The relevance of ESG
No business can now afford to ignore Environmental Social Governance (ESG). From the investor perspective, today’s financiers are aware that strong ESG performance is linked with stronger operational performance and higher returns.
Since the Covid-19 outbreak and the associated economic downturn, ESG funds have surprised us, often out-performing traditional investments. In addition, asset managers note a sustained growth in calls from investors for companies to disclose on ESG factors that may have an impact on long-term valuations.
Companies performing well against ESG requirements/ metrics are rewarded by the market, both in terms of access to capital and how they are valued. This is vitally important for companies looking to list (e.g. through an IPO) or selling out to Oil & Gas (O&G) major.
The annual asset manager survey by Russell Investments shows a growing appetite for responsible investing. ESG integrated in to the way companies do business is now essential to investors analysing long-term investment opportunities. Of the three reporting elements, Governance remains the dominant, but this differs by industry. For example, reporting on Environmental performance and impact(s) is more material to the energy sector.
The CEO of Blackrock, Larry Fink, writes an annual letter prior to the WEF event in Davos, Switzerland. In 2020, he advocated strongly for radical change and began a process to start voting against management and boards if they do not demonstrate “making sufficient progress on sustainability-related disclosures and their business practices and plans underlying them.” Whilst Fink is referring to large publicly listed companies, the knock-on effect is finding its way to smaller specialist investors and venture capitalists.
Over time, companies and countries that do not respond to stakeholders and address sustainability risks will encounter growing scepticism from the markets, and in turn, a higher cost of capital. Larry Fink
ESG in the Oil & Gas sector
The writing is on the wall, adapt and change or be left behind. In a recent FTI Consulting survey (2020 Resilience Barometer™), interviews with C-suite executives, “reaffirmed the growing relevance of ESG and sustainability issues for companies. 81% of leaders surveyed admitted that their company is under pressure to improve their ESG offering, with 28% saying they were under ‘extreme pressure’.”
In my discussions with investors in the energy sector, there’s a recurring theme, “nobody is willing to deploy capital in oil projects for more than five years.” With uncertainty surrounding oil demand and price, investor tastes are changing, and it seems increasingly unlikely that greenfield projects will appear on the menu.
Managing finance risk – the role of IFIs
The International Finance Institution (IFI) sector has always been an important source of financing in large oil and gas projects—both upstream and midstream. Their ESG assessment processes have always been rigorous and therefore time consuming but IFI compliance fulfils a vital role in effective risk management. IFIs’ strict project assessment is trusted and critical to securing wider investments from commercial lenders providing cover for construction risk.
“Good ESG performance is vital for securing investment” Namrata Thapar, the IFC’s Global Head of Mining
Let’s take a look at the Trans Adriatic Pipeline as an example. It’s a highly strategic project and forms part of the Southern Gas Corridor. It’s supported by the European Commission, leading European Governments and the US Government. The project needed the European Investment Bank (EIB) to be the anchor lender for a loan concluded in Feb 2018. This provided the required risk cover for the consortium of 17 commercial lenders to close their financing in Dec 2018.
ESG importance on the rise as oil & gas makes the transition
“Investors are increasingly scrutinising oil & gas companies through the lens of environmental, social and corporate governance (ESG) factors, as momentum builds behind efforts to promote clean energy, sustainability and the energy transition.
Pressure has increased particularly quickly over the past year. In March 2019, Norway’s Government Pension Fund Global (GPFG) announced it would sell off around £5.7bn worth of stocks held in oil & gas exploration & production companies that have, so far, failed to invest in renewable energy. In the days following, the combined market capitalisation of Tullow Oil, Premier Oil, Soco International, Ophir Energy and Nostrum Oil & Gas fell by around £130m or 3 percent. While the drop alone is perhaps unremarkable, the Norwegian fund’s move is the rather large tip of a much bigger iceberg.
PenSam, a £13bn Danish pension fund, has removed 100 oil and coal companies from its portfolio over the past three years, with the latest round of cuts in July targeting oil companies, including US-based Hess and Marathon Oil and Austria’s OMV. Both GPFG and PenSam retained stocks in BP and Royal Dutch Shell, which invest in renewable energy technologies, as if to show the companies whose stakes have been divested that the secret to continued investment is embracing cleaner energy solutions.”
