While O&G at its core contributes to climate change, the industry itself is not going away. However, the way in which it operates and its contribution to the economy will be transformed. ESG change is made through a mixture of policy and investment strategies and in this article Patricia Shevel-Bleikss and Suraj Sridhar explore the interactions and dependencies of the two and the implications of both for O&G's future ESG transformation.
Widespread support of ESG policies and the overall energy transition is rooted in investment and policy strategies. Climate change poses a series of catastrophic changes, making a compelling case that long-term economic prosperity is dependent on the mitigation of greenhouse gas emissions as quickly as possible. There is much that oil and gas (O&G) companies can do to align themselves with ESG values that extends well beyond their end product. Although change is made through a mixture of policy and investment strategies, in this article we explore the interactions and dependencies of the two and the implications of both for O&G's future ESG transformation.
II: Oil Industry Today
Due to an estimated 4.6% increase in global energy demand in 2020, the demand for fossil fuels has not diminished and will not any time soon. While the industry itself is not going away, the way in which it operates and its contribution to the economy and society will be transformed. While ESG is perceived by some to be difficult to implement and may seem like a profit-killer, for most companies including those within the O&G industry, it has the opposite effect. A number of oil and gas companies have already set net-zero-emissions targets. Many are sustaining efforts to decarbonize their operations and their value chains by smart investments and adhering to changing government policies.
Figure 1: Long-term oil demand forecasts
A recent report by the International Renewable Energy Agency revealed that investors are increasingly seeking out positions that reduce their exposure to climate change as well as the risk of stranded assets. The value of an investment is no longer just about returns, they want their money to make a positive impact on the world at large. Between 2018 and 2020, sustainable, responsible, and impact investing grew at a rate of more than 42%, rising from $12 trillion to $17.1 trillion. Increasing demand and a growing trend in sustainable investment will incentivise O&G companies to do more to contribute positively to ESG.
Figure 2: Global Growth of sustainable investing strategies (2016-2018)
A lack of an ESG strategy will ultimately affect an O&G company’s access to public, and increasingly private, capital hindering any prospect of growth in the future. O&G investment represented 2.55% ($255 billion) of total investments in the world’s largest investment manager BlackRock. With an ESG mindset, BlackRock's CEO Larry Fink warned that given “the growing investment risks surrounding sustainability, we will be increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices”. BlackRock is just one of the many stakeholders pushing companies to embrace ESG and to develop metrics to measure progress towards identified goals. The possible reduction of investment engages O&G companies to make a change in their process to accommodate ESG focused portfolios.
Capital markets are already driving dramatic growth in the value of companies that are strongly aligned with the energy transition megatrend. The combined capitalization of “the new green energy giants”—Enel, Iberdrola, and NextEra—has increased by more than 200%, growing from $110 billion to $350 billion. Meanwhile, the largest international oil companies—BP, Chevron, ExxonMobil, and Shell—have seen their combined capitalization shrink by 40%, from $980 billion to $570 billion, over the same period. Without ESG initiatives, investment will be limited and they will become unfavoured in capital markets. For such a capital intensive industry as O&G, investment is crucial to ensure continuity of production. New ESG trends must be adopted within their production process. Investors like BlackRock expect companies to begin to benchmark, identify policies, develop programs and align executive compensation packages to short and long term progress towards ESG goals.
Although, at its core O&G companies contribute to climate change, the complete expulsion of that industry will not tackle energy transition in the future. Given the O&G industry’s current impact and strategic importance to economic growth, job creation and socioeconomic prosperity in many countries, investments in the sector are needed for the energy transition to renewable energy. Investor pressure can improve the environmental impact of the extraction process itself – ensuring no oil leaks and utilising renewable energy technologies. Additionally, a complete change in product, with smart investment, can be done with minimum decrease in profit. An interesting case study to support this viewpoint is the once Irish peat company ‘ Bord na Mona’ (BnM).
Peat – or turf – is a fossil fuel extracted from bogs. In the past, it was widely used to generate part of Ireland’s electricity. However, the burning of peat releases greenhouse gases which are harmful for the environment, and extracting peat from bogs damages their ability to store carbon from the atmosphere. Under Ireland’s climate goals, the end of peat-fired electricity was well flagged. BnM formally ended all peat harvesting on its lands in 2022 from policy pressure, however it was smart ESG investments that made production continuation possible.
