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Pressure remains on some investors to give up their shares in oil, gas and coal-related stock. Elizabeth Carey asks whether this is wise and what the Stewardship Code has to say.
For LGPS funds, and the authorities that administer them, conventional wisdom on the climate emergency has evolved to favour reducing fund exposure to fossil fuel industries. This line of reasoning reflects pressure from groups like Friends of the Earth and Divest UK, who have put pressure on local authorities whose portfolios hold shares in oil and gas companies.
UK-oriented portfolios have had particularly high exposure to energy companies because of their relative over-representation: Oil and gas represent around nine percent of the FTSE All-Share whereas energy constitutes less than three percent of both the S&P 500 and the MSCI All Country World indices.
The debate has moved on considerably from socially responsible investment (aka RI 1.0), which was based on exclusions. We are now in ESG 3.0, which demands committed active engagement to support the carbon neutral 2050 journey spanning the entire industrial and investment spectrum.
The UK’s LGPS funds, working collectively, with aggregate funds of around £330bn, have an important role to play in this mission.
Benchmarking
Most officers and pension committee members of LGPS administering authorities will have debated how to translate their responsible investment beliefs into investment practice, while upholding their fiduciary duty to generate returns sufficient to fund defined benefit (DB) pension liabilities in perpetuity at affordable contribution rates.
Previous discussions focused on what an LGPS fund might sacrifice return-wise (and often dividend-wise) if it divested its stakes in fossil fuel companies. Managers of active investment mandates with a return objective above an index were loath to exclude whole sectors (like oil and gas) in case these performed strongly, leading to relative underperformance.
Passive mandates were similarly laden with the underlying fossil fuel component of the index, which in the UK could be proportionately high.
Asset managers and index providers like MSCI and FTSE have developed a plethora of investable active and passive solutions designed to reduce exposure to fossil fuel producing companies. Recent performance of low or zero carbon ESG products has been encouraging: At times they have outperformed their full carbon parent benchmarks, thus easing fiduciary duty (“What am I giving up?”) concerns.
For some, limiting the tracking error of ESG indices has made the choice of a low or no carbon index easier, for it limits the degree to which these indices can ever diverge from their parent benchmark. Nonetheless, a zero carbon ESG index constrained by a narrow tracking error (such as 0.50%) is essentially a contradiction in terms, for it cannot avoid some degree of exposure to carbon-heavy issuers.
“Stranded asset”
Falling oil prices reduce the cash flow and future earnings prospects of most oil and gas companies, and therewith the value of reserves held on balance sheet. The result can be large write-downs, dividend payment cuts and falling equity market valuations.
Some investors may wish to divest from companies in fossil fuel-related industries because of the risk that their assets may end up being “stranded” (i.e., not worth extracting).
Divestment can be seen as a risk mitigation strategy if investors choose to exit the sector before share (and/or debt) prices weaken further. A desire to protect an LGPS portfolio from perceived stranded asset risk may lead to full or partial divestment via a switch to low, or no, carbon investment strategies.
In passive mandates, where the scope for engagement is already limited, a switch to low or no carbon indices may be more consistent with a given LGPS fund’s RI beliefs.
Transition
A seismic shift is underway within the energy sector. As with other industries, the Covid-19 pandemic has accelerated a process of “creative destruction and disruption”. The rise of industrial-scale fracking lowered oil and gas prices and rendered coal uncompetitive for electricity generation where oil and gas were plentiful.
Beginning with the fall in oil prices since mid-2014, the shock collapse in spot prices to below zero in April 2020 have forced a revaluation of reserves and a re-think of capital investment plans more generally.
Wrenching reductions in longer-term pricing assumptions, combined with pressure from large investor groups like Climate Action 100+ or the LAPFF, are slowly but surely motivating many of the largest Western energy companies to modify business models and redirect capital investments towards renewables and lowering their greenhouse gas (GHG) footprint.
Sustained engagement with c-suite executives by, or on, behalf of institutional investors, bolstered by organised shareholders threatening dissenting votes, can motivate management to change direction of travel. After all, their well-paid jobs and personal wealth are directly linked to share price performance.
Shell, Total, BP, Chevron, Eni, Occidental Petroleum, Reliance Industries and now even Exxon have all committed to reducing GHG emissions from their activities, for example by introducing carbon capture, reducing and, or, eliminating flaring and planting forests.
More encouragingly, oil majors are directing increasing shares of their capital investment budgets towards new technologies like electric vehicle charging networks, renewable energy generation (hydrogen, solar, wind, biomass, geothermal) and long-term energy storage solutions for renewably generated electricity.
