ESG Focus | Aug 24 2020
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The energy sector is at the front line of the climate change war and is transforming at a rapid rate. FNArena examines the prospects for the fossil fuel industry's business model and briefly tracks the implications for Australian equities and bond markets
ESG Climate Change Megatrend – Part 2
–The soft underbelly of the fossil-fuel business model exposed
-Have we witnessed peak oil?
-Stranded assets, accounting, liability and the hot potato
-The impact of green investing on Australian equity and bond markets
By Sarah Mills
The biggest global transformation in the world today is the transition from fossil fuels to renewables, and this will drive an even greater transformation – the 4th Industrial Revolution.
It is being driven by decarbonisation policies, and a plunge in the price of renewables.
This transition to affordable, reliable low-carbon energy is, in turn, transforming the energy sector. Fossil fuels are being denied capital and renewables are attracting it.
Analysts note this trend will test the resilience of long-term financial and operational strategies of fossil fuel companies and create both risk and opportunities for equity and fixed-income markets.
The weak underbelly of the fossil fuel business model
The fact that fossil fuels are falling so hard and so fast reflects a business model that has externalised risk and internalised profits.
It has done this by relying on subsidies and tax breaks for profitability and risk-abrogation; and capital from coalitions of the willing who are banking on continued government support. Its potential to spark geopolitical conflict also counts against it.
The industry’s saviour has been the lack of viable competition, but that is no longer the case. Renewables in contrast no longer even need subsidies to compete. Some technical barriers remain, but the pace of technological change in the energy sector is breathtaking.
What’s happening with subsidies
Every year since 2009 the G7 and G20 have committed to phase out fossil fuel subsidies along with related commitments under the Sustainable Development Goals (SDGs) and the Paris Agreement.
This essentially means that anyone investing in fossil fuels are betting against the House – a risky strategy.
According to the International Energy Agency, government subsidies to the fossil fuel industry total roughly US$400bn a year, money that has, to date and after expenses, gone into the pockets of industry investors.
Recognising the critical role carbon plays in the economy, many investors have demonstrated a willingness to bank on a slower transition, or alternatively are willing to trade the volatility.
After all, the G7 governments alone, despite their commitments, continue to provide at least US$100bn in subsidies to the production and use of coal, oil and gas.
The German government, for example, has paid billions in compensation to fossil fuel and nuclear energy companies as it shifts to renewables. If this model were to be followed globally, it would suggest potential pay-offs in other countries. But this is not a certainty.
One thing investors can count on, however, is an average decline in government subsidies over time given they increase systemic and political risk, countering the SDG goal of reducing inequality (which we noted in Part 1 of this Climate Change series, is inextricably linked to the climate change SDGs), and has broader implications for markets in the long term.
Governments are only likely to continue to subsidise or side with the industry to the extent that it reduces shock to their economies from the transition.
From a direct ESG perspective, the industry has long relied heavily on capital from institutional and private investors to fund new projects. These funding sources include banks and direct shareholders.
This is drying up rapidly as institutions, financiers and insurers exit or reduce their climate-change exposures to fossil fuels, as well as divert energy allocations to renewable competitors.
Funds that are still flowing to fossil fuel producers are increasingly coming with sustainability conditions, so the cost of capital for new projects is rising, further underlining the industry’s structural weaknesses.
Have we witnessed peak oil?
The International Energy Agency (IEA) noted in February that global energy-related CO2 emissions stopped growing in 2019, as renewable energy costs plunged, even as the world economy expanded nearly 3%.
This suggests a tipping point may have been reached, one which could potentially have triggered an oil crash independent of covid-19 and the Saudi-Russian oil wars, as markets adjust to the new paradigm.
Covid-19, meanwhile, has brought the ballooning industry risk into stark relief, sending oil prices into negative territory and testing the world’s storage capacity to the limit. Most importantly, it proved the industry is broadly unprofitable (without and despite its massive subsidies) in both good and bad times.
