“Facebook’s travails with social justice organizations and an advertiser boycott has dominated the news, but that is only one aspect of increased focus on ESG. These criteria are being used to pressure energy companies. ”

Last Tuesday, there was a high-profile meeting involving senior executives of social media giant Facebook and representatives of several non-profit social justice organizations. According to media reports and based on comments from the social justice attendees, the meeting did not go particularly well. As Rashad Robinson, the president of Color of Change, put it, “The meeting we just left was a disappointment. [Facebook] showed up to the meeting expecting an ‘A’ for attendance.”

Terence Kawaja, chief executive of LUMA Partners, an advisory company specializing in digital media and marketing mergers and acquisitions, said he worried that Facebook founder, CEO and major shareholder Mark Zuckerberg's stance was already clear. Mr. Kawaja said that Facebook “ought to reorient their attitude towards this. It seems to be one of obstinance.”

At issue for Facebook is its role in policing racist and other inflammatory postings on its platform, especially in the ‘woke’ environment engulfing the nation. Facebook spokesman Andy Stone said the company has established new policies banning voting and census suppression and removed more than 200 white supremacist organizations from its platform. He characterized the meeting as “an opportunity for us to hear from the campaign organizers and reaffirm our commitment to combating hate on our platform. They want Facebook to be free of hate speech and so do we."

According to Jonathan Greenblatt, chief executive of the Anti-Defamation League, on the groups' list of demands is to put civil rights leaders in the company's corporate suite, rather than simply leave important issues to diversity-focused human resources executives. The group also wants victims of hate to be able to connect with a live employee at Facebook.

Facebook has pointed to research that found that it took down 90% of hate speech before it was reported, evidence that it has made major strides in its moderation efforts. That didn’t impress Mr. Greenblatt, an attendee at the meeting, who was quoted telling a reporter, "Ford Motor Company doesn't get to say 90 percent of our seat belts work."

Facebook has been targeted by social justice reformers and politicians to address ‘hate speech,’ and now the pressure is being brought by advertisers. The advertisers are being pressured by the social justice organizations and motivated customers and employees to abandon advertising on the social media platform in order to pressure Facebook to make more radical changes to its speech-policing policies.

Economic pressure is always a plank in social justice reform platforms. It is believed by these agents of change that economic pressure is the most effective leverage the public has against commercial enterprises to win concessions. Right now, not only have a number of social justice organizations organized boycotts of Facebook, but they are motivating their members and the public generally to apply pressure on companies to suspend their advertising. The pressure is ramping up to inflict financial pain on Facebook. The movement is hopeful that the pressure will force Facebook’s executives to embrace the social justice organizations’ demands.

Why is Facebook’s predicament of significance for the oil and gas industry? Facebook is being targeted under an increased focus on ESG (environmental, social and governance) criteria that is becoming a greater focus of investors. Investors are just as likely to be exploited on issues by activists – in the case of energy companies, it is environmentalists. The last time we remember the social justice weapon being used against oil and gas companies was in the 1980s when the issue was divestment of operations in South Africa over its apartheid policies.

Today, ESG is being used to target all capital flows to the oil and gas industry. While ESG standards initially targeted commercial bank lending to energy companies, the effort has expanded to include all global financial institutions such as the World Bank and the International Monetary Fund.

The most high-profile embrace of ESG criteria for allocating investment capital has come from Larry Fink, the CEO of BlackRock, the world’s largest fund manager with over $7 trillion in assets under management. In his 2018 annual investment letter, he wrote: “To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society.” Mr. Fink has been leading the charge to expand the corporation’s obligation to protect and promote the interests of shareholders. Expanding that obligation was endorsed by the Business Roundtable last year, when it released its revised “Statement on the Purpose of a Corporation.” The statement, signed by 181 corporate CEOs, including many of the nation’s largest corporations, expanded the obligations of corporations to include all stakeholders – customers, employees, suppliers, and communities, as well as shareholders.

One should not underestimate the power of ESG in the investment world. In a November 2018 Business Insider article reporting on The New York Times DealBook Conference, Mr. Fink was quoted as having told the audience, “I do believe that the demand for ESG is going to transform all investing. Now, that may be one or five years away from now, but it’s not that far away.” The future appears now.

