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What does Big Oil want?

15 Aug 2022 | Clean energy gets a boost. Disclosure frameworks face off. Plus: Has Big Oil found its Big Heart?

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🇺🇸 On Friday, President Biden’s Inflation Reduction Act received final approval from US Congress. At the heart of the sweeping climate and healthcare bill is $370B earmarked for climate solutions over the next 10 years, aimed at moving consumers and companies from fossil fuels to clean energy. Spending, tax credits and loans will bolster investment into, and uptake of, clean-energy technology, energy efficiency, emissions reduction, air pollution controls, and climate-friendly agriculture. Independent analysis shows it could slash US emissions 40% by 2030 from 2005 levels. But climate change mitigation is a global effort. And, last week, Beijing suspended bilateral talks with the US on climate change in response to Nancy Pelosi’s Taiwan vacay. Policy cooperation between the two highest-emitting countries isn’t the only casualty of “letting geopolitics be the tail that wags the climate dog.” The US’s clean-energy ambitions depend on access to rare earth metals, on which China has a near-total monopoly. In an effort to end its dependence, the US is scaling up its own mining, processing, and refining operations — but those projects take a long time. Even longer to train an entire workforce. And a decade is not very long.

⚖️ Investors are one step closer to a global disclosure framework. The consultation period has closed for two proposals left in the ring: the IFRS Foundation’s ISSB Climate and General Sustainability-Related disclosures (Team Single Materiality); and the EFRAG European Sustainability Reporting Standards (ESRS) (Team Double Materiality). “It is an exciting time in the world of setting standards for sustainability reporting,” enthuses Robert Eccles, who goes on to squeeze “fascinating” and “accounting” into the same sentence. The 2,000 responses to both consultations reach a similar consensus: Global standardisation is crucial. But it requires compromise. Feedback urges better alignment between the two: EFRAG is warned of insufficient “interoperability,” and IFRS, criticised for being too light on detail [says ICAEW: If you want companies to disclose “significant sustainability-related risks to enterprise value,” you may need to define “significant,” “sustainability-related,” and “enterprise value”] and on double materiality [says HSBC, which needs no such definition: “Enterprise Value is a backward-looking, lagging indicator unsuitable for the needs of asset owners… [who] need double materiality to inform decision making”].

🏷️ Regulated corporate disclosures will be welcomed by asset managers and advisers grappling with new MiFID requirements, on top of SFDR teething troubles. In its drive to direct capital to sustainable activities, European regulation has moved fast. Too fast, warn fund distributors, now mandated to assess — in addition to risk — the sustainability preferences of clients as part of the existing MiFID II suitability assessment. Responses must be translated into a concrete product offering, which is something of a challenge in the absence of rules dictating how fund providers should communicate Article 8 and 9 funds (due 2023), let alone the Corporate Sustainability Reporting Directive (due 2024) for which ESRS is designed. “The order of the regulations could have been better,” says BNP Paribas. “If first companies disclose their ESG data… asset managers could use them in the construction of [funds], and finally, distributors could assess investor preferences for sustainable investments.” Wary of greenwash accusations, firms are pulling back from product development. “Ultimately,” reports Investment Week, “the firms [with] solid data architecture in place are those [that] will stand against the winds of regulatory change.”

Story of the week: Who’s in charge of the transition?

“ESG investing is not designed to save the planet,” writes Ken Pucker in HBR. “Instead, [set] appropriate boundaries for capitalism and [let] the market innovate to help solve our global challenges.” He outlines four. In brief:

  1. Asset managers need better incentives. “It is naïve and unreasonable to expect investors to put public interests ahead of private interests.”
  2. Regulators must address outcomes. “Regulatory action must shift from input-based disclosures to outcome-based impacts.”
  3. Governments must mobilise public-private partnerships. “The current scale of investment required for the transition is insufficient.”
  4. Companies must address systems-wide change. “A problem like climate does not get solved by cleaning up the home office.”

Capitalism is a nebula of innovation — provided the right blend of incentives are in place. Last week, the US clean-energy bill jumpstarted (3). But all four pillars require urgent attention for it to work. Here’s why.

Oil and wind are different beasts

The rose-tinted view of the energy transition goes something like this: As investors throw money (and governments, subsidies) at renewable companies, their fossil fuel peers will want to take the helm. Putting to good use its wealth of infrastructure, enterprise, and labour, Big Oil will discover its Big Heart and usher the world into a new age.

