The Energy Transition: Investing Responsibly

How can investors invest responsibly in the energy sector? The answer lies in encouraging the companies to invest in renewables, adopting challenging net zero carbon targets, and improving the quality of their disclosures.

Introduction

The need for the concerted action on climate change has never been more acute. We are on course to miss the Paris Climate Agreement’s 1.5 Celsius warming target (Figure 1), and current EU efforts to reach a net zero carbon emissions economy by 2050 are also falling behind (Figure 2).

Figure 1. Deviation of Global Temperatures From the Pre-Industrial Mean

Source: BAML; IPCC AR15 Reports – Global Warming of 1.5°C; as of 2018.
Reprinted by permission. Copyright © 2021 Bank of America Corporation (‘BAC’). The use of the above in no way implies that BAC or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of the use of such information. The information is provided ‘as is’ and none of BAC or any of its affiliates warrants the accuracy or completeness of the information.

Figure 2. Current EU Net Zero Trajectory

Source: European Climate Foundation, BAML; as of December 2020.
Reprinted by permission. Copyright © 2021 Bank of America Corporation (‘BAC’). The use of the above in no way implies that BAC or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of the use of such information. The information is provided ‘as is’ and none of BAC or any of its affiliates warrants the accuracy or completeness of the information.

As investors, this poses a challenge to us. Responsibility for tackling climate change is not something the asset management industry can ignore, yet there is great deal of debate as to how it can best contribute. Without a firm consensus, the asset management industry’s efforts have been piecemeal, with managers operating strategies which range from exclusion lists to simply buying stocks which score highly on ESG metrics.

In our view, there is one area in which asset managers can significantly move the needle on climate change. Instead of producing pharisaical portfolios filled with low polluting stocks, asset managers should recognise that they have an unusual power: they own the companies which are the biggest polluters. In our view, asset managers need to use the influence their ownership gives them to encourage companies to reduce their emissions. And the best place for them to start is the energy sector, the biggest polluter on the planet. Indeed, even if one of the worst offenders can be brought into the fold, we believe this will have a far greater impact than if managers concentrate their ownership activities in any other sector.

Why the Energy Sector?

Any serious attempt to combat climate change must focus on transforming the way we produce our energy. The energy sector is by far the largest producer of carbon dioxide in the world economy, producing some 42% of global emissions (Figure 3).

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Source: IEA; as of 2018.
Based on IEA data from 2018, www.iea.org/statistics. All rights reserved.

The International Energy Agency (‘IEA’) estimates that global energy usage will grow by 50% over the next 30 years to 2050. Global energy production is still dominated by traditional oil and gas companies; and on current trajectories, renewable sources – such as wind and solar power – will not develop fast enough to simultaneously replace fossil fuels in the generation mix and fulfil the growth of world energy demand.

Clearly, this situation is not sustainable.

Something needs to change, and it is here that energy companies can make the most difference: first, by shifting their capital expenditure budget away from exploiting hydrocarbons towards renewables and carbon capture and storage technology (‘CCS’). Indeed, the IEA estimates that in order to have any chance of meeting the Paris targets, some USD1.1 trillion needs to be invested in renewable sources and CCS annually by at least 2040. However, the five largest western oil and gas majors have an annual capex budget that is almost 50% larger than the five largest utilities companies involved in renewables. To illustrate this point, Royal Dutch Shell has an annual capex budget of more than USD20 billion, whereas NextEra Energy, North America’s largest renewable company and the world’s largest producer of wind and solar energy, has an annual capex of half that figure.

Secondly, energy firms should be encouraged to commit themselves to a challenging, firm-wide net zero emissions target – giving a specific date by which their business will have no carbon emissions on a net basis.

How Asset Managers Can Help Drive the Change

Encouraging this shift in resources may therefore be the single most effective step asset managers can take to combat climate change. While it relatively easy to identify the need for change, asset managers also need to have a clear idea on how this can be done.

The first step is to have a clear idea of how companies are making progress. As we have already mentioned, examining the distribution of capex spend is one way to check what resources energy companies are committing towards a green transition. Companies’ net zero targets should also be compared, although this can be easier said than done, with variations in wording making it hard to make a direct comparison.

For instance, Shell has a 2050 net zero target, but one which applies only to direct emissions from their own operations (Scope 1) and indirect emissions from energy consumption (Scope 2). In contrast, Total has a 2050 target that also includes all other emissions that occur in the value chain (Scope 3), but is restricted to Europe.

Secondly, it is also important to track greenhouse gas emissions other than carbon dioxide, such as methane, nitrous oxide and Ozone. In addition, it is also important to analyse how much effort energy companies are devoting to developing their natural gas operations at the expense of oil. While natural gas is not a panacea with its own carbon footprint, it provides an important transition stage as renewable capacity is developed and is far cleaner than other fossil fuel alternatives.

This analysis on the potential impact of capex spending and emissions targets provides a holistic overview of companies’ target emission ambitions. By doing so, investors can determine a company’s credibility, both on a standalone basis and against peers. Investors should back firms which perform well or are on a positive trajectory, and encourage management teams to be ambitious on energy transition targets. If this logic is followed to its logical conclusion, ESG investors should have multiple investment options amongst oil and gas firms.

As Figure 4 shows, many European firms have significant renewable energy pipelines which are comparable to those of major utilities. However, US firms have been slower to embrace the need for change, with very few reporting any form of renewable investment at all.

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Source: BofA Global Research. Pipeline 2020-2022.
Reprinted by permission. Copyright © 2021 Bank of America Corporation (‘BAC’). The use of the above in no way implies that BAC or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of the use of such information. The information is provided ‘as is’ and none of BAC or any of its affiliates warrants the accuracy or completeness of the information.

A final change that investors should push for is the wider adoption of impact-weighted accounting, an additional set of disclosures on financial statements to reflect a company’s positive and negative impacts on stakeholders such as employees, customers, the environment and the broader society. This presents a more nuanced view of company performance, allowing investors to gauge a firm’s performance not only on a financial basis, but instead on one which accurately captures the wider impact of its business. By encouraging its wider adoption, investors will not only provide themselves with clearer information, but force management teams to reckon with the effects of their own business models – and as responsible investing becomes more widespread, eventually improve them.

Conclusion

If investors are serious about tackling climate change, it is imperative that they make an effort to tackle emissions at their source. As such, they should focus their attention on the oil and gas firms which dominate the energy sector.

For investors, taking the easier, and certainly less controversial, route of excluding oil and gas companies from the investable universe should not be the answer. Instead, we believe that responsible investors should encourage these mega-polluters to invest in renewables, adopt challenging net zero carbon targets and to improve the quality of their disclosures.

By doing so, the asset management industry has an opportunity to make material reduction in the pace of man-made climate change.