Ironically, to divest now from energy companies that are just starting to “get the message” could undermine their resolve to transformation themselves into greener, lower GHG energy businesses prospectively.
Unfortunately, the same cannot yet be said for state-controlled oil and gas companies in countries like Russia, China, Saudi Arabia or Venezuela, where cash generated from extraction activities can underpin the political objectives of undemocratic regimes.
As with semiconductors and 5G, a bifurcated global energy industry may emerge, split into companies based in Western democracies, many of them publicly traded, that are shifting investment away from fossil fuels, versus others who are motivated to maximise near-term cash flow through extraction of national hydrocarbon reserves.
A Regulatory Push towards Net Zero
The UK government and regulators have shifted onto institutional investors like the LGPS considerable responsibility for pressuring companies to reduce reliance on fossil fuels.
By 2023, compliance with the Task Force for Climate-related Financial Disclosure (TCFD) reporting framework will require LGPS funds to disclose their climate-related risks and opportunities along with various measures of GHG inherent in their investment portfolios. LGPS funds (and their pools) will need to undertake additional work to become signatories to the Stewardship Code of 2020.
TCFD, the Stewardship Code and the government’s Taking action on climate risk: improving governance and reporting by occupational pension schemes paper all recognise that the UK economy is on a journey towards carbon neutrality by 2050.
Actors across all levels of government, the private sector, institutional investors (including the LGPS) and the whole financial sector must work together to facilitate a “green revolution” so that our economy can function with GHG emissions 78% below present levels.
To this end, the combined effect of these new regulations will compel LGPS funds (and the pools and, or, asset managers who invest on their behalf) to
assess and, where possible, quantify the climate and GHG impact of substantially all of their investments, including but not limited to energy companies, and engage vigorously with issuers to bring about necessary changes in their business models to put them on a path to carbon neutrality by 2050.
The Stewardship Code lays out 12 unusually prescriptive principles about how LGPS administering authorities and their agents are expected to engage with issuers, including but not limited to energy companies.
As signatories, LGPS funds must establish RI beliefs that include “sustainable benefits for the economy, the environment and society” (Principle 1). They must “systematically integrate stewardship and investment, including material environmental, social and governance issues, and climate change, to fulfil their responsibilities” (7). They must “engage with issuers to maintain or enhance the value of assets” (9), notably through participation “in collaborative engagement to influence issuers” (10). If engagement does not bear fruit, LGPS signatories must be prepared to “escalate stewardship activities to influence issuers” (11), all as part of “actively” exercising “their rights and responsibilities” (12).
Escalation can include voting against management where appropriate. Only as a last resort should LGPS investors (or their agents) sell shares of any company that ignores sustained engagement by LGPS or their agents, acting in concert.
Inconsistent
The thrust is clear: The LGPS along with other pension funds and institutional investors, plus the asset managers who serve them, are to prioritise collective engagement to bring about actions that forge a path to Net Zero by 2050.
A priori divesting of holdings in the energy sector (or any other) would be inconsistent with the Stewardship Code’s priority on engagement and taking positive actions towards carbon neutrality.
In fact, relegating energy companies to the portfolios of investors outside the Stewardship Code (and similar regulations in the EU), who may be indifferent to the climate emergency, would be downright counter-productive to the cause of global net zero.
At the extreme end of the “divest” thought experiment, if energy company share prices fell so low, they might become attractive targets for regimes that seek to exploit fossil fuel reserves to bolster their own power.
Imagine a world where energy company shares became so cheap that Rosneft acquired BP or the Chinese National Oil Company acquired Shell. Unconstrained by regulations of the EU, UK or elsewhere, these new owners might simply maximise hydrocarbon production and near-term cash flow, the very result that the LGPS and similar-minded investors seek to avoid.
Far better is for the LGPS funds, and like-minded investors, to remain longer-term stewards of energy companies, using engagement with c-suite leaders to bring them along as part of the Net Zero solution, which many now realise is existential to them, too.
Regarding existing reserves that may ultimately become “surplus to requirements”, solutions must be found to ensure that these remain securely in the ground, and are not sold off to less scrupulous owners. This may become yet another topic for investor engagement with energy companies. A “don’t-divest-your-reserves” campaign may be needed down the road.
Elizabeth M. Carey, CFA, works as an independent advisor and research analyst for local government pension schemes. She spent much of her previous career working in corporate finance and capital markets in New York and London, and subsequently worked as an in-house M&A banker for GE Capital in London. The views expressed in this article are her own.
Photo by Michael Marais on Unsplash
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