More controversial than holding alcohol or tobacco stocks these days is retaining shares in companies with a poor track record on climate or the environment. Indeed, a growing number of asset owners have begun excluding energy, mining or other highly emitting companies from their portfolios if they don't have clear net zero emissions targets.
But some fund managers and asset owners argue that tempting investment possibilities still exist in these pollutive industries.
The number of institutions – including governments, pension funds and family offices – that have divested from fossil fuels to date stands at over 1,300, representing $14.1 trillion assets under management (AUM), according to advocacy group DivestInvest.
This has created opportunities in private credit that are hard for asset owners to resist, according to Bev Durston, managing director of alternatives advisory Edgehaven, which counts the UK’s Royal Mail Pension Plan as a client.
“We’re seeing attractive opportunities in the energy lending space in the US. You're getting significant 20%-plus returns just because of the flight of capital there,” she told the audience at the AsianInvestor Summit in June.
A leading regional sovereign wealth fund confirmed this was consistent with investment returns they had seen in the energy lending space.
CONFLICTS OF INTEREST
Dan Gocher, director of climate and environment at the Australasian Centre for Corporate Responsibility (ACCR), believes these lending pathways are at odds with public stances on ESG and could harm investors in the long run.
“I'm not surprised there are opportunities in distressed debt in the energy sector, and this will likely continue to happen, but it does not reconcile with a commitment to ESG,” he told AsianInvestor.
Durston said her advisory does work with their energy lending manager on ESG, but points out fossil fuels won’t disappear overnight. “ESG is very important, but we also think that we're still going to be reliant upon oil and gas for certainly the next 30 years,” she said.
However, Gocher warns that companies struggling to access capital may have other financial troubles. "Often, they have mismanaged their transition to clean energy or have poor governance," he said.
He gave the example of US coal company Peabody Energy, which unlike some peers, has failed to transition to a more sustainable model. The firm last year announced it faced its second bankruptcy in four years, exacerbated by declining asset valuations, additional collateral demands, and the threat of a lawsuit following a 2018 fire at one of its most profitable mines in Australia.
Like traditional “sin stocks” that comprise tobacco, alcohol, weapons and gambling industries, companies in the oil and gas or mining sector might be considered undervalued due to their negative image. This can make investing in them attractive from a financial perspective.
“While some of these stocks may inevitably be undervalued, long-term investors are likely to continue screening them out,” said Gocher.
Yoshihiko Kawashima, head of ESG for Asia ex Japan at Invesco, agrees: "In general, investors are more critical of oil and gas companies now and more exclusionary screening is being done based on their requirements."
However, he added that some investors may remain invested with a transition agenda. "Sometimes owning ‘dirty’ companies but encouraging transition is more impactful in terms of real world outcomes than only investing in companies that are green today," he said.
Critics of this approach believe transition finance could be used as a vehicle for greenwashing, or an excuse for not divesting from highly polluting but performing stocks.
Relatedly, researchers at Columbia University and Imperial College claim that carbon stock returns may outperform as investors increasingly demand compensation for their exposure to emissions risk. In a 2020 study titled ‘Do Investors Care about Carbon Risk?’, they showed a positive relationship between a firm’s carbon emissions and its stock returns.
The report also showed that negative screening and divestment by institutional investors were largely based on Scope 1 or direct emissions, but ignored indirect Scope 2 (from purchased electricity, steam or heat) and Scope 3 (from the company’s value chain) emissions, indicating the existence of greenwashing.