On the other hand, high hurdle rates can offer some reassurance that a company is only pursuing the highest quality projects. Put another way, a higher required rate of return may force a company to return cash to shareholders via buybacks or dividends, rather than spending on new projects. This may be especially relevant when considering companies in high-emitting industries. If you were an environmentally minded investor in a company that has doubled down on fossil fuels, calling for a high hurdle rate or directly demanding that capital is returned might be an effective strategy.
If climate change is one of your top priorities, your initial reaction to Figure 3 might be despair. But despair should be balanced with rationality. A major challenge for us ESG proponents is not confusing what we want to see in an ideal world with the reality we face. Although growth in renewable generation has been impressive, it has nonetheless been insufficient to meet the world’s growing demand for energy – to keep the lights on in schools and hospitals and enable growth and a better standard of living in poor nations. At least in the short term, therefore, demand for oil and natural gas will continue. E&Ps will be vital in delivering reliable and affordable energy in a responsible manner to meet this demand, and they will have a significant role to play in decarbonising the global economy, as long as production becomes less carbon intensive. A holistic perspective on the energy trilemma – security, affordability and sustainability – has never been more relevant.
This reality feeds into our fundamental view on the impact China’s emergence from three years of covid lockdowns will have on the market for oil. This view is reflected in our increased allocation to energy stocks. But we do not believe this contravenes our commitment to promoting decarbonisation. Through investment and engagement, we want to understand the project economics and, where relevant, argue for a change in methodology that could close the returns gap and put renewables on a more level playing field.
For energy majors, one catalyst for promoting the push into renewables is bringing down the hurdle rate that restricts investment in riskier or potentially lower-yielding projects. Clarity on policy will be a major tipping point. America’s Inflation Reduction Act, which will funnel $369 billion into clean technology investment, is the first domino to fall, triggering the crystallisation of incentives in Europe, China and beyond. The combination of subsidies and lower thresholds for returns should make a compelling case for investing in projects that could have a meaningful impact on global decarbonisation.
Coming at the problem from another direction, the idea that fossil fuel returns are artificially inflated by ignoring most of their environmental and social costs is moving into the mainstream.
For example, Duncan Austin, a guest contributor in this year’s Ruffer Review, talks about the market’s invisible hand being connected to an unmentionable foot. Fossil fuel projects overwhelmingly exclude the full extent of their contribution to climate change. Pricing in a social cost of carbon to reflect environmental damage might change the equation, making returns from renewables look more attractive in many instances.
A prominent feature of E&P Net Zero transition plans is advocating a carbon price. While the US does not have an explicit federal carbon price, some states have implemented their own, and the EU’s Emissions Trading System has been effective at reducing carbon emissions. As investors, we want to know how E&P companies are using this carbon price in their own returns calculations. Is the carbon price used akin to the social cost of carbon? Are these companies modelling what effect such a carbon price will have on the end-user demand for their product? At what point does the returns profile for oil and gas begin to look unattractive?
Part of our investment analysis and stewardship commitment includes building a robust understanding of the economics of a company’s capital allocation. This work is not limited to the oil sector. Over the past quarter, we have engaged with companies such as Titan Cement and UPM, a forest products company, on the implementation of an internal carbon price and the framework they use to allocate capital to projects that span timeframes and risk profiles. As we drive towards Net Zero, it is important to understand technological bottlenecks that might hinder progress. But it may be just as crucial to scrutinise self-imposed capital constraints in companies that are setting hurdle rates based on stale or dismissive views of climate policy and the treatment of externalities.