This article is an extract from a detailed post that initially appeared in Enterprising Investor
ESG considerations have enjoyed a strong tailwind of late. Regulatory and market forces have played significant roles in that growth.
Investors have different investment strategies and time horizons that influence capital allocation decisions. But ultimately, the combination of market forces, government action, and corporate transparency should help determine the optimal path.
Environmental, social, and governance (ESG) considerations are increasingly influencing capital allocation decisions across the spectrum of sources of funds. These interconnected indirect pressures may result in calls for greater transparency into the financing of legacy oil and gas asset acquisitions.
For example, credit rating agencies are explicitly integrating ESG considerations into fixed-income ratings. Asset managers face mounting regulatory interest in how they market “green” investment vehicles. Asset owners are making formal ESG commitments to the Principles for Responsible Investment (PRI). The risks associated with climate exposure in bank lending portfolios are drawing scrutiny from investors and regulators.
These factors could present growing challenges to prospective buyers of large extractives company assets as they seek capital through these channels.
Credit Markets
S&P reduced credit ratings on Exxon Mobil, Chevron, and ConocoPhillips in February 2021, in part citing “growing risk from energy transition due to climate change and carbon/GHG emissions.” This followed an earlier, broader warning that the industry faces “significant challenges and uncertainties engendered by the energy transition.” Other leading credit rating agencies have also integrated ESG factors into their credit analyses.
A business seeking to finance an oil and gas purchase with rated public debt might confront similar considerations in any rating assessment and, consequently, higher borrowing costs.
Conversely, rising interest in ESG has led to significant growth and more favorable credit costs for green and sustainability-linked bonds. Many such loans are indexed to specific metrics.
The SASB Standard for Oil & Gas Exploration & Production, for example, has a metric that asks companies to discuss “long and short term strategy or plan to manage Scope 1 emissions, emissions reduction targets and an analysis of performance against those targets.” Such corporate disclosures can help investors better assess the risks associated with different transition strategies.
Bank Debt
Sixty of the largest commercial and investment banks funded nearly $4 trillion in fossil fuels since the signing of the Paris Accord, according to “Banking on Climate Chaos 2021.” This indicates a continued source of capital to finance acquisitions in the extractives industry. However, added demands for transparency, in conjunction with the underlying fundamentals, could spark change.
Global central banks have concerns about climate risks embedded in bank loan portfolios. Near-term this means they are mostly gauging the problem and compiling data. But many central banks appear to be trying to guide their financial systems towards green energy. As such, their policies could exact a toll from US firms with overseas operations.
Banks are responding. “We acknowledge we are connected with many carbon-intensive sectors,” Val Smith, Citi’s chief sustainability officer, wrote. “Our work to achieve net zero emissions by 2050 therefore makes it imperative that we work with our clients, including fossil fuel clients to help them and the energy systems that we all rely on to transition to a net-zero economy.”
Indeed, as “Banking on Climate Chaos 2021,” noted, while overall lending continues, UBS, among other banks, has reduced fossil fuel related activity by nearly 75% over the period.
Investor-led initiatives could also focus more scrutiny on access to bank capital. In January, 15 institutional investors representing nearly $2.5 trillion in assets filed a resolution coordinated by ShareAction requesting HSBC “publish a strategy and targets to reduce its exposure to fossil fuel assets, starting with coal, on a timeline consistent with the Paris climate goals.” In June 2020, a Chinese bank walked away from financing a $3 billion coal plant in Zimbabwe. In fact, more recently China has pledged to stop building coal facilities abroad.
The SASB Standards include climate and ESG topics and metrics that reflect the potential financial impacts of loans and investments to industries exposed to transition risk, including several financials industries. The SASB Commercial Bank Standard, for example, asks companies to disclose a breakdown of credit exposure by industry and for a “description of approach to incorporation of environmental, social and governance factors into credit analysis.”
Private Equity
Private equity (PE)-backed ventures have purchased assets from oil and gas majors. These PE firms are not immune to ESG considerations. More and more PE limited partners are embedding ESG into their capital allocation processes. Several have committed to the PRI and markets are increasingly holding firms accountable to these pledges. Furthermore, the Institutional Limited Partners Association industry trade group has incorporated ESG as a core focus.
Separating ESG from fundamental financial considerations is becoming harder and harder. PE funds are directing capital to such fast-growing sectors as solar, carbon capture, and battery storage. Indeed, renewable energy asset funds are raising about 25 times more capital than their fossil fuel counterparts. Some observers have suggested the supply of capital to the traditional energy sector could be drying up.
Recognizing these challenges and opportunities, a group of asset owners representing roughly $4 trillion in assets have launched an effort to share and aggregate select ESG data for closely held companies with participants noting a need for transparency into how these companies are managed.
SASB and other reporting standards reflect these mounting and related needs and are being put to widespread use across private markets. Several case studies have demonstrated how these markets have employed SASB Standards.
Asset Owners and Investors
Many asset owners and managers have signed on to PRI. Given such long-term obligations, pension fund investors, among others, may prefer to avoid transition-exposed assets and gravitate to companies they perceive as better positioned for the energy transition.
Investors and asset owners are not homogeneous. Each has their own strategies, benchmarks, and portfolio needs. While some may steer clear of “dirty” assets, others might see upside to acquiring equity in “ESG laggards” that can improve their performance, engaging with management to identify and execute on business opportunities, or investing with a shorter time horizon in oil and gas markets.
Anglo American, for example, spun off its South African coal mines into a separate company rather than sell it outright. The firm’s leadership recognized that its shareholders had differing perspectives on coal. By executing a spin, Anglo afforded investors the option to hold, divest, or grow positions according to their own investment priorities.
Asset owners need transparency and data to assess these decisions. Even when a company exits certain oil and gas assets, it may retain financial liabilities. A US federal judge recently ruled a bankrupt privately held energy company could pass on environmental liabilities from aging wells. BP and Exxon could each face $300 to 400 million in costs to decommission these wells and insurers could be liable for more than $1 billion. Given the potential financial exposure associated with legacy / sold liabilities, investors might want to engage with management to better understand their asset disposal strategy and how they might contain such risks.
The Reserves Valuation & Capital Expenditure topic in the SASB Oil & Gas Exploration and Production Standard can help investors understand these exposures. This topic asks companies to discuss the sensitivity of hydrocarbon reserves to potential future carbon price scenarios as well as investments in renewable energy and how price and demand for hydrocarbons and climate regulation could influence their capital expenditure strategy.
Insurance
Access to insurance may pose another hurdle for buyers of legacy oil, gas, and mining assets as the financial system acclimates to the transition. Some have speculated that the insurance industry could be the downfall of fossil fuels given climate change–related issues and how the switch from carbon to renewable energy could affect portfolios. This speculation is not idle: Some insurers, including Lloyd’s of London, have committed to no longer sell insurance for some fossil fuels.
In the mining sector, an Australian mine faced challenges securing insurance; BMD Group was among more than a dozen firms that warned that lack of financing because of ESG considerations could destroy Australia’s $20 billion coal export sector.
SASB’s Insurance Industry Standard can help assess such scenarios. Metrics under the topic Environmental Risk Exposure ask companies how they incorporate environmental risks into their underwriting process and their management of firm level risks and capital adequacy. The Insurance Standard also includes metrics related to the incorporation of ESG considerations into investment management.
