ESG giving up its ring-side seat for a place in the ring
The Covid-19 pandemic has changed the world, sometimes radically, and will continue to do so for years to come. One of clearest examples of this change is the way environmental, social and governance (ESG) principles are becoming central to the policy debates and choices being made in most developed economies.
This shift from the wings to center stage was already underway when the pandemic struck. But it has accelerated so fast that few doubt the global reflation that markets anticipated later this year will, for perhaps the first time, be shaped to a significant degree by the tenets of ESG.
With this shift, however, comes some painful realities for advocates of ESG. As the father of New York’s current governor famously observed, policymakers tend to campaign in poetry but must govern in prose. That means being held responsible for policies that may generate short-term pain in pursuit of the greater good.
A recovery fuelled by green energy
That SRI/ESG investing is here to stay is beyond dispute. In the mutual fund space, the equity funds with ESG mandates tracked by Informa’s EPFR have taken in more money than their non-ESG counterparts four of the past five years while SRI/ESG Bond Funds set three inflow records in as many weeks going into the final days of February.
In many cases the impact of this money has been a broad, slowly unfolding shift in corporate attitudes, day-to-day operations and reporting. But in one area – energy – the impact of ESG values is already in overdrive.
Before the pandemic, ESG funds that invest in clean energy had been gaining ground as the impact of human activity on food security, biodiversity and climate change became increasingly evident. But Covid-19 lit the touchpaper under this trend. Oil majors concluded their future no longer lies with fossil fuel and, early this year, a new US administration took office promising to spend $2 trillion combating climate change.
Clean energy is not free
The Biden administration’s pledge to spend $2 trillion is over and above the US government’s proposed $1.9 trillion short-term stimulus package to fight the pandemic’s economic impact. That package could add up to 9% to US GDP growth in the short term. In the longer term, however, it has raised the spectre of higher inflation as this wall of money chases a supply of goods constrained by supply chain issues and production cuts.
One of the products that may be in short supply is energy. OPEC has cut production and market forces have mothballed a significant chunk of the US ‘shale patch’ output. In the case of the latter source, ESG goals are likely to focus on further reducing its footprint and filling the deficit with renewable energy sources.
Meanwhile, private players are also pulling back from a business model that maintains and expands traditional energy sources. Oil company Royal Dutch Shell is the latest, pledging in February to become a net zero carbon company by 2050. This is a jaw-dropping statement for a company that built its business model on selling billions of oil barrels.
Can green sources fill any supply gap? The lesson from Germany, the developed market that has pursued the most aggressive “greening” of its energy infrastructure, is yes – but at a cost.
The so-called Energiewende project has seen production from renewables pass the output from coal plants. But the costs include some of the highest electricity costs in the developed world and the championing of a new natural gas pipeline from Russia, whose E, S and G grades generally make painful reading, to provide a degree of energy security when the wind and sun cannot carry the load.
A matter of corporate survival
Globally only 28% of electricity generation comes from renewables - coal and gas represent close to 60%. As demand for green energy soars, lack of supply could have a severe impact on inflation.
But, for companies, making the transition is increasingly seen as a matter of long-term survival – and not just for the planet. Shell and other legacy energy companies can read the tea leaves as they watch portfolio capital flows racing away from fossil fuels towards carbon neutral energies. In response, UK major BP has pledged to spend a massive $60 billion on reaching 50 gigawatts of renewable energy by 2030.
These organizations know that any perceived lack of ESG focus is already starting to correspond with share price falls in other companies.
For example, analysis of scores from ESG tracked Data Simply has shown this correlation in Anadarko Petroleum, a US-based oil and gas exploration firm. When this company paid close attention to ESG - as measured by words associated with environmental, social or governance in its SEC filings - its share price performed well.
Later, the company’s attention on ESG waned, and a drop in share price followed. Another Data Simply pull showed a similar correlation when ESG focus dropped at Diamond Offshore Drilling.
Last year, EPFR also investigated these correlations across sectors, and found an additional price premium for stocks owned by ESG funds.
Time to set the expectations dial to ‘realistic’?
If current estimates prove correct, failing to address climate change could see global GDP drop by a quarter by the end of the century. So, the long-term investment case for many ESG projects is compelling. But major questions remain about how green energy suppliers will cope with surging reflationary demand over the next few years.
Because of the political tensions that surround ESG principles, especially in the US, advocates of the transition tend to categorize any criticism or discussion of unintended consequences as reactionary.
With the tide running so strongly in ESG’s favor and its rapid shift from critical philosophy to mainstream policy, however, it will be hard to avoid a degree of responsibility – at least in the minds of the voting public -- if renewables are unable to meet the needs of the anticipated recovery and energy costs soar at a time when inflation seems, to many observers and investors, already poised to accelerate.
ESG investment is a rapidly growing corner of the financial pie whose goals are large-scale and whose standards – and their implementation and measurement -- are complex and evolving. What is clear is that this shift comes with new targets, reporting requirements, legal liabilities, reputational risks, infrastructure needs and, in many cases, taxes and fees -- all of which have the potential to raise costs that will be passed on to customers.
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