In 2019, the MSCI World Index was up almost 24% in US-dollar terms, while the MSCI World Energy Index returned just more than 12% and has underperformed its wider global equity equivalent in four of the last five years.
Low returns, rising volatility and intensifying competition, make the industry increasingly unappealing.
Covid-19 also brought to the forefront the spectre of reduced petrol consumption through work-from-home shifts; potential carbon infrastructure restructuring related to 4IR; reduced consumer demand for tourism, particularly international tourism; a sharp reduction in corporate travel; and reinforced the push for global onshoring and optimisation of supply chains.
Citi in its Global Economics Review, says research on past pandemics reveals a legacy of persistent negative effects on economic growth – one that lasts for several years reducing energy demands. The analysts also perceived intensified deglobalisation to be the biggest structural risk to the global economic outlook.
None of this bodes well for fossil fuels.
Investors in energy equities are being advised to carefully balance their interests between renewables and fossil fuels and ensure that the fossil fuel companies they invest in are “best in class” from an ESG perspective.
This is because, with the exception of regulation, it is the flow of ESG funds into energy companies that will likely save them from early collapse and protect them against growing volatility in the sector.
High dividend yields of 5%-plus are no longer sufficient to provide a buffer against volatility that can trigger permanent losses in excess of -30%, and the associated asset impairment, storage costs and redundancy.
In Britain for example, 37% of electricity production now comes from renewables.
Investors there are experiencing painful losses in high-yield and private-debt holdings linked to fossil fuel investments. This experience is being repeated around the world.
We will examine the high-yield fixed income market in a separate article.
All of this suggests that we may have witnessed, or be approaching, peak oil. However, the fourth industrial revolution is yet to be rolled out. It will require investment and energy. But if the world is to main on-track with the Paris Agreement climate goals, emissions must fall one way or another.
Risk profile for fossil fuels
Fossil fuels face four main climate change related risks.
- Regulatory action
- Reduced fossil fuel subsidies and market competition.
- Sociopolitical stigmatisation
- Transition risk
Regulatory action: Governments directly or indirectly drive more than 70% of global energy investments, according to the IEA, so government policy has a huge impact.
The world’s governments have made their intentions clear, committing to the Paris Agreement every year since 2009, and that commitment is intensifying. Expect more regulation.
Subsidies: The industry’s lifeblood – subsidies – is being withdrawn. The relatively conservative IEA’s executive director Dr Fatih Birol, traditionally not a strong supporter of the Paris Agreement, came out punching in favour of renewables after the coronavirus crash.
We must “put clean energy at the heart of stimulus plans to counter the coronavirus”, he said in March, and urged governments to lower or remove subsidies for fossil fuel consumption.
Market competition: Any reduction in subsidies will have a massive implication for fossil fuels, especially given many renewables no longer need subsidies. Global upstream oil and gas investment is expected to fall by one third of 2019 levels for the foreseeable future to reflect this. Meanwhile, the cost of solar energy, for example, is falling at a rate of -10% to -20% a year. FNArena will examine this state of affairs in articles on oil, gas and renewables.
Sociopolitical stigmatisation: ESG investors are directing capital away from the worst climate offenders and “inequality” offenders towards competitors, as they seek to protect their portfolios from climate-change risk.
Transition risk: Transition to renewables is risky: for fossil fuel companies, investors and society. This means governments are unlikely to force the fossil fuel companies to go cold turkey on subsidies. As upstream investment subsides, any failure of renewables to fill the breach is likely to result in rude shocks to the system.
This means that transition risk holds some opportunity for the indefatigable fossil fuel investor with nerves of steel. The big wild cards will be technological advances that support reliable renewable base loads and energy storage.
The companies most likely to survive this decade will be the large diversified conglomerates that have declared and demonstrated a clear commitment to restructuring their organisations to a sustainable, decarbonised model. The first to fall are likely to be pure play energy companies with poor practices.
For example, over the past decade, the Australian share market grew by 20%, and Australia’s pure play fossil fuel companies almost halved in value.
