies with management teams drastically improving how they consistently track and proactively disclose trending, material ESG-related quantitative data points.
Due to the complexity and nuance of the energy markets, economic considerations and reliability concerns must be pragmatically addressed
Biases, inaccuracies, and unfounded preconceived notions are the foundational tenet of another controversial catalyst, i.e., the nascency of the energy transition and the evident need to greatly enhance the general comprehension of energy and decarbonization economics. Simply put, policymakers and generalist investors, along with several prominent social voices, demonstrate a limited understanding of the calculus dictating decarbonization.
At the same time, legacy energy must understand and accept the pragmatic utility of material ESG considerations, especially as it relates to quantitative measurement and disclosure. Flaring, methane leaks, spills, health/safety, water stewardship, waste, and flawed incentive structures do not just undermine a company’s social license to operate, they carry negative economic consequences which adversely impact investment multiples. Equally, ESG evangelists must objectively acknowledge the empirical fact that fossil fuels play a critical role in a thriving and functional global economy. Blind reliance on new, untested, and/or sub-scale technologies or divesting from certain industries is naïve and carries real-world risks whose costs typically are borne by those least able to afford them.
For the foreseeable future, fossil fuels are an unequivocal necessity for any economy to function, let alone, thrive
Without fossil fuels, everyday, common global stakeholders would experience greater geo-political risk, immense inflationary burdens, increased taxes, and an overall decrease in their respective standard of living23. In fact, this is exactly the playbook that is currently unfolding in Europe. Poor energy policy results in a variety of unfortunate vulnerabilities and unintended consequences. Mitigating child mortality, addressing income disparity, reducing political instability, and attacking energy poverty are foundational tenets any society requires to establish a viable path towards stability and long-term viable prosperity. As the global population trends toward ten billion over the next forty years24, we expect to see developing countries seek strategic partners to address problems impacting the quality of life.
These partnerships should be awarded to the entities that display the greatest amount of efficiency, responsibility, and innovation. With that in mind, the United States should be a top contender. The technological prowess of the American economy is a formidable instrument these developing countries should utilize to build out such a foundation.
The United States displays incredible overall energy efficiency, Chart Source25
Increased ESG transparency will lessen, but not eliminate, the lasting scars associated with the volume of wealth & capital the energy industry destroyed the prior decade
The economic necessity of fossil fuels does not change the reality that these businesses should be held to the highest standards. The moral case for energy is accurate26, but it does not alleviate the lasting scars associated with past blunders along with the volume of wealth and capital energy destroyed during the previous decade. Both investor and community PTSD remains from the shale days (along with other environmental disasters for that matter) and has not been forgotten. Like with any other sector, the energy space should showcase how enhanced responsibility, innovative technology, capital discipline, and resulting financial returns collectively drive overall performance. Fossil fuel companies should not be forced to apologize for their business, but they should be accountable for how they execute. Further, it is critical these companies quantitatively and objectively prove to the market and to regulators that they can be responsible producers of the raw materials necessary for tomorrow’s prosperity.
Accountability is contingent upon increased transparency by placing the burden of disclosure on the company. The burden of seeking strategic capital should require idiosyncratic and thoughtful quantitative disclosures which outline the strategic path forward. Regulation is not the answer as it disproportionately focuses on retrospective assessments that may not be material to a specific business. Regulations also struggle to maintain pace with technological innovation. The energy transition will accelerate if we allow market forces alone to dictate the winners of capital. Management teams who provide responsible financial performance and objective/material quantitative ESG disclosure will be best positioned to provide broader energy optionality for global stakeholders. History has taught us that competition and the continual pursuit of market efficiencies and valuation premiums have not failed technological innovation.
As the chart below highlights, the energy transition will require approximately 50x the capital of the Dot-Com era27. If the world chooses to be intellectually honest about decarbonization, then fossil fuel companies are only going to be capable of innovating if they are awarded massive amounts of capital. However, capital awards should only go to those who display the greatest degree of improvement and optimization while simultaneously offering financial return and pragmatic capital allocation.
