- Can reform-minded polluters win a premium valuation?
- Green solutions-focused stocks could come with higher risk
With its ambitions to electrify the automotive sector, Tesla (US:TSLA) is without doubt the most famous pure-play investment in a greener future. Its environmental credentials – increasingly sought after by ESG-minded investors – also go at least some of the way to explaining a premium valuation and a share price trading at more than 30 times sales.
Yet, whether simple or breathlessly optimistic, any investment narrative is open to question. Last week, Tesla bulls received their latest reminder of this axiom from the industry their company hopes to help supplant.
Speaking to the Financial Times, Occidental Petroleum (US:OXY) chief executive Vicki Hollub (pictured) highlighted her company’s efforts to pump most of the carbon dioxide it emits in the production of hydrocarbons back underground. Though this is nominally to smooth the oil extraction process, it also means most of the 28m tonnes of carbon emissions that would otherwise come from its annual operations are ‘removed’. That is more than the pollution saved by the number of drivers swapping to Tesla’s electric vehicles each year.
“What we’re sequestering today takes essentially about 4m cars off the road on an annual basis,” said Ms Hollub in an interview with the Financial Times. “It does more than what Tesla’s doing right now — although we need Tesla to continue what they’re doing.”
It is important not to lose sight of what is being measured here. Burning the 1m barrels of oil Occidental produces and sells each day leads to five times as many emissions as those apparently saved by its sequestration process, a point that is unlikely to result in a valuation premium anytime soon.
Its cash flows also remain almost entirely chained to the price of oil, a fact which helps explain why Occidental dropped out of the S&P 100 Index in December – to be replaced by none other than Tesla.
Ms Hollub’s intervention, nonetheless, raises a serious point as to whether ESG-laggards such as the incumbent energy sector can use their scale and expertise to eventually win a market premium in their bid to transition to better practices, on a medium to long-term view?
The company that best encapsulates this potential is Denmark’s Ørsted (DK:ORSTED), which since its 2016 initial public offering has transformed itself from North Sea explorer into a renewable energy star. After completing the sale of its oil and gas divisions, the group has gone on to command a forward price-to-earnings ratio of more than 50, compared with single digits for integrated oil and gas majors.
At £62.4bn, Ørsted’s market capitalisation makes it more valuable than BP (BP.), despite the latter’s recent promises to increase green investments from $500m (£365m) to $5bn a year over the next decade, compared with annual capital expenditure of around $20bn.
That might prove hard to sustain against FactSet-compiled forecast operating cash flows of $108bn between 2020 and 2024, but what is not in question is the value investors have assigned to BP’s future earnings. Over the same period, analysts expect the oil group to generate $31bn in net income, compared with $10.1bn for Ørsted.
Reasons for doubt likely include fears of another oil price slide, indebtedness, or the sector’s infamy for burning through capital and running over budget on what amount to enormous and bespoke engineering projects. By contrast, the renewable energy industry benefits from manufacturing principles of falling costs, scale and learning.
Other ESG-minded investors will fret about the incumbent sector’s ability to maintain its social licence, a criterion which the managers of the BlackRock Energy and Resources Income Trust (BERI) managers Tom Holl and Mark Hume say is integral to their investment selection criteria. In recent years, the trust has also broken from a split focus on hydrocarbons and mining, reducing its weighting to oil and gas in favour of companies involved in the energy transition.
Whether incumbent energy companies can replicate Ørsted’s strategy shift in so short a time remains in question. Despite some bold commitments, including Total’s (Fr:FP) ambition to become a top-five renewables player, integrated majors still face an enormous task in adapting or weaning themselves off the scale and synergies that their legacy businesses provide.
The message from equity markets is that the transition plans on offer are not yet as bold – or virtuous – as they should be.