Mr. Fink has openly talked about the potential ESG offers his firm to grow its assets under management. BlackRock is one of the leaders in sponsoring exchange-traded funds (ETF). An ETF is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds and generally operates with an arbitrage mechanism designed to keep the ETF trading close to its net asset value, although deviations can occasionally occur. ETFs have become a significant asset class on Wall Street, allowing investors to target their investments via packages of stocks with specific characteristics to achieve the investment goal. ETFs eliminate the need to purchase a portfolio of individual stocks to create that vehicle. Additionally, ETFs are traded so the owner can buy or sell immediately, rather than waiting for a mutual fund’s end-of-day valuation to buy or sell.

As part of BlackRock’s strategy, it plans to double the number of sustainability-focused ETFs if offers to 150. A reason for its plan is recognition of the potential for ESG ETFs. At the present time, ESG funds account for only $20.9 billion in ETF assets under management, or about 0.4% of the roughly $4.5 trillion the ETF industry controls. BlackRock also will eliminate from actively-managed portfolios investments in companies that derive 25% or more of their revenue from thermal coal. Lastly, it aims to increase sustainable assets 10-fold from $90 billion today to $1 trillion within the next 10 years. The latter goal is in keeping with Mr. Fink’s comments about how much ESG investing will grow in the future, largely driven by the desire of younger investors for socially acceptable investments.

A 2019 survey by Allianz Life Insurance Company found that 66% of millennial and nearly half of Gen X respondents said they were interested in at least having some money in ESG investments. However, only 17% of millennials and 7% of Gen Xers actually have money invested in ESG funds, according to the survey.

Another reason why BlackRock is targeting ESG funds is that they are moneymakers, in an industry where fees are being slashed due to competitive pressures. While ESG investing is growing, the expense ratios for ESG funds are falling. ESG funds, because they are a more recent phenomenon, as well as being popular, will lag the fees charged for basic total market funds. A column late last year in Forbes magazine shows the impact of the higher expense fees of ESG funds. At Vanguard, the fee for the Vanguard Total Stock Market Index Fund is 0.14%. That contrasts with the Vanguard Global ESG Select Stock Fund fee of 0.55%. Although that fee is still a significant savings compared to typical actively-managed fund expense ratios, the 0.41 percentage point spread between the two Vanguard funds is large, especially when considered over long investment time horizons.

For example, $10,000 invested in a fund for 30 years with a 0.14% fee would cost you over $2,300 in fees, assuming a 6% average annual return. The fees paid with a 0.55% expense ratio would come in at over $8,700. That $6,400 difference is significant to final total returns because the annual fee difference compounds over the life of the investment, as well as with every extra dollar you invest. That extra $6,400 in fees adds to the profits of the asset manager, boosting his bottom line.

There are three financial markets that are subject to ESG pressure, enabling pressure to be directly applied to companies. The three markets are: equities, bonds and commercial loans. When it comes to fossil fuels, global institutions such as the International Monetary Fund and the World Bank, as well as various regional national banks are very active in financing energy projects. These institutions are subject to ESG pressure from their owners – governments from around the world – as well as activists. Getting them to stop financing new coal power plants is an important goal of many environmental organizations.

When it comes to commercial banks, of the top ten global commercial banks, they have between 8%-14% of their total credit exposure to all publicly-listed energy companies. A more important measure of activity comes from a study by banker UBS, which showed that between January 2014 and September 2017, 60% of the financing for the world’s biggest 120 coal-fired power plant developers came from Chinese banks. The next biggest source of funding came from Japanese banks (8%) and Indian ones (7%).

In the bond market, the hottest segment is green bonds, primarily in the municipal debt sector. A study published earlier this year of U.S. municipal issues of green bonds produced interesting results. The only effective difference between a green bond and a non-green bond is the use of proceeds. The former must be invested in “environmentally friendly projects,” such as sustainable water management and energy production.

Green Bond Issuance Has Grown

The purpose of the study was to examine whether “greenium” exists, or the premium green assets trade for compared to otherwise identical non-green securities. The conclusion of the study was that this relationship was “precisely equal to zero.” The study’s authors observed that the spread between green and non-green bonds was approximately 0.45 basis points, a trivial difference. In fact, in approximately 85% of matched cases studied, the differential yield was exactly zero.

