Measuring carbon intensity is about to become a big business. The Big Four accounting firms have announced huge expansions of staff and investment to cater to this new business opportunity. Perhaps we’re paranoid, but we view this as a necessary predecessor to a carbon tax. The more accurately pollution is measured, the more accurately it can be taxed, at least in theory. And on top of that, the carbon offset business, recently in the news when forests planted out west to offset carbon emissions burned down. The carbon offset trade has set up a high level study of means to standardize and trade offsets, while disputing claims that offsets are nothing but licenses to pollute. Without offsets, big corporations will have to really reduce their emissions. Those carbon neutral pledges will go up in smoke, so to speak.
For now, though, we want to examine carbon intensity and risk. Carbon intensity is just one part of ESG investing— that is, considering the environmental aspects of any business, whether it meets social responsibility requirements and whether the company is governed up to standards. ESG investing is not a goody-goody cottage industry. Funds supposedly following these standards have over $900 billion under management. We are not sure how well managed, though. DWS, a major German investment manager is now under investigation by US and German authorities for issuing misleading statements about the extent of the firm’s ESG investing.
The financial press speculates that more firms may run into trouble. Meanwhile, a think tank claimed that big fund managers had ESG portfolios not only misaligned with the goals of the Paris Accord but also owning oil and gas stocks. A fund manager explained that the holdings represented “tilting strategies” that reduced the carbon footprint of the fund while still obtaining a benchmark return. Sounds like “leaning in” to carbon mitigation without actually taking the full plunge. In other words, yes, these ESG oriented portfolios still own oil and gas stocks. Just less of them, that is, below their respective benchmark’s weighting. George Soros, the veteran fund manager, wants Congress to enact laws that require funds to invest only in companies that meet the governance (G) standard of ESG. What if the politicians add in the S and G standards?
Keep in mind that there is a big difference between a lot of vague corporate discussions regarding deep and meaningful CO2 emissions reductions at some indefinite point between now and 2050 and what the corporation says in documents filed with the Securities and Exchange Commission (SEC). The former says to us the corporation and its board see no urgent need to address this issue and may do so leisurely, perhaps in their 2045-2050 planning horizon. (In this vein we read recently that PacifiCorp, owned by Warren Buffett’s Berkshire Hathaway, announced the closure of its last Wyoming coal plant in 2039. Buffett is 91.) But misrepresenting actual investment policy in a securities prospectus is another matter entirely. In fact it is a violation of SEC regulations and a federal crime.
You might think that separating out “bad” carbon emitters from the rest of a stock or bond portfolio is a simple matter. So called “ethical investors” refrain from owning securities in alcohol, tobacco and firearms firms. Similarly investors should be able to eliminate oil, gas and coal stocks from their portfolios. For instance, N.Y. State’s main pension fund, with assets of $268 billion, is considering for disposal the less than $1 billion invested in shale and oil sands projects. This is a fairly simple, straightforward decision, in or out, and it won’t make much difference to overall performance given the fund’s size. So what is the big deal?
A recent article by four fund managers and a finance professor (“Decarbonizing Everything”, Financial Analysts Journal, vol. 77, no.3) attempted to quantify carbon intensity. The authors came up with three ways to evaluate the direct carbon emissions of a company. First they measured the total direct corporate carbon output of the company. Second, they took the previous measurement and added the CO2 footprint of its suppliers and the users of the product it produces. Finally, a third measure was created based on Wall Street analysts’ opinions. Imagine the difficulty of putting together these disparate measures on a consistent basis. It is not surprising to learn these three evaluative criteria did not produce consistent results. The authors concluded that “significant progress needs to be made in the measurement and disclosure of … emissions…” This portends a lot of confusion before the standards settle down.
So, what are we getting at? First, the fossil fuel industry broadly, and this includes utilities as well, needs to recognize that measurement of carbon emissions will become a big business, akin to the bond ratings business of Moody’s or S&P. Second, these measurements, we believe, are likely to extend beyond the fossil fuel business. This means users of fossil fuels as well as producers may soon find themselves under more financial pressure to rapidly cut emissions or pay higher pollution related taxes. We already see the outline here with increasing public pressure on corporate polluters and an increasing receptivity of politicians to take action. Eventually public pressure is likely to mount such that fewer and fewer business leaders will want to appear on the environmental activists' equivalent of the FBI’s most wanted list. Institutional investors with fiduciary responsibilities will not want to belatedly explain their reluctance to part with energy investments despite it being obvious (in hindsight) those investments were in peril. Once this becomes a social movement, economics will become less important in decision making.
In short, investors have slowly begun a serious examination of carbon emissions. This quest, if pursued consistently, will take them beyond the fossil fuel and utilities industry. And in doing so this will likely involve more industries that can change their spots so to speak and become “green”. Something which the fossil fuel industries cannot do easily if at all.
Ultimately what will a higher carbon emissions score mean for business, however it may be calculated? With an increasing realization regarding the environmental harm caused by various emissions, polluters will likely pay a higher cost of capital. The growing threat of environmentalist lawsuits or onerous government regulation serve to elevate underlying business risk. All things being equal (which they seldom are) elevated business risk requires as an offset with the reduction in financial risk, i.e. debt levels to maintain the same overall risk profile. However companies in the midst of major transitions are often voracious consumers of debt as they try to borrow and spend their way to a more prosperous future. In the interim, though, this strategy could result in lower stock prices and shareholder discontent.
By Leonard Hyman and William Tilles for Oilprice.com
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