The Energy Transition is projected to cost – $150T over 30 years, Chart Source28
The extent and magnitude of trust must also dramatically increase. Regaining much of the trust in the legacy energy sector is largely contingent upon the quality and breadth of quantitative data provided, along with the willingness of management teams to take ESG seriously and provide what they can. In other words, embrace the proverbial “marathon” since the energy transition will take several decades, not years, to complete.
The pursuit of long-term capital should emphasize a lessening of qualitative superlatives and reliance on superficial accolades. Management teams who continually combine trending, material ESG-related data with consistent, responsible financial performance will rise the tide across the industry. In short, the intensified standard management teams are held to should incrementally improve their respective measured disclosures and corresponding thoughtfulness of disclosure.
Action Items – What is required to regain trust?
At its core, we feel the underlying culprit hindering the expansion of capital access for energy centers on trust. Regardless of hydrocarbon’s economic necessity, a substantial percentage of the public, including investors, have lost faith and trust in the industry. The argument over fossil fuels should not be debated within a binary context (i.e., eliminate or keep). Rather the industry must systematically revise how the narrative is conveyed. Specifically, the energy space needs to align with the world’s increased desire for quantitative measurement and trending data analytics. Let the data which represents the material attributes of the business do the talking.
At the same time, let’s place less weight and emphasis on the divestment crowd and focus more on constructive engagement. While it is unreasonable to expect 100% of the population to agree, we feel both legacy energy and energy transition can successfully attract incremental capital from the pragmatic middle through the execution of the following action items:
- Energy company investor messaging requires a three-pronged approach:
a) Providing retrospective financial and corresponding material ESG-related trends
b) Conveying a forward-looking strategic narrative that thoughtfully implements how the business is going to evolve along with how “evolution” is going to be quantitatively measured
c) The continual need to objectively educate – the outside world, including the proponents of divestment, does not understand the complex nuances of the business’ value drivers. Plans addressing how to compete & adopt decarbonization strategies must be concisely delivered, and most importantly, bottom-up drivers of the business should be identified both qualitatively and quantitatively
- Capital market participants should broaden eligibility, but not guarantee, access to capital among energy companies:
a) Eliminating eligibility to capital due to the nature of the business as opposed to its individual forward-looking strategy is counterproductive in the long run
b) Capital flows should not be a function of idealism or political orientation, and let’s stop the attempt to rebrand or rename “ESG” purely for the sake of realigning its conceptual purpose with self-interested agendas
c) Strategic focus should center on where raw materials can be responsibly produced at the lowest possible all-in economic costs, including the long-term potential of carbon considerations, namely anticipated or potential taxes. The proxy for responsibility should require incorporating material ESG considerations into that analysis
- Trust issues reside on both the private and public sides:
a) Both realms equally require the proactive conveyance of material quantitative data to complement the forward-looking strategic narrative envisioned by management teams
b) ESG-related disclosures should be organized according to a thoughtful “bottom-up” infrastructure that represents the competitive drivers of the business
c) Incrementally adding material quantitative disclosures that showcase consistency and trend is imperative
- The economic and societal necessity of hydrocarbons distinctly implies businesses should not be apologetic for the nature of their business:
a) Reimplementing trust and investability among stakeholders is an unequivocal requirement and entails incrementally improving the degree of thoughtful and quantitative transparency provided
b) The context supporting trending data highlighting the objective magnitude of respective strengths and weaknesses of the company should provide reasoning and trend, not spin
c) Take the added step of educating and not preaching to the audience – relative to the other industries, the entire spectrum of energy is by far the most complicated and misunderstood. Evolve to a position where you can eventually allow the data to do the inherent talking
- Energy company management teams must systematically report progress on innovative capabilities and quantitatively measure technological prowess:
a) The legacy energy space should establish “core” ESG considerations based on the individual company-specific, bottom-up differentiators
b) The defensive mindset of energy (which is understandable given the variety of existing biases) must be replaced with continually educating energy outsiders using ESG-related considerations
c) The energy debate should be a battle for the middle, not a campaign to win over the permanent detractor. The detractor/divestment crowd has showcased a distinct desire not to be objective. Investors seeking return will flock to those who provide it – distinction amongst performers, in part, will derive from those whose story is easiest to understand and who provide the best material data
Conclusion – Establishing Common Ground to Rebuild Damaged Bridges
Vilifying the fossil fuel industry and pushing divestment strategies to expedite the energy transition is not going to work. Building out the oil and gas industry and expanding energy optionality are not mutually exclusive considerations. For the sources of energy optionality to reliably expand, the capital markets must figure out how to responsibly invest in viable technologies that simultaneously offer an attractive ROI. Who specifically develops those technologies should not necessarily be the first attribute which deters investors from providing capital. More importantly, the “penalty box” should be the result of poor execution, lack of strategy, or undisciplined capital deployment rather than idealistic desires and political motivations that do not incorporate economic realities. The expertise housing decarbonization implementation lies within the fossil fuel industry. Without their inclusion and participation, the successful execution of the energy transition will prove much more difficult.
