Q&A: ESG strategy in the energy sector
January 2022 | SPECIAL REPORT: ENERGY & UTILITIES
Financier Worldwide Magazine
January 2022 Issue
FW discusses ESG strategy in the energy sector with Clara Cibrario Assereto at Cleary Gottlieb Steen & Hamilton LLP, Simon Ede at CRA, Hillary H. Holmes at Gibson, Dunn & Crutcher LLP, and Silke Goldberg at Herbert Smith Freehills LLP.
FW: How would you describe the growing pressure on energy sector companies to address environmental, social and governance (ESG) issues across their operations?
Cibrario: The pressure to address environmental, social and governance (ESG) issues is increasingly an existential question for many energy companies. Businesses may be forced to adapt their business models considering ESG pressures. As governments worldwide set net-zero targets, generally by mid-century, fossil fuel assets risk becoming ‘stranded’ as compliance with emissions targets forces plants offline. Other companies may be forced to change their business models by pressure from litigation or in response to court decisions. Pressure faced by energy companies may be asymmetric. Certain energy companies have faced various pressures, for example because of litigation, while other energy companies have so far escaped scrutiny. If this remains unequal, ESG pressures may alter the dynamics of competition in the energy sector, as some businesses face pressures their rivals may have avoided to date.
Holmes: The pressure is real and it is here to stay. Energy companies must integrate ESG into their core functions. In getting started, executives must recognise that there is no ‘one size fits all’ solution. Resources at energy companies vary, each company’s ability to pivot or implement ESG initiatives varies, and the investor pressure varies among companies and industry subsectors. Considering this, we advise companies to break down the ESG acronym. Take the E, the S and the G one at a time. Identify what the company is already doing within each area, leverage those efforts, and tell investors about them. Then develop clear and reasonable goals within each area, implement controls to ensure progress toward those goals, and update investors periodically. Throughout this journey, try to keep the pressure at a manageable level. Communication with stakeholders is key – simply showing effort, commitment, clarity and eventual progress will provide valuable returns.
Goldberg: While ESG considerations are affecting companies across all sectors, energy companies have been at the forefront of many ESG developments. While ESG is not limited to environmental issues, the current media and wider public attention on climate change and decarbonisation has meant that the energy sector, which includes some of the largest emitters, has been particularly scrutinised. However, the energy sector is not only dealing with the challenges of the energy transition, it has also – alongside companies in other sectors – been increasingly faced with the need to integrate other ESG issues, such as human rights, modern slavery, community engagement and anti-bribery. The successful implementation of ESG standards by energy companies is particularly essential to maintaining their social licence to operate.
Ede: There has always been pressure on energy companies to do well by the communities in which they operate. ESG strategy, however, is now quickly becoming crucial to sustaining energy companies’ social licence to operate. ESG as an investment focus and lending criteria is creating direct financial implications for non-performance. Implications for access to debt and equity funding are sharpening the focus of energy company boards of directors and management on where and how they participate in the energy economy, such as fossil fuels versus renewables. The pressure on ESG is only likely to increase, particularly in matters relating to the climate as impacts from climate change grow in severity and frequency.
“Traditional oil & gas companies are directly faced with the pressure to decarbonise, and have started to diversify their portfolios with renewable energy assets.”
FW: What effect are policies around CO2 emissions targets and reductions having on energy companies?
Holmes: Many energy companies are adopting ambitious plans to promote a lower carbon future by building on the innovation the industry has leveraged for the past 150 years. Several companies have adopted 2050 net-zero goals and particular goals for ‘scope 1, 2 and 3’ emissions and reporting. These efforts are resulting in the development of new technologies, the implementation of new data-gathering systems, the adoption of new project analysis methodologies, the use of a holistic approach to business lines and their net impact on the environment, new partnerships with multiple stakeholders, and new reporting practices and related control systems.
Goldberg: The current political climate of increasing CO2 reduction pledges is fuelling the energy transition and is affecting both hydrocarbon and renewable energy companies. Traditional oil & gas companies are directly faced with the pressure to decarbonise, and have started to diversify their portfolios with renewable energy assets. Taking UK offshore wind as an example, the recent offshore round four for subsea leasing space in the UK saw strong participation from and successful outcomes for oil & gas companies. Some large oil & gas companies have also taken active steps to divest hydrocarbon assets to reduce their carbon exposure. Related to increased emission reduction targets, the increasing trend of carbon prices is also having an impact in Europe. The European Union Emissions Trading System (EU ETS) price of well over €60 per tonne of carbon, and a UK ETS price of £55 reflects the inherent need for companies to price in the cost of their emissions going forward and may further incentivise decarbonisation efforts.
