As responsible investing (RI) rises in popularity, so too does the scrutiny of funds that are marketed with a focus on environmental, social and governance (ESG) issues.
One of the questions we are hearing in the market is, “Why do some ESG funds hold oil and gas stocks?” Some background on the different approaches to RI is essential for answering this question.
Inclusionary vs exclusionary strategies
While there are many different approaches to RI, most of them can be grouped into two broad categories: inclusionary and exclusionary strategies.
Exclusionary strategies are pretty straightforward, involving the exclusion, divestment or negative screening of certain industries, typically based on personal values rather than financial considerations. Tobacco and weapons are two of the more common screens applied to exclusionary funds, which have been active in the Canadian market since the 1980s and are often marketed as ethical or socially responsible investments (SRI). There are now a number of mutual funds and ETFs in the Canadian market that apply this exclusionary screening to oil and gas.
In recent years, it has become evident that ESG factors are material to investment decisions, which means they could impact a company’s value and therefore should be disclosed so investors can make informed decisions. This has moved RI from the margins to the mainstream, as some of the largest and most sophisticated investors in the world bought into the concept. Inclusionary strategies such as ESG integration, shareholder engagement and positive screening moved to the forefront because of their dual focus on financial performance and societal issues.
ESG integration is about looking at a company’s ESG performance to uncover risks and opportunities that may not be visible in traditional financial metrics. For example, if a company’s directors are all white men and the company is not disclosing climate-related information that investors are looking for, then this company may not be managed as well as its peers, and its shares, therefore, may be overpriced. That’s what ESG integration is about: using all available information – including ESG and financial data – to make a more complete assessment of a company’s long-term value. The ESG integration process may lead to a buy or sell decision, or it could lead the fund manager to hold the stock and engage with the company – a practice known as shareholder engagement.
Shareholder engagement involves using the power of ownership to strengthen a company’s ESG performance and its long-term value. Using the above example of an all-white, all-male board of directors, shareholders of a publicly traded company can vote for more diverse representation on the board, or engage in a dialogue with management to ask for better climate-related disclosures. Leading asset managers often combine ESG integration and engagement to form a two-pronged inclusionary approach.
Positive screening is another inclusionary strategy that can be easily understood as a “best in class” or “best of sector” approach. There are ESG leaders and laggards in every sector, and a positive screen involves choosing the leaders within each sector.
In some cases, fund managers will actually combine inclusionary and exclusionary strategies. For example, a fund might exclude tobacco and weapons manufacturers while performing ESG integration and shareholder engagement within the remaining investible universe.
An ESG lens on oil and gas stocks
Some ESG funds take an exclusionary approach to oil and gas, while many follow an inclusionary approach. Below are some of the rationales for taking an inclusionary approach.
The risk angle
Risk management is a major driving force behind inclusionary strategies such as ESG integration, shareholder engagement and positive screening. Climate change is a systemic issue, which means that it will affect many industries including energy, mining, insurance, agriculture, real estate, transportation and others. If a Canadian equity fund excludes all of these industries, it will not be left with a diversified portfolio.
This systemic reality can lead a fund manager to take a three-pronged inclusionary strategy that involves integrating ESG factors into portfolio construction; owning the leaders in each sector, including oil and gas; and engaging with companies in the portfolio to mitigate risk and strengthen their sustainability performance. Shareholders have a seat at the table to voice concerns about unsustainable practices and to encourage oil and gas companies to become the energy leaders of the future by adapting their business models for a low-carbon world by, for example, reducing emissions and diversifying into renewables.
The opportunity angle
On the opportunity side, our economy runs on fossil fuels and it will take some time to fully transition to a low-carbon economy. In the meantime, oil and gas companies like Suncor, Cenovus and Enbridge are positioning themselves as sustainability leaders. Suncor and Cenovus have both pledged to reduce their emissions intensity by 30% by 2030. Cenovus recently went a step further by joining Spain’s Repsol and Norway’s Equinor in pledging to achieve net zero emissions by 2050. Equinor actually changed its name from Statoil to show that it’s transitioning away from oil.
Meanwhile, Enbridge has capacity to generate 4,121 megawatts of clean energy. Its wind farms alone power 868,209 homes, which is about 6% of all households in Canada.[i] This complicates the case for divestment, as selling their shares also means losing exposure to one of the largest renewable energy companies in Canada that has the scale and distribution network to be a transition leader.
These companies recognize that a low-carbon transition is coming, and they are positioning themselves as sector leaders of today and tomorrow. A fund manager may view these types of energy companies as attractive investment opportunities while demand for energy remains high and substitutes lack scale.
The environmental impact angle
Investment decisions do not have the same impacts as consumption decisions. For example, while switching to an electric vehicle or a plant-based diet has measurable environmental impacts, selling oil shares does not. That’s because selling stocks does not change the demand for oil and gas.
From an investment perspective, a fund manager may take the view that there is a higher probability of generating positive environmental impacts by taking a stake in a leading energy company and engaging with its management to reduce emissions and improve its environmental practices more broadly.
When considering ESG funds, it is important to recognize there is a wide range of strategies, including inclusionary and exclusionary approaches to oil and gas. Both approaches can be valid, depending on the specific preferences and objectives of each investor. The Canadian market offers a wide range of RI products to satisfy clients’ unique views on energy and other issues.