U.S. midstream infrastructure represents one of the largest pipeline infrastructure networks in the world. It is the backbone of U.S. economic growth and energy security, transporting natural gas and petroleum products used by American households, manufactures and businesses.
Thanks to the unprecedented growth in domestic oil and gas production, which has rapidly transformed the U.S. position in the global energy market, companies are moving quickly to invest in the buildout of new pipelines to manage supply.
However, with pipeline development comes the environmental and social due diligence that is well-known and expected of the oil and gas industry. While industry has long focused on remaining good stewards, pipeline companies are increasingly under pressure to adopt and implement standards that focus on documenting and mitigating environmental challenges. Enter the concept of Environmental Social Governance (ESG), an investment and operational strategy that has permeated the market due to its ability to manage risk while also achieving business and market outperformance.
ESG and midstream markets are colliding. ESG analysis is gaining prominence with investors who now expect pipeline companies to better evaluate and disclose how their business and investment plans address these risks and opportunities.
What Is ESG?
With the marketplace experiencing a major paradigm shift in the categorization of business strategy and risk management, the concept of ESG has emerged as a significant element in developing a more complete picture of how companies can manage risk and create shareholder value.
Social and environmental factors were traditionally considered exogenous to investment risk calculations. Within the past few years, the perception of risk has now shifted to include these issues as they can now be financially tied to a company’s bottom line, something that is of interest to C-Suite management and to investors. Institutional investors ranging from banks, pensions, sovereign wealth funds, endowments and mutual funds, all recognize these financial implications. Thus, they are more frequently including ESG risk factors in their assessments.
This strategy is pervasive in recent years because its ability to capture financial value has been empirically proven time and again. World-renowned academic institutions, top global investment banks and consulting firms have all individually conducted studies that reiterate the financial and market value of ESG. The reason is because the concept of socially responsible investing has transitioned from an exclusionary approach to portfolio development to a “best in class” or “ESG-tilted” approach.
Historically, exclusionary strategies led investors to screen out companies as investments if they were perceived controversial. However, this dramatically reduced what is known as the investment universe — by eliminating certain industries or companies all together, investors would be limited in their options for diversifying their portfolios to mitigate risk and to capitalize on returns.
Now, during this ESG paradigm shift, investors no longer have to choose between doing well financially and doing what’s socially responsible. They are shifting capital towards companies that show positive ESG performance relative to industry peers or by avoiding or limiting companies that do not meet certain ESG thresholds. This strategy allows investors to have more options for portfolio buildout and diversification, which can be linked to reduced volatility and enhanced risk-adjusted returns. Studies also show that increasing ESG performance can lower the cost of capital of companies, improving their valuation.
Today, companies and investors are now actively working together in this space, fostering more transparent, open and productive dialogue about ESG risk management. The debate is no longer centered on if a company should incorporate ESG in risk management; rather, companies are simply trying to determine how they interact in this space.
Investors, Pipeline Companies Converge in ESG
Oil and gas, by the nature of its operations, garners tremendous focus on environmental and social
issues. Yet, the industry is not going anywhere for the foreseeable future; it’s a foundational driver of the
The question becomes how companies manage their holistic risk profiles. In the past, these subjects were most likely addressed in a CSR report or via a brief policy statement posted on a webpage. Now, a more proactive approach is taken. Companies are initiating productive dialogues with their shareholders around long-term risk factors including natural and environmental capital, social capital and governance oversight.
Within the past few years, the topic of climate change and its impact on the growth and valuation of oil and gas companies has made headline after headline in major media outlets. The 2015 Paris Climate Agreement effectively launched the movement for investors to consider climate risk associated with oil and gas operations. The assertion is that if the world is to avoid catastrophic climate change, international players must do their part to prevent a 2 degrees Celsius increase in global temperature. For this reason, the oil and gas sector is now considering the possibility of shifts in traditional energy demand, impacting reserve valuation, or regulation-based emission restrictions to remain within that temperature threshold.