Ede: Climate risk concerns and emissions policies have been driving a historic reallocation of capital into low carbon segments of the energy industry. Where applied, emissions trading schemes, renewable energy support mechanisms, and coal retirement mandates have helped dramatically reduce the carbon intensity of electricity generation. In the UK, for example, carbon intensity of electricity has fallen by half since 2008, with first a switch into gas and more recently renewable generation. The current market, however, rewards portfolio choices more than improvements to operating practices in existing portfolios around emissions. We find there is much less reward for those that can operate fossil-fuel assets in the cleanest way possible. Although divestment has been a popular strategy for many investors, the consequence has often been the sale of these assets into more private ownership where the incentive to disclose and reduce emissions may be less.
Cibrario: It remains to be seen whether emissions targets set by governments may translate into concrete obligations for energy companies. In May 2021, the Hague District Court made a groundbreaking ruling against Royal Dutch Shell, ordering the company to reduce its worldwide CO2 emissions by 45 percent by 2030 compared to 2019 levels, in line with targets set out in the Paris Agreement. This ruling shows the increasing pressure companies are likely to face for their own contribution to emissions, but it is unclear at this stage whether other courts may follow suit. Increasingly, energy companies will also have to ‘price in’ carbon at all levels of their supply chains. The ‘Carbon Border Adjustment Mechanism’ being developed as part of the EU Green Deal would propose a levy on emissions embedded in certain products imported into the EU, taking effect from 2026.
“The regulatory environment will become more intense over the next couple of years – both in terms of prescribed disclosure and government enforcement actions.”
FW: Where do you see the regulatory environment headed in terms of mandatory ESG disclosures for energy companies? Should energy companies be preparing now for this eventuality?
Goldberg: Increasing disclosure obligations are here to stay and will only increase. The recent implementation of the Task Force on Climate-Related Financial Disclosures (TCFD) regime as mandatory disclosure obligations in the climate related disclosure space, the quick pace of its adoption and current push for wider deployment, reflects a clear regulatory intention. This current trend is unlikely to be limited to climate matters but will be further expanded to wider ESG implications. Already, many ESG considerations are subject to disclosure obligations in the UK, such as modern slavery, diversity and streamlined energy reporting. However, what is largely needed is a clear standardisation and centralisation of these obligations to unify a currently fragmented system. In any event, energy companies should brace for more disclosure requirements over the coming years and ensure they implement the required internal systems today to gather the required data to enable themselves to comply with obligations in the future.
Cibrario: Mandatory ESG disclosures have already become a reality. The EU will quadruple the scope of companies subject, and expand the mandatory content of non-financial reports, starting in 2023 under the new Corporate Sustainability Reporting Directive. Just before COP26, the UK took a leap forward, announcing that the environmental disclosures as recommended by the TCFD, soon to apply to certain UK-listed companies, will become mandatory for the entire economy by 2025. At the same time, it unveiled its work on its own ‘green taxonomy’ of sustainable activities. The US Securities and Exchange Commission is heading in a similar direction, as are some jurisdictions within Asia, the Middle East and North Africa. Oil companies with operations spread geographically should test their capacity to measure impact, not only against climate, but also human rights and the communities affected by their operations. Internationally, divergence in disclosure standards, but most of all perhaps, green taxonomies, will be something to watch.
Ede: The direction of travel is clear with respect to climate risk and ESG reporting more broadly. There are already, in some jurisdictions, climate risk disclosure requirements for financial reports. ESG, however, extends beyond just climate risk. Social and governance issues are captured under more of a patchwork of different regulations and governance codes. Subjectivity makes for risk of inconsistency and opacity. Regulatory mandates may, therefore, emerge from currently voluntary frameworks – like the United Nations (UN)-backed Principles for Responsible Investment (PRI) or the Sustainability Accounting Standards Board (SASB) – in the same fashion as they have for climate risk. Management teams, however, should not bother waiting for a mandate. ESG disclosure is becoming a basic minimum for access to debt and equity funding as well as access to business opportunities.
