It is important to understand the hurdle rate if we want to get a sense of how a company is allocating capital. The risk-free rate has risen meaningfully over the last year, and the other two components are being forced up by uncertainty and risk aversion.
Market uncertainty is high, whichever way you measure it. The VIX volatility index remains elevated as markets guess where inflation is going and how the Federal Reserve will respond. Meanwhile, indices based on newspaper coverage of policy-related economic uncertainty and disagreement among economic forecasters also indicate uncertainty. If we zoom in on climate policy specifically, this upward trend in uncertainty is clear (Figure 2). If companies can’t be sure how much they can expect in the way of green subsidies or tax breaks, they are unlikely to pursue projects whose profitability depends on such support.
Uncertainty brings risk aversion in business, as in every walk of life. As a result, the hurdle rate imposed when assessing potential value creation projects is stubbornly high. Whether this is a good or a bad thing depends on the company in question.
High hurdle rates can have negative ramifications for important innovative or transformational solutions, notably to the climate crisis. Simply put, returns from renewable energy are far lower than those from fossil fuels. A US oil and gas exploration and production company (E&P) makes this point in its plan for the Net Zero energy transition (Figure 3). And consider the market’s reaction to BP’s announcement that it was dialling back on targets to slash oil output: the stock price jumped to its highest in four years. It seems investors are rewarding a renewed focus on fossil fuels, with their higher profit margins. Indeed, there is a clear valuation gap between oil majors that won’t consider pivoting to renewable energy and those making the change (Figure 4, page 15). The market wants near-certain returns, and it wants them now.