The story for big diversified conglomerates that have shown a willingness to exit coal and adopt sustainability initiatives is another story. BHP Group shares, for example, are trading at pre-coronavirus levels, while pure energy plays like Santos are languishing near their post-coronavirus lows.
Climate change and the Australian equities market
Australia has one of the most energy intense share markets in the world and is heavily exposed to climate-change transition risk.
According to Market Forces, about five years ago, some 12 companies comprised half of the ASX’s capitalisation – nearly all had high exposures to climate change.
Now 20 companies comprise 47%, illustrating the declining weightings of primarily those with fossil fuel exposures.
In the Australian market, risks range from coalminers to oil and gas majors, power generators, diversified miners with some fossil fuel operations, to companies providing services to fossil fuel producers, including banks and insurers.
The 22 carriers of ‘unburnable’ carbon risk
Despite the bleak outlook for fossil fuels, companies are pursuing at least 100 new and expansionary fossil fuel projects in Australia at a cost of almost $150bn.
Market Forces noted that “in aggregate, fossil fuel companies are estimating they will freely be able to extract (for subsequent sale and combustion) over three times more carbon than is compatible with the 2C limit.”
The organisation describes this as “unburnable carbon risk”.
According to a Market Forces report published a few years ago, Australia has 22 companies that plan to either expand fossil fuel investment, or are relying on scenarios inconsistent with the Paris Agreement, to justify their future prospects.
These companies include: Woodside Petroleum ((WPL)), Santos ((STO)), Origin Energy ((ORG)), South32 ((S32)), APA Group ((APA)), AGL Energy ((AGL)), Oil Search ((OSH)), Aurizon Holdings ((AZJ)), Ampol ((ALD)), Worley ((WOR)), Seven Group Holdings ((SVW)), Beach Energy ((BPT)), Washington H. Soul Pattinson & Co ((SOL)), Mineral Resources ((MIN)), Whitehaven Coal ((WHC)), New Hope Corp ((NHC)), Cooper Energy ((COE)), Karoon Energy ((KAR)), Canarvon Petroleum ((CNV)), Senex Energy ((SXY)), FAR Ltd ((FAR)), and New Century Resources ((NCZ)).
BHP Group ((BHP)), which teeters on the edge of these but has divested much of its coal holdings and continues to make strong commitments to ESG investors, has a market weighting roughly equivalent to all of the above.
Market Forces notes that at the start of 2020, super funds had more than $175bn of Australians’ retirement savings invested in the 22, plus another $165bn in BHP.
Market Forces notes fossil fuel lending for expansionary projects by Australian Banks surpassed $35.5bn as at July 8, 2020 and the level of lending to fossil fuels has remained consistent since 2016.
Commonwealth Bank had the greatest exposure.
Stranded assets, accounting practices and investor options
Market Forces describes unburnable carbon risk as “the risk to investors who hold shares in companies owning reserves that those reserves will become ‘stranded’. … Valuations of fossil fuel reserves are based on discounted cash flow analysis.
“Anticipated future changes in the use of fossil fuel reserves, even though they may have little impact on price and production trajectories for say, a decade, can still have a significant impact on current value. So the investment risk to shareholders in fossil fuel companies is significant.”
It adds that the aggregate market value attributed to individual company reserves is almost certainly overstated. For example, at the time the report was published, BHP had the eighth largest carbon reserves of listed companies worldwide but fossil fuels accounted for only about one third of earnings, but about two thirds of operating assets.
Market Force says investors have three choices:
- Do nothing but plan for regular risk assessment;
- Engage and hold companies accountable for their progress against commitments.
Legal exposures and the hot potato
Of course, taxpayers are footing the bill for most of this, not only with subsidies but with funds being siphoned from taxes for write-offs.
Even were the Australian government to change its attitude towards the Paris Agreement, and cut subsidies or regulate against fossil fuels, taxpayers may still end up wearing much of the bill, depending on the vagaries of the Trans-Pacific Partnership (TPP) global courts, which are being granted the power to arbitrate over losses to multinationals arising from changes in government legislation.