Holmes: The regulatory environment will become more intense over the next couple of years – both in terms of prescribed disclosure and government enforcement actions. Considering this environment, US public companies should absolutely be preparing. There are a number of steps companies can take to ensure that they manage risk and are ready to respond to new regulations. First, as part of the company’s disclosure controls and procedures, companies must review the existing process for assessing the materiality of climate change matters to the company and determine whether any additional climate change disclosures should be included in their SEC filings. Second, assess the company’s other public climate change disclosures. Third, evaluate whether additional disclosure controls are needed around the company’s other public climate change disclosures, particularly with respect to voluntary disclosures. Fourth, monitor regulatory and legislative developments on greenhouse gas and climate change matters at the international, federal, state and regional levels, and assess the potential impact of such developments on the company’s business. Finally, prepare for additional SEC disclosure requirements related to climate change and ESG matters.
FW: What metrics are energy companies using to track, demonstrate and report on their ESG credentials? Does the absence of globalised standards hamper these efforts?
Ede: An absence of a common framework makes life harder but not impossible. There are many useful frameworks, including the Task Force on TCFD, the Global Reporting Initiative (GRI), the SASB, the International Integrated Reporting Council (IIRC), the PRI and the Global Real Estate Sustainability Benchmark (GRESB), to name a few, for developing a company’s ESG reporting approach. There are also several initiatives which have sought to harmonise and provide common standards, such as the Better Alignment Projects from Corporate Reporting Dialogue and the EU taxonomy, for climate issues. There still remain a number of standards – for example for quantifying scope 1, 2 and 3 emissions – which means companies have a choice of both metric and approach to deal with. Our core recommendation to companies is to focus on issues which are material, both from a historical and prospective basis, and choose metrics for which they have accurate data. Given that much ESG reporting can be subjective, where judgement is called for, be transparent about rationale and the implications of calculation choices.
Holmes: Common ESG metrics include carbon footprint reductions, energy efficiency improvements, diversity in leadership and workforce, and employee health and safety, as has long been the case for oil & gas companies. Ambitious companies might also report their progress against the World Economic Forum’s 21 universal ESG metrics. The absence of standardised disclosure requirements or metrics creates a real challenge. Until we have standardised disclosure, it is important for a company to clearly define its metrics, both publicly and for internal tracking purposes. There are several voluntary ESG reporting frameworks from which energy companies may choose. The three most widely used include the guidelines issued by the GRI, the SASB and the TCFD. The GRI standards are designed to frame the impact a company has on the world. The SASB standards are more focused on how ESG issues affect the company and its financial performance and include industry-specific guidelines. The TCFD disclosure recommendations are structured around four thematic areas that represent core elements of how organisations operate: governance, strategy, risk management, and metrics and targets. It is likely that any disclosure framework mandated by a regulatory body in the US will apply a framework like SASB.
Cibrario: Most companies preparing for environmental disclosures are looking at the work developed by the FSB’s TCFD. In the energy sector, organisations should consider providing key information on their greenhouse gas (GHG) emissions, energy water and land use, and low carbon. Alternative metrics on the financial aspects relate to revenue, costs, assets, liabilities and capital allocation. Companies subject to European Union (EU) law are also looking at the metrics now being developed by the European Commission for purposes of setting ‘green’ thresholds under the EU taxonomy for sustainable activities. Although the thresholds are likely to vary between countries, the metrics and units of measure for each indicator should begin to converge. In any case, firms should prepare to provide historical trends and forward-looking projections to report on their ESG impact, by relevant country or jurisdiction, business line or asset type.
Goldberg: We have seen companies use a very wide range of tools, and many have commented that the range of non-standardised criteria for reporting are somewhat confusing. A move to more standardisation would help to clarify expectations and ultimately lead to better disclosures.
“There is no point promising net zero if you do not accurately know what your emissions footprint is today.”
FW: Could you highlight any tools, such as new technologies, that can help energy companies map and model their ESG performance?
Holmes: There are almost too many ESG advisory firms to count at this point, but these consultants can add great value to a company that is first establishing or upgrading its ESG initiatives. The key is to find one that understands the energy industry and the various methodologies than can be used to increase the company’s sustainability or ESG scores. Even though these scores are often published without the company’s request, these scores can have a real impact on a company’s access to capital or stakeholder relations. Consultants can also assist with defining both goals and risks and conducting a materiality review. Leveraging advice from ESG consultants and outside counsel also helps the board of directors exercise its duty of care and oversight with respect to ESG issues. Beyond this, to monitor and track technical targets, such as reductions in ‘scope 1’ emissions, larger energy companies have developed technology in-house and integrated it into their regular operations. Many smaller companies must engage firms that provide this technology but struggle to find them on a cost-efficient basis. As this practice matures, this technology will hopefully be more readily available to even the smallest companies.
