Over the last twenty-five years, ESG (Environmental, Social & Governance) has emerged from the backwaters of the investment management process to become central to the management of financial assets. What started as ethical investing for a few charitable trusts and endowments wanting to avoid sectors like defence, tobacco and alcohol in the 1990s has evolved into a central pillar of mainstream capital allocation. More recently, however, the rise of ESG has encountered some headwinds.
In our April 2022 update, we suggested that ESG might become a casualty of the war in Ukraine and that the accepted ESG framework might require a refresh. While ESG was under pressure before the February 24th Russian invasion, Putin’s devastating actions have undoubtedly intensified this pressure.
In recent weeks there have been some noticeable ripples on the usually calm and consensual surface of ESG investing. Probably the most high profile event was the police raid on the offices of DWS in Frankfurt amid allegations of greenwashing and the subsequent resignation of its CEO. Additionally, the Head of Sustainable Investing at HSBC Asset Management was suspended for suggesting that we might have collectively overestimated the cost of climate change. And in the US, S&P’s decision to exclude the EV pioneer from its ESG Index while retaining Exxon prompted Elon Musk to tweet that ESG was a sham.
Beneath these events are some hard truths that face the accepted wisdom of ESG. The hardest of these truths are in the energy transition debate. Before February 24th, the West and Europe, in particular, did not consider Russia’s poor human rights record as sufficient reason not to buy its energy.
Today Europe is heading towards a previously unthinkable future without Russian oil and gas. The rush to source energy that is not Russian has meant that we are building bridges with some unsavoury oil-producing countries, such as Saudi Arabia and Venezuela. Germany is building facilities to import LNG; the UK is incentivising new investment in the North Sea, and everyone is re-evaluating their nuclear energy options.
The new priority of energy security has allowed people to speak up in defence of what was previously assumed to be ‘the indefensible’, albeit it wasn’t career-enhancing for Stuart Kirk of HSBC. If you look up who owns the largest oil reserves in the world, it is often surprising to see Canada, a non-OPEC+ member, in the top three. However, most of Canada’s oil is in the form of its heavy tar sand deposits, which are only economic to extract when the oil price is well above $100, along with some nasty environmental considerations.
Unsurprisingly the people of Alberta Province in Canada are becoming vocal. Provincial premier Jason Kenny said, “hostility is beginning to soften as leaders are mugged by reality. We cannot allow some of the world’s worst regimes to dominate global energy markets. We can supply the US with oil, and there will be no need to deploy the US Navy on the Great Lakes.” Thus he reinforces the point that the Canadians are the ‘nice’ Americans. The critical question is whether the decision to cancel the KXL pipeline connecting Albertan oil to the US Gulf Coast can be reversed. A downward sloping forward curve for oil and an ESG framework that has substantially increased the cost of capital for such projects are limiting factors. (Indeed, the same factors restrict the output of the shale deposits from the Permian Basin in Texas and Oklahoma).
While the markets remain concerned about interest rates and inflation, the dominant theme in equity markets so far in 2022 has been energy. The defining factor of investment performance year to date has been energy exposure. With crude oil, natural gas and thermal coal prices all substantially higher, the share of the market cap for the energy sector has increased. However, valuations do not currently indicate this change will be permanent. Despite their stellar share price performance, oil company valuations remain historically low. They do not suggest a long-term future of sharply higher energy prices.
What is the market telling us? Why is the market not discounting higher energy prices and a better future for oil companies? There are two factors at play here. First is that through its ESG lens, oil exploration and development remain un-investible despite the apparent low valuations. Second, the market is discounting significantly lower oil prices in the foreseeable future. Indeed, with most commentators forecasting an economic slowdown and others a recession, like Musk’s ‘super bad feeling’ and Jamie Dimon’s ‘hurricane’ warning, this is not good news for oil prices.
In the 1970s, when OPEC was exerting its control over the oil supply to Western markets, it took us a decade to find alternative supplies from places like Alaska and the North Sea. The West responded by lowering its demand for OPEC oil via two painful recessions, substituting gas-guzzling cars for smaller Japanese imports, rationing power and imposing speed limits on motorways. This time our journey will involve less demand for Russian oil and gas. However, alternative energy sources are more obvious even if they are bridging fuels to get us to a fully renewable future. Locally sourced bridging fuel projects can give investors strong returns in the current climate. However, the ESG lens might need an adjustment to bring them to fruition.
Written by Jeremy McKeown
