Fink, Frackers and Putting the ‘G’ in ESG
(Bloomberg Opinion) -- If you’re jazzed about the environmental, social and governance, or ESG, investing thing, then the energy sector is probably way down your list of priorities. On the other hand, if, like Larry Fink, you’re trying to wield a $7 trillion cudgel in the interest of getting folks to pay attention to this stuff, then energy is a top target.
The BlackRock Inc. CEO’s letters and associated media blitz on Tuesday morning can be summed up as one long, thinly veiled threat. Fink acknowledges climate change is real and its consequences potentially catastrophic and, therefore, capital markets will shift accordingly — whether individual investors and companies are prepared for it or not. So best get on with it. Moreover, should companies fail to adequately take the initiative, BlackRock “will be increasingly disposed to vote against management and board directors.”
There has always been a hefty dose of moral suasion at the heart of the (amorphous) ESG investing theme. Shame can be a powerful tool. BlackRock’s move appears to be at least partly a response to criticism it wasn’t living up to its earlier rhetoric. And it comes days after the CEO of Siemens AG felt the need to issue a response to climate critics that was both extraordinarily long and edited to a standard I can only describe as anguished (see my colleague David Fickling’s detailed take here).
When it comes to energy companies, though, the moral suasion approach has been playing out for decades already. Moreover, as my colleague Mark Gilbert points out here, roughly two thirds of the assets managed by BlackRock are in index trackers that can’t shift money away from climate laggards, whatever Fink thinks. Indeed, given the sheer unpopularity of energy stocks, it seems likely much of the money still in there is passive.
But that doesn’t mean BlackRock is powerless.
That energy has shrunk to only about 4% of the S&P 500 has at least as much to do with the sector’s recent past as it does with concern about the future. The past decade delivered, simultaneously, the biggest surge in U.S. oil and gas production ever and investment returns that lagged the market by a mile. The ultimate culprit for this is skewed incentive packages for the executives running the companies, rewarding growth at any cost and largely shielding managers from the decline in oil prices that inevitably results from such growth (see this, this and this).
Doug Terreson, the lead energy analyst at Evercore ISI, has been tracking shareholder (mis)alignment at oil and gas firms since 2017. He found that, across the five years through 2018, Big Oil and E&P CEOs earned 123% and 116% of their target bonus on the back of annual total shareholder return of 1.2% and negative 11%, respectively. That compares with an average payout for S&P 500 CEOs of just 76% but on the back of an annual return of 8.4%.
Fixing this disconnect may seem disconnected from the objectives laid out in Fink’s letter (who in ESG circles wants to make oil stocks more attractive?), but there is much to be gained by bolstering the E via the G.
Pushing oil and gas firms to prioritize returns would go a long way in dealing with the worst excesses of breakneck growth. An obvious example is flaring of excess gas production, especially in the Permian basin, where the Railroad Commission of Texas has effectively abdicated its responsibilities. It is of course ridiculous that so many firms decrying the burden of regulation ignore the fact that (a) shale gas production has surged regardless of White House occupant and (b) they’re literally venting or burning a fuel that could be sold.
Analysts at Sanford C. Bernstein track Permian flaring on a quarterly basis and find that small-and-mid-cap E&P firms tend to flare a higher proportion of their gas and on a more consistent basis. This fits with a growing divide between smaller producers and the majors moving into the shale patch when it comes to setting hard targets on methane emissions. It also speaks to the reality that the long tail of smaller producers are at a structural disadvantage versus their larger peers in terms of unit costs and cost of capital, making them even less inclined to take a long view, slow their growth and invest more in mitigating their environmental impact. While activists have been pressing for consolidation, entrenched management and seeming disinterest from the investing heavyweights have largely blunted such efforts.
Yet Fink’s own logic dictates that rising risk premiums related to climate change will exacerbate the economic disadvantage for many smaller oil and gas producers. That means BlackRock has perfectly aligned incentives on both ESG and straight financial grounds to be much more aggressive in voting down the skewed pay packages and chummy board structures that have blighted the industry for so long. The majors may well capitalize on this via consolidation of struggling competitors. However, they also face higher risk premiums, which translate already into a demand they disburse, rather than invest, a higher proportion of their cash flow. And they also have to secure votes come proxy season.
BlackRock is bound to put its clients’ money where they want it to go, passive or otherwise. The test of Fink’s words is whether he is willing to use the power that still comes with that.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal's Heard on the Street column and wrote for the Financial Times' Lex column. He was also an investment banker.
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