Ede: There is a plethora of management reporting tools and frameworks in the market which can deal with the internal and external reporting on ESG. The main challenge is getting good data. The maxim, ‘garbage in, garbage out’, applies more than ever. There is no point promising net zero if you do not accurately know what your emissions footprint is today. Energy companies, for example, are increasingly being held to account for the ‘scope 3’ emissions of their value chain, which is complex to estimate. The focus should, therefore, be on robust management processes as much as systems acquisition so that firms are able to communicate what is at stake, what risks can be managed, and what cannot as it relates to the different ESG topics. Importantly, these processes need to be aligned with the overall business strategy and priorities, linked to management incentives, and subject to board oversight.
FW: How important is it for senior executives in the energy industry to build ESG considerations into their business strategies? What advice would you offer on effectively managing ESG risks and opportunities?
Cibrario: Genuine engagement with ESG considerations is of growing importance considering the potential liability at stake. Increasingly, parent companies may be held liable for the business conduct of overseas subsidiaries where ESG issues arise. In 2019, the UK Supreme Court held that Zambian villagers had a good, arguable case that the English parent of a Zambian mining company owed them a duty of care with respect to the ESG impacts of a Zambian mining project. Environmental claimants have also signalled that they may have board liability in their sights, where directors do not take ESG issues into account in their decision making. To improve corporate social responsibility, many energy companies turn to disclosure, increasingly required in the EU for large public-interest entities, such as listed companies. Disclosures are not, however, the exclusive solution to managing ESG risk. The spectre of ‘greenwashing’ claims may arise if disclosure overreaches.
Ede: Much of ESG is simply about doing good business. Well-run companies tend to try to look after their stakeholders. But for many energy companies, it is more than about maintaining a social licence to operate, it is also about future profitability. Climate change and how we respond to it will fundamentally transform our economies. It will become a key, if not the main, driver of risk in any energy businesses’ long-term valuation. So even if you maintain a more traditional view that management should focus on shareholders’ interests, there is a clear need to keep ESG matters close to the heart of their strategy. Energy companies can strive to improve ESG performance by taking a gradual and comprehensive approach to ESG. Companies can start by fulfilling fundamentals such as data collection, operationalising across the organisation, and finally embedding into the strategy development process.
Goldberg: It is essential for ESG considerations to be built into a business’ strategy as well as for these considerations to be taken into account at all levels of decision making, whether by the senior executives, at committee level or on a day-to-day basis by the workforce. A central consideration in the ESG space is awareness. Energy companies must ensure that their board, managers and workforce are educated and trained with regard to ESG risks and opportunities. Coupled with the implementation of the necessary internal governance structures, this will enable the company to identify such risks correctly, address them appropriately and ultimately seize any opportunities that arise successfully.
Holmes: It is critical for executives in the energy industry to build ESG considerations into their business strategies, but it must also align with and support the profitability of the business. As one example, ESG initiatives increase an energy company’s access to capital. ESG is not only a demand of equity investors holding one-third of investable capital, but financing products designed to be consistent with ESG principles can provide access to much needed funding that might not otherwise be available. This is critically important for oil and gas industry participants, which have been excluded from much of the bank and investor capital available in the US. To ignore the option of ESG financing products is to leave money on the table. Sustainability-linked products provide a way to access capital that is only available for ESG-friendly investments. Furthermore, they can be used to support the company’s ESG initiative or messaging, which can provide uplift to the value of the company. Also, companies can potentially get better pricing in light of the high demand for ESG-friendly investment opportunities – just look at how interest rates on sustainability-linked bonds are typically lower than regular-way bonds issued by the same company.
“Genuine engagement with ESG considerations is of growing importance considering the potential liability at stake.”
FW: Looking ahead, what are your predictions for ESG in the energy sector over the coming years? What overarching trends do you expect to unfold?