That said, it is in a way understandable why certain hesitancies aimed at legacy energy exist today. The entire energy spectrum must continue to rebuild trust and confidence among investors while systematically revising incentives and accountability. Capital discipline, thoughtful forward-looking messaging and increased ESG transparency will aid in rebuilding previously lost faith. At the very least, legacy energy companies should strive to become foundationally “bi-lingual” and learn the vocabulary of the sustainability professional. Macro policy alone, i.e., inflation, market cycles, and impending interest rates, will force investors in pursuit of alpha to at least reconsider investment within the space. The companies who have already prepared thoughtful quantitative ESG-related data and disclosures will most likely receive an increased “benefit of the doubt” since they are best positioned to mitigate claims of climate hypocrisy against investors.
At the same time, accurate, fair, and objective data, not skewed or idealistic political beliefs, or unfounded preconceptions, should fundamentally influence how material progress is monitored. Moreover, proponents of fossil fuel divestment must implement a greater degree of intellectual honesty and economic reality into their respective assessments. Investors are not in the business of assuaging guilt. Introducing new frameworks, acronyms, or calling ‘ESG’ something different is also a waste of time. Instead, functional advancement will result from a portfolio decision-making protocol that mandates attractive financial performance while simultaneously holding management teams to the highest standards.
Constructive guidance and desired mandates only occur through ownership and collaboration – not isolation and skewed vilification. Management teams who devise innovative capabilities in a responsible, disciplined, and maintainable fashion will be rewarded more than those who do not. In other words, the best influential driver of behavior derives solely from competitive pressures – but competition, and future potential for that matter, are inherently capped without ample investment. Needless to say, divestment strategies are short-sighted, counterproductive, and riddled with a variety of harmful financial and societal implications.
The energy transition will inevitably falter if the capital markets do not institute a distinct level of aggressive patience that responsibly facilitates functional innovation among fossil fuel companies. Execution and innovation are largely contingent upon the quality and consistency of capital flows within the space. Simultaneously, a management team must showcase a distinct level of capital allocation discipline, meaning expectations associated with energy optionality expansion must remain pragmatic and economically realistic. Allowing the vast amount of “noise” to remain in the market only panders to the lowest common denominator of energy detractors and will ultimately prove counterproductive in the long run.
Fossil fuel divestment is littered with harmful corollaries and adverse ripple effects that will predominantly harm the most vulnerable. At the same time, management teams should be pressured and expected to provide material, trending data that validates and complements the strategic directives of the company. Success, namely expanding reliable and affordable energy source optionality without sacrificing financial return (i.e., the responsible balance), is only possible if trust, accountability, capital, and technology remain the epicenter of stakeholders’ collective focus.
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13Pickering Energy Partners internal analysis, BloombergNEF
15The analysis utilized the “ESG Industry Materiality Map” located on MSCI’s website – https://www.msci.com/our-solutions/esg-%20investing/esg-industry-materiality-map#
25Pickering Energy Partners Insights research
26We are not referring to any research piece or periodical, but instead utilizing “moral” in a broader conceptual sense
27CNNfn and Birinyi Associates, RystadEnergy, BloombergNEF, and the International Renewable Energy Agency (IRENA)
28Pickering Energy Partners Insights Research