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This strategic implementation of ESG requires a significant number of resources. The unprecedented nature of the ESG evolution represents a distinct challenge for management teams. The cost-benefit analysis associated with ESG integration is speculative, rather than substantiated. It is clear, however, that access to the capital markets requires a deliberate approach to ESG. As companies prepare for the coming year, we feel there are five key factors management teams need to consider.
The information influencing portfolio construction, insurance underwriting, and debt financing increasingly relies on ESG-related data and many existing data sets are either incredibly skewed or rooted in a flawed methodology. The energy space must come to terms with the fact that the majority of externally controlled ESG data influences access to capital. In other words, the energy sector lost the proverbial battle for data supremacy a long time ago. Ongoing access to quality pools of long-term focused capital is contingent upon the perceived strength of any given ESG profile. Establishing economic reality has been a struggle for the space due to the complexity of the sector – ESG adds to its relative intricacies.
Reactively telling the story (or not communicating it at all) allows the narrative to be controlled by entities and individuals that do not understand the unique underlying business model and/or are biased against sector overall. Moving forward, it is critical to construct a custom bottom-up reporting infrastructure that provides the opportunity to consistently track and monitor material quantitative data.
The current perspective dictating the external assessment of energy was seized by their energy detractors a very long time ago. These groups have been incredibly successful in conveying the message that fossil fuels should be eliminated without addressing the societal and economic ramifications of such a decision. The traditional rebuttal to this argument is generally centered on the moral case for affordable energy. This rebuttal, though accurate, has experienced little success. The moral case for energy is also not what investors need to validate entering or maintaining an investment. We agree with the moral case for affordable energy. However, it does not address the specific risk management and/or due diligence related considerations investors must answer.
Energy detractors should also not be ignored, but management teams should rethink how to allocate resources around their specific messaging. Rather than wasting resources to change the detractor narrative, focus on pragmatic investors interested in how an energy company plans to remain disciplined with their capital allocation strategy in a decarbonizing world. In other words, operating on the opposite ends of the debate spectrum will result in little progress. Engaging with “the middle” investors requires establishing a custom reporting infrastructure that communicates trends in material data points.
The desire to immediately eliminate fossil fuels is not a practical option. Energy can invest in renewable technology and create energy efficiencies, but immediate elimination of fossil fuels is not economically feasible nor is it socially acceptable. The energy ecosystem will transition over the course of decades, with the contribution of the traditional energy participants.
The irony of the detractor movement lies with the attempt to cut off access to capital for the groups best suited to execute the energy transition. Entities that exclusively focus on immediate fossil fuel elimination can be conceptualized as a “sledgehammer”. While energy companies have not been the most responsible stewards of capital historically, basing a proposed strategy on idealism is counterproductive.
The only way to execute the energy transition is through disciplined technological innovation over time, which requires vast amounts of capital. Competing in a decarbonizing world while simultaneously showcasing capital discipline is required to access long-term capital. “Sledgehammers” choose to focus exclusively on virtue signaling, while “bridge builders” attempt to match non-fundamental trends with financial characteristics to better understand risk.
Construct and align your narrative and disclosures in accordance with the “bridge builders” mentality. Investment exists on one island while energy endures on another – the bridge that connects them is a quantifiable data infrastructure that tracks progress. Simply put, to engage these investors, companies must be able to provide quantitative support, i.e., baselining, measurement, and benchmarking. There is an opportunity to access larger pools of capital by educating the “bridge builders” without acquiescing to the sledgehammers.
Relying on anecdotes, superlatives, and qualitative disclosures will no longer appease external stakeholders. As the greenwashing risk becomes a regulatory focal point, validation in the form of supporting data will be expected. The SEC has identified climate risks as a priority and pledged to require companies to be more transparent about their social and environmental disclosures. The agency has consistently stated that it plans to propose rules that mandate certain disclosures, such as carbon emissions, to help investors assess climate risks across many different businesses. As a result, asset managers will be forced to validate these disclosures.
An ESG story is not decision-useful unless it meets a distinct disclosure standard. The underlying business model does not singularly determine investability based on ESG. Effective messaging and disclosure institutes an approach that is both sector and framework agnostic. The key frustration plaguing framework reliance is that frameworks were built from the top down. Bottom-up analysis is required to differentiate disclosure and convey economic reality. In practice, metrics indicated for other industries will apply to the competitive differentiators of a business. This means companies must be not only framework agnostic but provide disclosure that transcends sector. It also means the utility of sustainability reports centers on a due diligence review as opposed to a marketing document.
The goalposts of ESG evaluation are continually shifting. Taking a step forward only to take two steps back has burdened all sectors for the last five years. An effective ESG strategy is founded upon the ability to be agile as opposed to starting from the bottom with each change. In other words, ESG is a data management exercise requiring a disciplined infrastructure. Just as with building a house, the foundation must be set before the roof. Disclosure and data expectations progress with the growth of the business and industry. Falling behind the evolution in ESG data and disclosure will significantly restrict access to capital. To maintain and expand access to capital, companies must plan for ESG reporting to be an annual consideration, similar to financial reporting. And like financial reporting, consistency and proactive messaging are critical.
For more information, contact rracz@pickeringenergypartners.com.