What the study did find was that borrowing costs were on average approximately 10% higher for green bonds versus almost identical non-green bonds. That premium reflected the greater difficulty in marketing green bonds, which enables investment bankers to charge borrowers more for the effort. The authors also examined the pricing effects of third-party certifications on the pricing of green bonds. This would ensure green bond buyers that the bonds were legitimate and not subject to “greenwashing,” where there are questionable environmental benefits. The study found no evidence that certification leads to incremental yield benefits for municipalities selling green bonds. As a result, the study concluded that municipalities actually increase their borrowing costs by issuing green bonds. Is this a cost that municipalities, and their taxpayers, wish to bear for virtue signaling?

Companies Issuing Green Bonds

In the equity arena, ESG investing has grown in popularity over the past five years. At the start of 2019, estimates were that $12 trillion in assets under management in the U.S., according to the Forum for Sustainable and Responsible Investment, and $23 trillion worldwide, according to the Global Sustainable Investment Alliance, is managed based on ESG criteria. Both totals represent about 25% of the respective market totals.

ESG Investing’s Impact Is Growing

The climate change movement has had a significant impact on ESG investing. In fact, it was the number one reason cited in a recent article by The Economist. As they put it, what is boosting ESG is the “realization that extreme weather events pose threats to businesses seeking investment.” That concern is further amplified by the fact that governments are taking steps to limit greenhouse gas emissions, and large, long-term investors, such as national pension funds, are demanding managements pay attention to climate risks. The last reason for more attention being paid to ESG investing is the higher profits from those funds at a time when investment manager margins are under pressure, as we pointed out above.

ESG investing has had a mixed performance, although more recent studies by Bloomberg and Thomson Financial show this approach outperforming comparable funds composed of companies not ranking particularly high on ESG criteria. One has to wonder how much the recent outperformance of ESG investing has been driven by self-selection. If investors want to crowd into a limited ESG investing space, the flood of money may be responsible for the outperformance.

The greatest challenge for ESG investing is the lack of company disclosures of metrics allowing measurement and comparison of their performance. The Economist article focused on the “E” aspect of ESG. Carbon emissions disclosure is rising. Based on the magazine’s examination of over 5,000 publicly listed companies, it found in America, the disclosures for companies in the Standard & Poor’s 500 index increased from 53% in 2014 to 67% in 2019. In Europe, the increase was from 40% to 79% in the Euro Stoxx 600, and from 13% to 46% in the Nikkei 225 in Japan.

While carbon disclosure is increasing, many investors question how much and how well this risk is being incorporated into strategic planning and operational practices. Answering those questions has not been done well by the energy industry, especially given its exposure risk that was highlighted in two charts accompanying The Economist article. The challenge was summed up by Mr. Fink when he stated: “Climate change is different. Even if only a fraction of the projected impacts is realized, this is a much more structural, long-term crisis. Companies, investors, and governments must prepare for a significant reallocation of capital.” That will be a challenge.

The first chart showed the tons of CO2 equivalent emissions per $1 million of revenue by aspect of the business for every investment sector of the Standard & Poor’s 500 index. Energy stands out as most at risk, with the largest component of its carbon emissions due to the use of its products by customers.

Energy Most At Risk When Carbon Considered

The second chart reflects an assessment of the risk of climate change by market sector based on physical risk versus regulatory risk. The imposition of a $75 carbon tax is the vehicle used to assess the regulatory risk, although that could be magnified if government clean energy mandates are considered.

Why Energy Is At Risk In ESG World

Today, the “S” of ESG is receiving the greatest attention among investors, as the fabric of the nation, and even the world, is seemingly being pulled apart over racism and the attacks on freedom of speech and thought. These tensions have been elevated as citizens react to the often draconian and imprecisely levied restrictions by government leaders on peoples’ work and personal freedoms. When you are in the middle of a storm, it is hard to imagine blue skies ever returning. Survival and focusing on the moment guide our actions and emotions.

In virtually every economic model, including the most reactionary for limiting climate change damage, energy continues to play a major role. Oil and gas will supply over 50% of our energy needs, even with demand shrinking. Securing the future supply necessary to fulfill these projections will require trillions of dollars. Raising that investment will be challenging in an era of intense ESG focus, and the struggle of energy company managements to demonstrate they can manage their businesses, while meeting the needs of civilization, generating returns for their investors, yet not destroying the world.

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