BnM’s ‘Brown to Green’ investment strategy transformed a traditional peat business into a climate solutions company. The investments made over two years allowed the company to fully focus on renewable energy generation, recycling and the development of other low carbon enterprises. The changes provided sustainable employment and supported Ireland’s objective to become carbon neutral by 2050. Although it is a difficult task to entirely change the end-product, it was the right decision for BnM with profit of just under €28 million last year. Now even with policy changes BnM can succeed and investors still earn returns in a company that without ESG investment would become a dead-end.
Past examples of environmental policy highlight the extent of market-correcting capabilities of nations. In the case of lead additives in gasoline, the United States EPA (Environmental Protection Agency) successfully phased out leaded gasoline consumption beginning with its inception in 1970. In that case, not only was the market failure glaring – preschool blood lead levels in the US tracked with violent crime rates 20 years later – alternatives such as lead-replacement petrol and unleaded gasoline were already available at only a minor transition cost and required minimal update to infrastructure in select industries such as adding catalytic convertors to cars. In the case of climate change, the industrial portfolios of entire countries need to be mobilised, and ambitious policy does not always deliver ambitious results. The UK’s Hinkley Point C, a £23bn nuclear power plant to be constructed in Somerset by 2026, was criticised in a National Audit Office report in 2017 for commiting “electricity consumers and taxpayers to a high cost and risky deal in a changing energy marketplace,” casting doubts over its value for money. Hinkley Point C was also controversially financed with a 33% equity stake in the name of the state-backed China General Nuclear Power Corporation – a signal that interventionist capital formation in renewable energy is politically unsustainable.
Today, countries run their environmental transformation projects on smarter public-private partnerships (PPPs). These aim to combine the efficiency seeking behaviour of private investors with risk mitigation provided by public sector involvement to deliver secure, albeit slower, growth of renewable industries. Saudi Arabia’s Vision 2030 project aims to open up the Saudi economy to foreign investment in many sectors, including a privatised renewable energy sector, in an attempt to diversify their dependencies. Its oil exports, which reached 54% of GDP in 2008, have fallen to 24% in 2019, after industry clusters were created to encourage investment in non-oil industries.
Figure 3: Change in the share of energy sources in U.S. energy consumption over time (1776-2020)
Although the majority US energy consumption share has already shifted toward renewables, especially hydroelectrics, over the past century, unpacking the international policy environment today can hint toward the future of renewable energy technologies elsewhere. A 2018 report by the International Energy Agency (IEA) highlights the renewable energy policy recommended more generally to all countries. It stresses that early stages of renewable energy investment must be financially supported by the state to mitigate short-term risks of investment, overcome issues of high capital costs, and build local supply chain infrastructure.
Price-correcting measures such as the UK’s Climate Change Levy have also been found to stimulate innovation – firms paying the full levy conduct more patenting activity than those exempt from it. Other studies by the OECD find that price-correction through carbon trading schemes, while they aim to level the playing field and build in the social cost of carbon to its production, do not go far enough, driving investment away from new technologies; they fail to address the underlying risk, treating a supply-side issue with a demand-based solution.
Therefore, the role of legislation in ensuring the correct incentives prevail is key – price-correction must be combined with policies that create security for investors. Target setting, when stuck to as in the case of leaded gasoline by the EPA, can establish some certainty as to the direction that the legislators will take in coming years – a crucial thermometer for firms to synchronise their timeline for green investment. Property rights and patent rights are similarly the bedrock of green investment according to the IEA – something yet to be cemented globally, and that is missing from many developing nations that still look to fossil fuels as the cheapest source of energy.
It is clear that a government is as dependent on investors to bring efficient provision of energy endogenously in the market as the same investor is on the government to issue sufficient exogenous support to market incentives in the form of security against the risk of adopting new technologies. We can note that when it comes to transition to a low-carbon emissions economy, the timeline and order of events matter. Both investment and O&G firms today are large enough to constitute entire nations, making them more liable to climate risk than if the industry was composed of many smaller firms. Therefore, investment initiatives take a leading role in punishing free-riders who do not align with environmentally conscious behaviour. However, this is insufficient, since new technology always comes with new risks; rather it is the regulator who can influence the interpretation of new technologies by investors. Regulation acts as a steering wheel to the engine of investment - while governments cannot move entire industries toward a low carbon-economy, they can certainly point them in the right direction.