Adani and Santos, to name two high-profile cases, have both been granted government approval for dubious projects, and many observers have suggested they may in fact be banking on billion-dollar bail-outs.
Such bailouts have the potential to mitigate investors’ losses but it is unlikely Investors will get off scot free, particularly given the Australian share market’s broader exposure to the fossil fuel sector, but mainly because the concerns about inequality related to climate change are likely to result in broader imposts.
In December 2016, Noel Hutley SC and junior counsel Sebastian Hartford-Davis determined that directors ignoring climate risk could be liable for breaching their duty of care. This was reconfirmed in a supplementary opinion in March.
Such rulings open the door for litigation against directors.
A common trend in the coal and oil and gas sector has been for majors to sell at-risk assets to juniors, which then go bust (small cap investors beware), with the clean-up and rehabilitation costs being borne by the government. Perhaps director litigation may temper such practices.
Similarly, in the United States, massive bankruptcies have been registered in the shale-gas industry and the taxpayer has been left to pick up the cost of rehabilitation.
This could reduce growth and escalate environmental degradation, which could further hit equity and fixed-income markets as government debts spiral. It is unclear how ESG policy makers intend to deal with this. To date, market observers have speculated on major market corrections and possible “resets”. It may also fall under the aegis of the inequality ESG.
Many Australian investors are attempting to reduce domestic fossil fuel exposures by investing internationally in green exchange-traded funds and green bonds, and sovereign equities and bonds in countries with low carbon exposures.
While many investment advisers are still suggesting that organisations and family trusts, and other passive investors include fossil fuels for purposes of diversification, the Market Forces 2020 report disagrees.
It found that screening out fossil fuel extraction and downstream industries can have negligible impact on risk-adjusted returns. But this is only if it isn’t overly restrictive.
“The fossil fuel sector is unnecessary to prudent portfolio structure … it is possible to produce risk-adjusted returns that are competitive with appropriate broad-market benchmarks through a portfolio that does not invest in fossil fuel companies.”
Ranking Australia’s major climate-change exposures
Market Forces produced a study in 2014 that ranked ASX200 companies according to their exposure to fossil fuels and used this to screen out the most fossil-fuel exposed companies.
Then US-based analysts at the Aperio Group used simulation software to assess the impact of the screens on risk and return compared to the ASX 200.
While dated, the report still offers a useful guide for ESG investors finding their green feet.
The survey ranked companies in three tiers, to reflect their exposures and potential divestment status:
Tier 1 – includes companies substantially involved in fossil fuel extraction: the report suggests these should be regarded as divestment candidates:
Woodside Petroleum, Origin Energy, Santos, Caltex Australia (now Ampol), Oil Search, Beach Energy, Aurora Oil and Gas, Whitehaven Coal, Karoon Energy, Senex Energy, Drillsearch, Linc Energy, Aquila Resources ((AQA)), Horizon Oil ((HZN)), Buru Energy ((BRU)), and Coalspur.
Tier 2 – includes companies with large downstream fossil fuel exposures and are also regarded as divestment candidates. They include APA Group, AGL Energy, and Energy World ((EWC)).
Tier 3 – includes companies with large absolute direct fossil fuel exposure but those that face less risk, usually because of their size and the diversification of their businesses. Market Forces lists these companies as either divestment or engagement candidates and they include BHP Billiton, Rio Tinto, and Wesfarmers ((WES)).
- BHP has been very active on the engagement front dedicating $400m to sustainable initiatives.
- Rio Tinto, which had also been working on engagement lost significant market confidence after the Juuka Gorge incident but is also in engagement mode.
- Wesfarmers has been actively building its ESG credentials, signing green finance deals, which tend to include, among other things, reporting on progress against climate change benchmarks.