Lower ESG risk isn’t risk-free
At some point in 2019, ESG picked up the baton from factor investing as the buzz phrase of choice for asset management firms’ marketing departments. Slogans along the lines of “doing good to do well” have been pushed to investors and there has been some evidence (such as Trustnet’s fund surveys) that ESG stocks have delivered superior performance over the past two years.
Positive returns are in no small part down to the weighting of the so-called quality factor in many ESG portfolios. Companies like Microsoft (US:MSFT) and Alphabet (US:GOOGL), have scored well enough against environmental criteria to be held at, or above, their market capitalisation weighting in benchmarks. They were the top two global stocks in ESG managers’ portfolios, when we looked for Investors’ Chronicle’s Ideas Farm in December. Spectacular share price gains from companies like these has helped feed the narrative that green investing makes money, but should it have?
The tech stock boom is about great businesses with dominant market positions whose cash flows become more prized every time interest rates fall. Although cleaner than old economy sectors such as oil & gas or banks (who fund polluters), this is not primarily a green story. Furthermore, as antitrust pressures potentially mount and stretched valuations become more of a leap of faith in earnings upgrades, quality giants may have to at least pause for breath.
In case the days of just hanging onto mega-cap momentum is over, ESG returns must come from stocks with different factor characteristics. This fits with the inclusion rules of newer share indices that prize the positive impact companies have in the fight against climate change. Looking at more than whether a business is a low polluter relative to other large companies, indices such as iClima Global Decarbonisation Enablers weight more towards companies contributing to reducing carbon emissions in the world economy.
The iClima index has a pure focus on carbon avoidance – businesses across five sectors which are energy, transport, carbon capture (sequestration), waste solutions and sustainable products – and caps holdings at a 2 per cent weight. This means investors’ money really will go into finding solutions and not just adding momentum to the share price of large companies managing their own carbon footprint. In fairness, products by Microsoft and Google help users reduce carbon impact, but funnelling capital to less ubiquitous companies is important to the sustainable company eco-system.
Shifting emphasis to smaller players in the supply chain of the green economy might be virtuous, but investment returns are reward for risk, not good intentions. Considered in traditional factor investing terms, the risk investors hope will pay off here are to do with the size of businesses (smaller companies carry more solvency risk and their share prices drop more in a downturn because there are fewer buyers for them) and the uncertainty whether potential is realised.
Advances in quantifying the climate risk companies pose have been impressive, but investors should not allow financial fundamentals to take a back seat. The iClima index does have inclusion rules on the intraday trading volume of companies, but such measures suffer the flaw that market liquidity can rapidly dry up in a crisis. Although, the index is diverse and there are many established companies included. In general, quality indicators found in the financial statements of index constituents must not be overlooked: visibility on the profitability of index holdings; how margins have progressed; free cash flow generation.
Of course, with many companies at the forefront of environmental technologies, the investment case is about growth. In which case, the momentum in earnings growth and forecast upgrades are measures to consider, too. Without such interrogation, investors in green funds are just buying into the story of massive state-sponsored investment in renewable energy and infrastructure creating a rising tide. That may be right, but if weightings only focus on green factors and not financial ones, investors may not have the right balance between stable and speculative growth in their green portfolios.
Talk of the great rotation out of quality and into value stocks forms a big plank of the investment case to look at value premiums offered for relatively ‘brown’ or bad-ESG stocks. The fact is, companies that are penalised for their environmental risk with a lower share price and wider spreads on borrowing costs, are effectively quantifying their risk premium.
The likelihood of stranded assets – for example coal mines being abandoned – means some companies will be value traps. Yet businesses that change gradually could reward what is effectively an ESG ‘value’ premium. Research by Bank of America has shown that companies in the energy, materials and utilities sectors that have worked on sustainable development goals (SDG-13 targets) have improved their return on equity for investors.
The move to green and sustainable energy is undoubtedly (and thankfully) an unstoppable trend but investors could be rewarded for backing rapid improvers as well as trail blazers. Understanding the various risk premiums on offer, remains crucial to constructing well balanced portfolios.
