Fight, flight, freeze or fawn?

17 Nov 2021 |Royal Dutch hell, carbon's tokenisation treatment, woke MBAs, and oil's record cost of capital. Plus, the divest/engage dilemma gets tricky.

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🌐 For a COP26 recap, check out this thread. Really big picture? Governments and investors face the same hurdle. How do you get countries/companies to fall in line in a system that encourages leaders to prioritise national/capital interests on said line?

💸 Institutions like the AIIB want to level the Global North/South divide by deploying capital to developing-nation climate projects, arguing financing—not support—will attract investment and drive “the biggest reallocation since the Industrial Revolution.”

⚖️ Good news: Article 6 rules for a global carbon market are here, with one framework for businesses, another for countries. Bad news: A 5% levy for developing markets hits only the former, and millions of poor-quality Kyoto-era credits escaped cancellation.

🌳 As the carbon market takes off (NNIP gets credits! ABP gets credits!), one area to watch is blockchain, where offsets are getting the tokenisation treatment. At the forefront is Klima DAO, which just accumulated 9M tonnes (worth $100M) of offsets.

🔀 A new study says engage, don’t divest, arguing 1. The impact on cost of capital is almost meaningless, 2. Where meaningful, it negatively affects ‘clean’ vs. ‘dirty’ returns, 3. If you sell dirty stocks, someone who doesn’t care about ESG will buy them.

📊 But divestment is affecting the energy market, where cost of capital is now 20% for long-cycle offshore oil vs. 3-5% for renewable infrastructure(!). The fossil-fuel exodus = steep financing + depressed valuations, while smoothing the path for renewables.

📚 Business schools are getting woke. Last week, eight leading European institutions launched the Business Schools for Climate Leadership; in the US, the NYT reports MBA programmes are responding to a jobs surge by building ESG into courses.

🎓 The ‘why’ is obvious. More interesting and less obvious is the ‘so what’. Matt Levine calls it a story of intellectual frameworks: History shows education—more than even constraints and incentives—shapes the way business leaders run their companies.

🚢 Headlines identified two ESG blindspots this week. First up: supply chains, although progress arrived in the form of the first ever proposal for global sustainable trade finance rules. The ICC’s guidelines may hit networks and supply chains in 2022.

🇨🇳 Second up: the $128T bond market, of which just $1T finances sustainable projects. Meanwhile, foreign investment in China is hitting record levels—and no wonder, given the yield available to the 84% of asset managers with no sovereign bond policy.

Util in the news

🎙️ “Understanding a company’s impact requires a lot of analysis. But even a perfect human has limits in what they can cover, and then there are the limits of being human and prone to biases.” So, how do you do it at scale? Util CEO Patrick Wood Uribe joins S&P Global’s Essential Podcast to discuss our solution: AI.

🗞️ Private capital is key to meeting emissions targets, but Morningstar points to our latest study as evidence markets first need strict reporting and “quantifiable metrics of impact.” There’s “no excuse” for both ESG and non-ESG fund groups scoring negatively on SDG13: Climate Action (-5.9% and -10.6%, respectively).

Chart of the week: Royal Dutch hell

Football didn’t make it, but Shell is coming home. Depending on who you ask, it’s a story about share structures, or taxes, or climate activism, or a bit of everything.

Shell says the restructured UK-based organisation will be “simpler for investors to understand and value” and more on track to meet net-zero emissions by 2050.

Shell's 'room for improvement'

Behind the scenes, two catalysts arrived in the form of divestment and engagement.

Dutch pension fund ABP pulled back from Shell after failing to persuade the fossil-fuel sector to rapidly decarbonise. Just a couple of days later, activist investor Dan Loeb’s Third Point suggested Shell split into two standalone companies: one comprising liquefied natural gas and renewables; one housing the legacy energy business, including upstream, refining, and chemicals operations.

For its own part, Shell contends it needs the legacy business to fund renewable development. Given the investor pressure from all sides, however—not to mention its current environmental footprint—it needs to move in more ways than one. Fast.

Story of the week: Should you stay or should you go?

It’s a perennial question for ESG investors: Divest or engage?

Of course, there are more recourses than the two adopted by Norway’s GPFG and Japan’s GPIF, respectively. To borrow from the sympathetic nervous system, you can:

  • Fight: I can effect change. Engage and vote. Tell everyone.
  • Flight: Management won’t cooperate. Divest. Tell everyone.
  • Freeze: I like the returns, but not the publicity. Leave to activists.
  • Fawn: I like the stock. Snap up unloved shares at a discount.

While fawning may not be ammunition for larger, more accountable asset managers, it should be on their radar. Why? It informs the efficacy of fighting and fleeing.

Or so suggests a new study, The Impact of Impact Investing, which outlines four arguments for engagement over divestment:

  1. The impact of divestment on cost of capital is negligible. To effect a 1% change, impact investors must comprise 80% of investable wealth. Better to exercise rights of control to change policy.
  2. Where divestment has a meaningful effect, investors miss out on returns. When you sell dirty and buy clean, you move prices accordingly. If there’s more upside in dirty stocks, you also reward the fawners.
  3. When you sell a dirty company, a fawner will buy it. Probably at a low cashflow multiple and big discount. Probably without a care to ESG, making them less likely to apply pressure that could force change.

In the energy market—the lightning rod for this debate—point (2) is already happening. If the cost of capital is indeed 20% for long-cycle offshore oil vs. 3-5% for renewable infrastructure, the expected returns of the former prove attractive to hedge fund managers under less pressure to conform than their mainstream counterparts.

Meanwhile, writing from COP26, Investment Week’s Kathleen Gallagher reported that several heads of responsible investing spoke of a personal wish to divest vs. a fiduciary obligation to engage, presumably to avoid leaving returns on the table.

It’s not always easy to walk away. And, while often dismissed as a soft option, engagement insulates against financial risks and price shocks. Equally, it’s not limited in scope—though perhaps by ambition.

Engagement has been criticised for a perceived tilt towards risk mitigation rather than positive outcomes, with investors focusing on sector-specific governance issues. Critics say it’s heavy on words, light on action. It doesn’t have to be.

Armed with more granular and scientific environmental data, investors locked into engagement can change the entire impact—rather than just ESG profile—of their holdings by looking beyond a company’s relative Scope 1 and 2 performance. Absolute Scope 3 impact, and particularly the social and environmental effects of products, should be the locus of investor activity. For those disinvesting, it already is.

Two words were used a lot at COP26: Pot (total capital aligned to target) and piping (how it reaches that target). Engaging or divesting is a function of what you want to achieve, approached via orthogonal directions. Same pot, different pipes.

Gallagher concludes that transparent data will be the most powerful tool for investors. To apologetically extend a tired metaphor, impact data could be the whole plumbing.

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