Tier 4 – these include companies with Indirect fossil fuel exposure and the report advises institutions to start with engagement but commends them as divestment candidates if engagement outcomes are unsatisfactory.
They include: ANZ Bank, Aurizon Holdings, Boart Longyear ((BLY)), Cardno ((COD)), Commonwealth Bank, Decmil Group ((DCG)), Downer EDI ((DOW)), Incitec Pivot ((IPL)), Cimic Group ((CIM)), LendLease ((LLC)), Macquarie Group ((MQG)), Mineral Resources, Monadelphous ((MND)), National Australia Bank, NRW Holdings ((NWH)), Orica ((ORI)), QBE Insurance ((QBE)), QUBE Holdings ((QUB)), Suncorp ((SUN), Cleanaway Waste Management ((CWY)), Westpac, Worley.
For those keen to monitor this space, Market Forces also provides news on bankers and insurers and suppliers to fossil fuel companies in Australia, allowing investors to better calculate their fossil fuel exposures in these stocks.
For example, the US-listed company Marsh & Mclennan has been identified for finding an insurance broker for Adani. This would appear to represent limited financial risk to the company but may raise the ire of large social investors, impacting the share price. Liberty Mutual, HDI/Talanx and Aspen were revealed as Adani’s insurers.
Climate change is making its presence felt in the fixed income market.
On the one hand, tumbling fuel prices have been wreaking havoc in high-yield energy markets linked to fossil fuels.
On the other, a whole new market has opened in the form of green finance. We will examine this briefly but will cover green financing in greater depth in a separate article.
Green finance – the basics
A new market for issuance has opened in the form of green finance. Basically, sustainability-linked loans tie a borrower’s cost of funding to their ESG performance and are often linked to specific sustainability initiatives.
The market recognises that the shift to sustainable energy is inevitable and costly. It also recognises that more sustainable companies are likely to perform better in a decarbonising world, and offer something of a safe harbour.
The market is loosely defined and includes green loans, green bonds, project finance and general sustainability-linked bonds.
Global green bond and loan issuance hit US$250bn in 2019, posting growth of 49%, according to the Climate Bond Initiative (CBI). The United States was the largest market, followed by China, then France. CBI expects the market could hit US$1trn by 2021/2022.
Clean energy dominated with 31.5%, followed by low carbon buildings (29.3%), low-carbon transport (20.2%), water (9%) and land use and waste (both at 3.5%).
Bond ratings are underpinned by the CBI international gold-standard certification, data from the Global Reporting Initiative (GRI), a developing ratings system by ratings agencies S&P and Moody’s, and greater disclosure on sustainability (in the United States, this is being wrought by the Sustainability Accounting Standards Board).
Green bonds – bonds linked specifically to green assets such as low-carbon buildings, renewable energy and low-carbon transport, have proved the most popular investment vehicle to date.
According to the Responsible Investment Association of Australasia’s 2018 Benchmarking Impact report, green bonds on issue in 2018 totalled $4.9bn – far outpacing other impact investments, which stood at $948m.
Woolworths ((WOW)) became the first supermarket in the world to issue green bonds certified by the not-for-profit Climate Bonds Initiative. The move was linked to Woolworth’s 2020 sustainability strategy and specific investments in LED lighting, energy-efficient refrigeration, solar panels and the reduction of plastic on fruit and vegetables.
The issue met massive demand, the order book rising to $2.2bn, far greater than the initial raising, demonstrating the strong institutional demand for green bonds.
Commonwealth Bank and Wesfarmers signed a $400m three-year bilateral sustainability-linked loan, the first in Australia to be linked to achieving better social outcomes – also perceived as critical in supporting the transition to renewables.
This loan was the highest value single-lender loan facility and was linked to a reduction in carbon emissions and an improvement in indigenous employment opportunities in return for a margin discount on their loan. A miss on commitments triggers an increase in pricing.
This article has focused on the legal, political, and equity and fixed-income market implications for the fossil fuel industry arising from climate change. The next article offers an overview of the coal, oil and gas industries.
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