Key points

• The value of investments and the income from them can go down as well as up and investors may not get back the amount invested.
• Investors should note that the views expressed may no longer be current and may have already been acted upon.
• Past performance is not a reliable indicator of future results

Sustainable investors are debating what the best approach is towards the traditional energy industry. Some advocate a complete exclusion of fossil fuel companies, but this inadvertently forces those companies towards ESG-agnostic investors and away from any ESG accountability. Our preferred approach is a transitions-based engagement policy where companies are incentivised to convert towards more sustainable operations. This can target the whole supply chain, including industries that rely on fossil fuels such as airlines, avoid energy price shocks that can trigger recessions and speed up the transition towards renewable energy. We also believe it aligns with the goal of the International Energy Agency’s (IEA) Net Zero initiative.

Ultimately, renewable energy sources are not yet at the scale required to substitute fossil fuels and therefore, the pragmatic and possibly most sustainable long-term approach is to support those companies becoming cleaner and penalise the laggards. True inclusion is not about incremental change but providing systematic support for the whole supply chain to improve.

The ESG conundrum posed by fossil fuels

The world needs to transition to cleaner forms of energy to tackle climate change, but the problem is not as straightforward as simply switching to alternative energy sources.

Renewable energy is not currently able to wholly substitute fossil fuels in the medium term. Many renewables still only provide intermittent power while energy storage continues to be an obstacle, for example with wind power. Moreover, renewable energy doesn’t have the scale yet to dislodge fossil fuels.

The volume of renewable energy has increased significantly over recent years, but it’s still only a minor contributor to global supply. The share of renewable energy in the world has only risen from 6.0% in 1965 to 11.4% in 2019. The International Renewable Energy Agency (IRENA) estimates that we need 74% of primary supply to come from renewable sources by 2050 to achieve the 1.5c scenario.

We also cannot ignore that fossil fuels, despite their harm to the environment, power essential industries and services. If the prices of these energy sources rise too high it could trigger recessions, which in turn could slow down investments in renewable energy. In addition, the environmental impact of fossil fuels varies according to its type and nature of extraction. For example, coal causes significantly more pollution than oil and natural gas, and oil sands are dirtier than conventional oil fields. These factors suggest we should support cleaner fuels.

Fossil fuels vary in their impact on the environment

Finally, any investment decision around energy would need to define the scope of fossil fuels including whether to just exclude producers or also users. For example, excluding fossil fuel exploration and production companies would ignore those industries that rely on them such as the airline sector, autos and many chemical companies. On the other hand, specifying fossil fuel companies too broadly would be unworkable and severely limit the investment universe. In that respect, any exclusion parameters that we choose would require some degree of arbitrariness.

Weaning the world off oil and gas

The International Energy Agency’s (IEA) Net Zero initiative calls for an “immediate and massive deployment” of clean energy technologies and innovation. We agree and investment professionals should support funding towards increasing the capacity of renewable sources, energy conservation, finding efficiencies and electrifying end use sectors. But we would also go a step further and suggest current fossil fuel providers improve their standards substantially to reduce harm to the environment. This dual approach will help the world to get green.

We are more cautious on the IEA’s demand for no new investments in fossil fuel projects; while on face value this appears positive, it could have negative consequences. In our conversations with corporate management teams, we observe that many traditional energy companies are forgoing new oil and gas projects despite lucrative energy prices due to pressure from sustainable investors. This breaks the link between demand and supply and disrupts the normal operation of commodity markets.

If energy companies do not flex supply, it will lead to further rises in the price of energy, which could trigger cost push inflation. A 2014 paper from the Federal Reserve used a nonlinear oil price model to show that high oil prices explained a 3-5% cumulative drop in US GDP in the two years following recessions in the 1970s, early 1990s and 2007. If energy markets are inhibited in their response to prices, recessions could become deeper and harder to escape from.

Another possible effect of completely halting new supply is to shift the balance of power towards private and state oil companies. These companies are usually non-listed, so they don’t have shareholder pressure to become sustainable and improve their environmental standards. They can exploit high energy prices by ramping up production with only limited impact on aggregate supply. This could create a negative scenario of persistently high oil prices, high inflation and elevated emissions. It is better to keep assets in companies that are accountable rather than offloading them to dirty producers.

A transition-based engagement policy in action

A transition-led energy engagement policy that includes the fossil fuel industry by rewarding producers shifting to sustainable business models while penalising the laggards could be a solution.