Ede: ESG will be front and centre to many energy company strategies going forward. With the rapid expansion of ESG reporting and the evolving standards for reporting, there is a significant risk there will be some kind of breakdown of accounting and reporting processes. There is already a lot of concern about ‘greenwashing’ by companies with fossil fuel assets. Some companies have felt the pressure to make ambitious promises, sometimes before they have a clear view on how to accomplish them. Problems with reporting could arise if gaps between aspiration and execution emerge. We think, ultimately, that this will drive greater regulatory oversight of ESG reporting activities – which will be for the better. Perhaps the focus on ESG will lessen as a topic as it becomes a normal element of corporate strategy rather than some new element to think about. ESG will continue to become a mainstream component of reporting and strategy.
Goldberg: ESG is here to stay and reflects a renewed focus by the public, investors and governments on the wider sustainability of businesses – not only from a profit perspective but its wider societal implications. The pressures to decarbonise the energy sector will accompany us for the coming decades and will require a full-scale transition. Energy companies which integrate ESG considerations are likely to fare much better, will be able to access wider financing options and are less likely to be singled out by non-governmental organisations (NGOs) as targets for litigation to drive behavioural change, as we have already seen taking place in Europe. We are already seeing disclosure obligations expand to private companies, a trend which will be further fuelled if there is a reallocation of the carbon intensive asset burden toward the private company space and to avoid loopholes for wider ESG compliance.
Holmes: The core issue will continue to be the tension between profit and social purpose. Companies that have been holding back on articulating some sort of social purpose as part of their business description will shift strategy or message, or both. The social licence is basically the same as the investor licence, which we must recognise originates in a desire for economic returns. Nothing else is sustainable in the long term. Thus, purpose and profit must sync-up eventually. We expect to see increased sustainability financing, primarily more green bonds, social bonds, blue energy transition bonds, sustainability-linked bonds and sustainability-linked loans. Energy companies will use these capital-raising products more in 2022 than in 2021, which was a record year. Along with these developments, we expect to see increased litigation around sustainability disclosures, particularly climate impact initiatives, and increased shareholder activism around ESG issues at public companies.
Cibrario: We expect that businesses are likely to see a rise in pressure from activist investors. In May 2021, activist investor Engine No. 1 engaged in a proxy battle with ExxonMobil, electing three directors to ExxonMobil’s board to help drive a green energy strategy. Another activist investor, Third Point, called in October 2021 for Royal Dutch Shell to split its business lines into multiple successor entities. Relatedly, pressure is likely to be faced by energy companies to divest certain assets that present ESG issues. Investors may also start withdrawing from investments that present significant ESG risks. In 2020, the world’s largest asset manager, BlackRock, announced its intention to eliminate from its active investment portfolios any companies that generate a quarter of their revenues from thermal coal production. Others, including activists who may want to influence business strategy from the inside, may stick with their risky investments, engaging rather than divesting.
Clara Cibrario’s practice focuses on corporate and financial matters, with a specialisation in sustainability regulation. Since 2020, she has dedicated herself to building and growing Cleary’s European sustainability practice. Prior to joining Cleary Gottlieb, in addition to working as a lawyer in Italy and China, she spent two years at the Massachusetts Institute of Technology leading projects in the field of public and private sector innovation, and intellectual property. She can be contacted on +39 06 6952 2225 or by email: ccibrarioassereto@cgsh.com.
Simon Ede is a vice president in CRA’s energy practice. He is an energy economist with over 20 years of industry experience. He focuses on helping clients to understand and respond to structural change in their markets. His work has involved market analysis, valuation advice, as well as developing strategic and risk management responses to this change. He can be contacted on +44 (0)20 7959 1550 or by email: sede@crai.com.
Hillary Holmes is a partner in the Houston office of Gibson, Dunn & Crutcher and co-chair of the firm’s capital markets practice group. Ms Holmes’ practice focuses on capital markets, securities regulation, corporate governance, M&A and ESG counselling, with 20 years of deep experience in the energy industry. Ms Holmes represents issuers, underwriters and boards of directors in strategic capital raising and complex M&A transactions. She can be contacted on +1 (346) 718 6602 or by email: hholmes@gibsondunn.com.
Silke Goldberg has over 17 years’ experience of working in the energy sector, advising clients in relation to complex energy and climate change issues internationally with a particular focus on renewable energy and the energy transition. She also advises clients on all aspects of European and UK energy law and regulations, including unbundling issues, REMIT and network codes. She has longstanding experience in electricity and gas trading arrangements and has advised interconnectors and other transmission and distribution system operators. She can be contacted on +44 (0)20 7466 2612 or by email: silke.goldberg@hsf.com.
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