Conversely, the unprecedented growth in domestic oil and gas production has created an obvious investment opportunity to allocate significant amounts of capital towards pipeline infrastructure buildout. This is in an effort to address the dearth in pipeline takeaway capacity. However, if future oil and gas resources begin to hypothetically remain “in the ground,” or if significant costs result from emission restrictions, will spending billions of dollars on pipeline infrastructure assets ever recoup their massive upfront costs? Interrelated with this concern is the fact that pipelines must also consider their emission profiles. Greenhouse gas emissions, such as those from natural gas processing and fugitive emissions, is a major ESG issue for pipeline companies to consider, made extremely evident in the recent growth of climate change and greenhouse emission shareholder resolutions.
Investors in oil and gas and pipeline operations are increasingly requesting better disclosure and transparency. Via shareholder resolutions, they are asking companies to lay out long-term strategies showing how ESG factors may affect their ability to generate value. Large asset managers such as BlackRock, Fidelity and Vanguard have augmented their engagement teams and are working with portfolio companies, particularly regarding better governance and preparedness on climate change. Climate resolutions brought by concerned shareholders have won increasing investor support. In 2017, the first majority votes on climate change reporting disclosure passed at Exxon Mobil, Occidental Petroleum and PPL; 2018 followed suite when Anadarko Petroleum and Kinder Morgan had majority votes to publish an assessment on how their portfolios could be affected under a 2 degrees Celsius scenario.
Kinder Morgan also had a shareholder proposal to report on plans to measure, monitor and mitigate methane emissions resulting from all operations, including storage and transportation, according to a 2018 shareholder memo on methane emissions by Miller Howard Investments. This resolution did not pass for Kinder Morgan. However, Range Resources did receive a shareholder majority vote for this type of methane proposal. This is a clear message to energy companies: upstream, midstream and downstream players must be prepared to disclose how they plan to adapt and transition to a low emission, low carbon economy.
Beyond the argument of climate change, midstream oil and gas activities face other key challenges around ESG, all of which investors evaluate. Leaks or accidental discharges, let alone damage to ecologically sensitive land, can lead to tremendous legal fines and what could be significant reputational damage. Pipeline rights-of-way and the impact on social and human rights are other sources of breaking ESG-related headline news. Pipeline companies are well versed in the fact that their social license to operate is entirely dependent on developing both trusting and engaging relationships with local communities and impacted stakeholder groups.
These relationships are proven to directly link to a company’s bottom line, driving senior management’s attention. If a midstream company does not properly conduct due diligence to actively involve impacted stakeholders in the buildout of their pipeline infrastructure, expensive problems can result. Whether it is delayed construction or suspended operations due to well-publicized protests, uprisings, or even physical damage, these impacts have been shown to cost millions, not to mention the tangential cost of diverting C-Suite level attention to these issues versus running day-to-day company operations.
Companies that prevent and proactively manage these environmental and social impacts can avoid expensive project delays- and worst case, project shut downs, legal liabilities and environmental remediation and cleanup costs. Best in class companies will most likely be favored for future capital allocation when new project development opportunities arise.
Finally, midstream companies are also feeling the pressure, as is the entire oil and gas industry, to divulge on certain ‘G’ factors of the ESG equation. Governance metrics at the forefront of ESG risk analysis includes political spending, board independence, board diversity and executive compensation. These issues tend to drive significant weighting in external rating agency scores or proxy research reports. Companies are quickly acting to more transparently publish information on these metrics since these scores are often the indicators that investors reference when making portfolio allocation decisions.
U.S. midstream companies presently find themselves at a critical juncture — adapting to the pressing need for new pipeline infrastructure, while at the same time, integrating the risks associated with a carbon constrained future and managing anti-industry rhetoric. These considerations fall at complete opposite ends of the spectrum.
What is the solution?
By proactively engaging in ESG risk mitigation policies and standards, companies can begin to walk the line on these divergent issues. ESG strategies will facilitate capital allocation for infrastructure build out — investors see the opportunity for superior business performance, higher valuation, lower cost of capital and enhanced risk-adjusted returns. Not to mention the critical environmental and social issues that are tangentially addressed through these enterprise risk management strategies. This paradigm shift is one that is occurring now and will continue to drive business strategy into the foreseeable future.
Tags: Environmental Social Governance (ESG), investment, November December 2018 Print Issue
Alanna Fishman is director of policy and social responsibility at HBW Resources, a consulting and advocacy firm based in Houston with offices nationwide.