As sustainable investors we can advise and hold energy companies to account, putting pressure on them to disclose and meet transition targets. By rewarding companies that are transitioning towards renewable energy, we are dangling the important incentive of lower costs of capital to the better players in the industry. Companies that are not transitioning will have higher costs of capital and correspondingly lower shareholder returns, inducing them towards transition.

The International Renewable Energy Agency (IRENA) estimates that there is a US$33 trillion (or $1 trillion annual) shortfall to achieve the 1.5c 2050 climate change target. If the energy sector is given the right incentives, we can leverage their expertise in allocating capital to and managing challenging energy projects to help address this gap. In this way, a transition-based investment policy is a pragmatic and market-aligned approach towards sustainability.

We have seen two major victories for sustainable investors recently at Exxon Mobil and Chevron. At the former company, at least two directors have been added to the board to push the climate change agenda. At Chevron, shareholders voted for the company to substantially reduce its scope 3 emissions. These developments were only possible because of the work of shareholders who engaged with the company rather than excluded them.

Pioneer Natural Resources

Pioneer Natural Resources, a fracking business in the Permian basin, Texas, has been excluded by some ESG funds. However, delving deeper into the company and looking at its value chain presents a more nuanced picture of its sustainability.

In 2016, it was dismissed as having poor sustainability and operating in a polluting sector that was undergoing a price slump. After engaging with management, we concluded the strategic direction of the company was not reflected in the share price. Pioneer was working hard to improve its sustainability by committing to reducing emissions and emissions intensities, and as engaged investors, we wanted to support that transition.

Today, Pioneer has adopted emissions targets that align with the Task Force on Climate-related Financial Disclosures (TCFD), and cut its use of flaring in gas operations to just 2% of production, which it intends to reduce to less than 1% next year and to zero by the end of the decade. It aerially monitors all its Permian facilities to rapidly detect and repair leaks and only builds a well once it’s fully connected to a gas line to limit escape.

We met with the Executive Vice President in 2019 to specifically address water demand and the company has made progress. Pioneer has reduced its freshwater input by increasing the use of recycled water and is partnering with local cities to buy treated effluent water. The company expects to cut freshwater use to below 20% this year and more in future.

On the social side, Pioneer is fostering an inclusive and diverse culture and has policies in place to develop, train, promote and retain employees in a merit-based structure. It has board level accountability for health and safety, environmental impact and ESG protocol, and has boosted shareholder friendliness through better disclosure and launching share buyback programmes.

All these initiatives indicate a company that has a comprehensive, integrated approach to sustainability, and this is showing up in its metrics. It’s scope 1 and 2 greenhouse gas emissions are around half the global industry average and it intends to cut this by a further 25% by 2030. This is excellent but it’s important to continue developing and in a recent meeting with the CEO we stressed the need to move the target to net zero.

Pioneer’s ESG disclosure scores doubled between 2016 and 2019 and investors are beginning to recognise its qualities. Pioneer is now a sustainability leader among its US peers and its success is likely influencing other companies. It’s crucial for companies like Pioneer to use its best-in-class position as a springboard for further improvement and we are discussing this with the company. We also engaged with Parsley Energy, presenting to the board shortly before the company was acquired by Pioneer in October 2020; both companies share a complimentary approach to sustainability.

Every energy company is a potential transition-through-engagement story

Too many ESG investors prioritise the environment to the detriment of social and governance issues, while others simply analyse the end product, ignoring all the other stages of production. To make the best sustainable investment choices, we should be comprehensive and inclusive in our approach, considering the environment as well as the widest range of effects on society, and assess the whole supply chain.

We believe that the right sustainable position is to work with energy companies in their journeys towards transition, creating incentives for those embracing transition and penalising those that don’t. By engaging with energy companies, ESG-aware investors can provide trusted counsel, encouragement and accountability. This process is already delivering results.

For all the success engagement has had, it will be limited unless authorities intervene. Energy companies are increasingly targeting net zero scope 1/2 emissions but scope 3 emissions, which result from assets not controlled by energy

companies, is a societal issue. Denbury, a competitor to Pioneer Natural Resources, is the only upstream producer that has committed to net zero scope 3 emissions because its carbon storage business enables it to do so. The best solution for scope 3 net zero to work more broadly is for governments to introduce a carbon tax and encourage more carbon capture, potentially through subsidising tax credits.

As engaged investors we should work with companies, consumers, governments and peers to transition towards renewables as a society. That means moving beyond simple green and non-green exclusionary labels, and towards making sounder, nuanced investing decisions that seek to maximise long term sustainability. Ultimately, every energy company is a potential transition-through-engagement story, and by using this approach, we should have more examples like Pioneer.

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