Proponents point to the recent supermajor shopping spree as evidence. US and EU oil companies have spent billions on renewable acquisitions. Why pay, hand over fist, for companies, brands, and technology for which you have no ambition?

Yet there are few concrete signs of ambition. Despite lofty pledges, companies are investing a fraction of their profits into renewables. Nor has a season of bumper earnings changed spending habits. Oil companies have channelled record profits into record dividends, prompting UN Secretary General Antonio Guterres to accuse the sector of “grotesque greed,” and governments to threaten windfall taxes.

Let’s take first question first. Q1. Why invest in renewables at all?

First, there’s the ROI. Supermajors with a toe in renewables can reap the benefits of clean-energy stimulus and attract kinder shareholders.

Second, they’re not paying hand over fist. “The deals are tiny compared with the tens of billions that would be needed to strike a deal for a ‘green energy major’,” reports the FT. They’re tiny, too, relative to total expenditure. Renewables “continue to be a rounding error in most annual reports,” reports Bright Green. “In 2021, it ranged from 1-4% of spending.”

Q2. If you have them, though, why not scale them?

Here’s a fact frequently overlooked: They do a similar job, but renewable and oil companies are very different types of operation and investment. The former is all about growth, with a product that experiences little price volatility (though it relies on a commodity that experiences plenty of it). The latter is all about value, with a product that experiences high price volatility.

By some estimates, reducing oil returns to the level of utilities would reduce net income up to a third. Meanwhile, renewables require high upfront costs. Early movers, such as Ørsted and Equinor, were able to fund renewable growth by a) selling oil businesses, and b) ‘farming down’, or selling, wind projects to oil majors post development. The margins on both will depreciate as the transition gathers pace.

Of course, fossil fuels are in terminal decline. It no longer makes sense to funnel profits into oil exploration. But if renewables aren’t the obvious replacement for expenditure, what is?

Q3. What about shareholders?

The long-term implications of deserting customers and investors, respectively, means more investment risk and less ESG pressure.

To compensate investors for risk (and secure management bonuses), oil companies are paying it forward with unprecedented dividends and share buybacks. Morningstar finds that, since 2018, dividends have grown by over 50%. Since 2016, they’re up 80%. Most recently, BP promised a $3.5B share buyback and 10% dividend — 10x its expenditure on low-carbon energy this year.

Few shareholders appear inclined to vote against dividends in favour of low-carbon projects (those who would, have, in all likelihood, divested). Can you blame them?

“When the markets are rising 20% a year, people tend to forget about dividends,” T. Rowe Price’s John Linehan told the NYT. “But the longer your investment horizon, the more important dividends are for you.”

There’s a reason Ørsted and Equinor are state owned.

Incentives matter

Here’s what happens if clean-energy stimulus isn’t met with boundaries elsewhere.

  1. Asset managers are judged by their returns, company leaders, by their investors. Result: Companies are incentivised to spend their profits on dividends, not expensive growth projects. Particularly in a volatile market.
  2. Regulation doesn’t moderate company impact, only disclosures — and, if ISSB has its way, only single materiality at that. Result: Companies have no incentive to reduce fossil fuel sales. Particularly if there are fewer ESG shareholders.
  3. Companies need only clean up house to improve public perceptions. Result: Companies are incentivised to buy clean energy companies. Not to scale or sell clean energy. Particularly if doing so comes at a cost to shareholders.

How do you fix it?

Ideally, companies with one foot in dirty and one foot in clean activities would split their operations.

It would reduce pressure on oil companies to be ‘all things to all people’, which can result in the ‘clean’ business being underfunded or mismanaged. It allows the ‘dirty’ business to focus, without distraction, on cashflow, and ‘clean’ business, growth, with profits moving from the former to the latter. It broadens the number of companies to which sustainability-focused talent and investors can flock: an urgent priority for an industry whose capacity is creaking under demand.

Investors could make it happen, as they did with Ford last month. It requires focus on relevant metrics. Absolute capital expenditure — like lofty commitments — is a misleading indicator of intent. The EU Taxonomy, not to mention ISSB, is an inadequate indicator of sustainability. Whether at the point of investment or engagement, shareholders need insight into the real impact of a company’s real business lines.