A critical development announced in 2019, by the EIB President Werner Hoyer prompted the extractive industry to urgently reassess. He said, “We will stop financing fossil fuels and we will launch the most ambitious climate investment strategy of any public financial institution anywhere.” The European Bank for Reconstruction and Development (EBRD) followed saying the same. And in September 2020, the International Finance Corporation (IFC) introduced new climate change conditions for its investments in commercial banks to encourage the lenders to wind down support for coal projects. The IFC already excludes coal-related investments from its loans
Regulation, reporting and standards
More widely, it’s possible to find examples of institutions discussing the introduction and coordination of new regulation, reporting requirements and standards relating to sustainability and ESG reporting.
In the UK, the Bank of England (BoE) recently implemented recommendations made by the Task Force on Climate-related Financial Disclosures (TCFD) which aim to help businesses and other organisations to communicate climate related risk. According to the BoE, loan exposures to fossil fuel producers, energy utilities and emission-intensive sectors amount to around 70% of the largest UK banks’ common equity Tier 1 capital. For UK insurers, portfolio exposures in ‘high-carbon’ technologies form around 12% of equity, and 8% in corporate bonds.
Further, in a recent discussion paper, the UK’s Financial Reporting Council (FRC) believes that, in order to tackle current confusion and fragmentation, ‘non-financial’ reporting should be placed on a similar statutory footing to financial reporting.
“Non-financial information is becoming increasingly important and there is an urgent need for comparable information in this area.” Sir Jon Thompson CEO Financial Reporting Council
And, a coalition between Bank of America (BofA), the big four accounting firms, and the World Economic Forum, developed a framework for global ESG standards. The International Business Council (IBC) outlined 21 non-financial metrics to measure how well companies are addressing issues ranging from the gender pay gap to environmental protection.
“We want to set a benchmark with the IBC work so that we can have metrics that are completely transparent to the world from all companies,” BofA Vice Chairman Anne Finucane
O&G faces an existential question
In simple terms, the cost of capital is increasing and the pool of capital is declining. More projects are chasing a smaller amount of more expensive money.
In order to access cheaper capital, companies will have to:
- Resort to speculative funds with ‘triple margins’
- Secure equity-based deals instead of debt financing as investors seek greater control and risk management
- Accept that debt financing of greenfield O&G projects is now almost impossible.
The financing forecast looks gloomy, and it’s meant to be, but an energy transition is already in full swing as a response, and the Covid-19 pandemic provided an added impetus.
What’s the good news?
A new lending instrument referred to as a sustainability loan (SL), or also known as a positive incentive loan has recently come on stream. This instrument requires the borrower’s compliance with pre-agreed sustainability performance targets (compatible with a borrower’s disclosed Corporate Social Responsibility strategy).
Sustainability loans do not preclude accessing debt for the O&G sector. Howeverthe cost of loans will typically depend on factors such as the degree by which a company improves its ESG performance, and its ability to meet various ESG and sustainability targets over the duration of the loan—linked to a company’s overall ESG profile.
Amidst a shrinking finance offering, there is however some surprising data. The Banking on Climate Change 2020 report, which tracked data on 35 private financial institutions, shows the world’s largest banks have invested $2.7 trillion into fossil fuel industries since the 2015 Paris Agreement. Though there was a fall in investments immediately after the Paris Agreement, however, researchers found that in 2019 those investments shot back up by some 40%. The largest recipients have been North American firms such as Oxy, Enbridge and TC Energy. In part, this may be due to President Trump’s relaxation of environmental laws governing O&G licencing—especially for tar sands, fracking and large pipelines traversing environmentally and culturally sensitive habitats.
This picture would likely change if former Vice President Joe Biden wins the US Presidential election for the Democrats. The Financial Times, shows the extent of the hit the energy sector has taken. In spite of a stable oil price around $40 per barrel, energy stocks on the S&P500 almost halved in value to $598 billion since the start of 2020 – making energy the worst-performing sector in the US this year.
The future is ESG, with or without you
The facts:
- Investors demand transparency on ESG metrics
- The cost of capital is directly linked to ESG performance
- O&G companies operating without ESG are being de-rated by investors
- Shareholders and investors use divestment, or the threat of divestment to hold a company’s feet to the fire
- The O&G industry has to respond to the ESG trend to survive in the medium to long-term.
In my next blog, I will examine how ESG factors should not be seen as an add-on to your business, but integrated, as part of prudent risk management.
About the author
Michael Hoffmann advises on geo-political risk to guide market-entry strategies, stakeholder engagement, mergers and acquisitions and sustainable impact investment. Michael formally held senior external affairs roles within BP and was a director of the Trans-Adriatic Pipeline (TAP).
