No impact on secondary markets?
ESG transition approaches suggest making companies more sustainable. Many providers of so-called responsible investments promote ESG transition investments. Typically, the argumentation is: You have to put money into brown companies so that they can finance the transition to become a greener company. That sounds plausible but may be misleading.
In the case of listed investments, securities are bought from other investors. No capital flows to the companies themselves. This is different with capital increases, new bond issues or private equity and credit investments. Not every such investor investment is truly additional because of an often high investor demand (“capital overhang”). In any case, issuers receive additional capital which they could use to finance a green transition. Unfortunately, even in the case of some so-called green, social or sustainability bonds, it cannot be guaranteed that the proceeds are used to finance greener or more social transitions (compare The Economics of Sustainability Linked Bonds by Tony Berrada, Leonie Engelhardt, Rajna Gibson, and Philipp Krueger as of September 14th, 2022).
ESG Transition? Big Oil throws cash at shareholders, not renewables
According to Nathaniel Bullard from BNN Bloomberg (“Big Oil’s pullback from clean energy matters less than you might think” as of June 25th, 2023) “The world’s five biggest publicly listed oil and gas companies posted just under $200 billion in total profits last year. Faced with three strategic possibilities for how to use their cash piles — extract oil and gas apace, move their businesses into renewable power and energy transition assets or return money to shareholders — the supermajors have largely sprung for the third option in recent weeks”. They invested in transition in the past, but their overall energy-transition investment share is low with about 3% according to Bullard. “And there is no shortage of capital at the moment — according to the International Energy Agency, more has been invested in clean energy than fossil fuels every year since 2016”.
It seems to make little sense to promote investments in Big Oil stocks or bonds as transition investments. Blackrock, one of the largest asset managers with very large holdings in Big Oil companies, probably disagrees with me. Exxon, Chevron and ConocoPhilipps are among the holding of its U.S. Carbon Transition Readiness ETF. According to Blackrock, the ETF provides a “broad exposure to large- and mid-capitalization U.S. companies tilting towards those that BlackRock believes are better positioned to benefit from the transition to a low-carbon economy” and “harness BlackRock’s thinking in sustainable investing through a strategy utilizing research-driven insights” (BlackRock U.S. Carbon Transition Readiness ETF | LCTU (ishares.com)).
I would rather invest in companies specialized in renewable energies. And even with listed investments, investments could have some positive impact.
Shareholder engagement with the bad or the good companies?
In theory, share- and bondholder engagement can have a positive impact on companies. For Big Oil, that did not work well so far: “Resolutions that would have forced the companies to align with Paris Agreement climate targets failed. BP and Shell have also pulled back on their strategies to cut fossil fuel production” (Bullard).
Shareholder engagement seems to be more fruitful when targeted at already somewhat responsible companies (compare Shareholder Engagement on ESG Performance by Barko et al. (2022)). That is also my experience (see Active or impact investing? – (prof-soehnholz.com)).
ESG Transition: But we still need oil and gas!
Certainly, we still need oil and gas for our economy for a long time. But Big Oil will certainly sell us oil and gas as long as we adequately pay for it. I do not expect that they decide to sell oil and gas only to stock- and bondholders.
Maybe, responsible investors should not invest at all in brown companies or companies with social deficits which distribute dividends instead of investing the available capital in a greener or more social future (see Transitionierer: Dividendenverbot für ESG Sünder? – Responsible Investment Research Blog (prof-soehnholz.com)).
Underdiversification and return risks?
Many investment advisors (and promotors of diversified products) argue, that investors should not deviate much from diversified indices. This would mean to also invest in brown and not very social companies. These advisors and promotors rarely mention the – mostly very low – marginal utility of additional diversification. Also, most likely, you will not hear the argument that if you start with very responsible investments and then diversify, the average responsibility score of the portfolio will shrink. There are very few convincing arguments why investors should invest in all the same countries, industries and companies as broad indices. Focusing investments on few of the most responsible investments can generate attractive returns and risk adjusted performances (see 30 stocks, if responsible, are all I need – Responsible Investment Research Blog (prof-soehnholz.com)).
Some argue that theory proves that brown investment should have high returns in the future. According to them, brown companies have to pay higher interest rates to creditors and higher returns to stockholders than responsible companies. Thus, shareholders of brown companies should have higher returns than shareholders of green companies.
Lower brown risks
There are other arguments, though. Brown companies certainly have more ecological risk than green companies. Therefore, the risk adjusted returns of brown companies may not be so attractive. And if brown companies have to invest instead of distributing dividends, higher returns for stockholders mean that in the future, someone has to pay a relatively high price for the (formerly?) brown stock. Instead, investors can invest in already green companies. Those companies have lower capital investment requirements for transitions. But they can still improve their greenness and/or distribute dividends. That seems to be the more attractive investment case. And given the low current share of truly green and social investments, I expect responsible investments to continue to grow for many years to come.
Since 2017 I try to invest in a limited number of most responsible companies. Since even these companies can still improve significantly in terms of responsibility, I also try to engage with all of them (see Shareholder engagement: 21 science based theses and an action plan – (prof-soehnholz.com)). So far, that approach works well.