C-MACC Perspectives 31 – ESG
ESG: Is It About Outrunning Others Rather Than The Bear?
- This report looks at the measures being taken by companies to improve the E&S segments of their ESG standings, both and actual and cosmetic – and shows some interesting initial data with respect to success.
- It also covers the issue of whether absolute or relative behavior will matter the most and examines how companies might improve valuations by playing the relative game.
- Chemical industry participants with strong climate change narratives, while not sacrificing earnings (yet) appear to be outperforming those with weak arguments – we question what will happen when companies start taking decisive action.
See PDF below for all charts
This reports is grounded in two assumptions; that ESG sector neutral funds will continue to outperform the broader market and offer more risk offsets than funds that are not sector neutral; and that companies taking bold action to improve ESG footprints will continue to see greater investors favoritism than those that might have a better absolute score but are stationary in terms of their actions. To date there is anecdotal evidence to support both claims, but nothing empirical yet – it is early days. If these trends continue, it becomes a relative rather than absolute game for corporates and the valuation rewards could be very high for those with concrete plans and demonstrable progress versus those with more general lofty goals. While large index fund and ETFs may be obligated to own multiple stocks in each segment – ESG managers with discretion may elect to express their sector weighting with only one or two names – beating your neighbor becomes key.
Exhibit 1: We have snipped this chart from a recent Nikkei Asia article and cannot verify the data, but even if it is only partly correct, it is intriguing. We would be concerned that, certainly prior to 2017, there was not enough data to do this analysis and we would also suspect that the analysis excludes important companies that simply do not report the data, as we have found.
In prior research we have commented on the inaccuracies of and inconsistencies in ESG measurement within complex process industries such as chemicals, and subsequent to that report we have confirmed with investors that they are paying much more attention to Governance metrics for chemical companies because the Sustainability and Environmental measures require further work to be trusted as appropriate. In a recent report we showed a chart of carbon footprint per share of stock – a subject that we will cover later in this report. The number of companies shown in the chart was restricted by the number providing consistent data. This makes it hard to compare absolute measures company to company. But you can measure progress.
We are grateful this morning for two excellently timed FT articles – both linked below – which talk about the confusion in ESG investing and whether it is necessarily in the best interest of the planet – something we have discussed more broadly in prior work – focusing on the inaccuracies and inconsistencies in the measurement of E and S metrics across the providers. The first article provides color on the inflow of funds – Exhibit 2 – which is a major factor in the outperformance of ESG today – the flow of money into the ESG favored stocks is almost guaranteeing their outperformance.
Exhibit 2: The FT article is free to read and linked here. These are European funds, but the growth in the US driven by fund availability is equally impressive. The second FT article which looks at some of the ESG pitfalls is linked here
The FT articles discuss the issues facing investors, many of which we agree with. In this report we talk about what corporate actions might look like. In the ESG world, because absolute comparisons around E and S are so difficult to make, and because the data providers are inconsistent, corporate action may be more important that someone else’s measure. For example, this week Dow has confirmed definitive lines in the sand with respect to Carbon Emissions (a 15% reduction by 2030), and recycling, with a goal of capturing 1million tons of polymer for recycle or alternate use. But will the talk – summarized below – be enough, or will the company need concrete action?
- While we cannot compare the stocks because of the business mix, will Dow get more credit from the statements below or will Shell get more credit for the action (investment under development to build new furnaces at its ethylene plant in the Netherlands to reduce CO2 emissions by 15%)?
- Will Dow have to back up the statements below with firm projects or other initiatives to get the benefit of the doubt?
- Will Air Products get more credit because its carbon reduction goals are twice those of Dow by 2030 (30%)?
Exhibit 3: Dow Inc.’s Sustainability targets. October 22, 2020
What we have is a lot of conjecture and not a lot of evidence to work with, except the somewhat intriguing data illustrated in Exhibit 1. For example, if doing the right thing could really drive a 15% increase in your multiple, you should be willing to spend 14.9% of your earnings to make it happen. That would be in the best interest of your shareholders, assuming the higher costs did not increase your cost of borrowing or risk a dividend.
The same article that produced Exhibit 1 compared ExxonMobil’s stock price with Total’s. A company that is doing a great deal to improve its environmental footprint (while not stepping completely off the reservation) with one that appears to be doing very little. We have recreated the chart in Exhibit 3 but have added Chevron, as the other US major, which certainly has a better ESG narrative today, whether or not the actions are behind it. The stock shows very clear underperformance from Exxon versus both Chevron and Total. Just to be sure that there was not start-point bias in the analysis, Exhibit 5 shows the same data from 2015 and the same result
Exhibit 4: Exxon has produced very substantial sustainability reports and has been an advocate for a carbon tax in the US for years, but it looks like the reasoning might be a desire to be told what to do, rather than make any pro-active moves. Chevron has talked a better game, but has not done very much – Total has been much more active, but not as active as BP, which has seen its stock price punished. We compare Total with Chevron and Exxon in the chart, but note that Total trades in Europe and the comparison is illustrative only.
Exhibit 5: The same pattern over a longer period
This analysis is important if ESG is a relative game and analysis that we have seen suggests that sector neutral ESG funds are doing almost as well as unconstrained ESG funds. Sector neutral funds are an easier sell if you are looking to beat a sector neutral benchmark like the S&P500. You do not have to avoid energy; you just need to buy the company(ies) that tick the most ESG boxes. Exhibits 4 and 5 do not paint pretty pictures, but if you are a large cap US manager, choosing Chevron over Exxon has driven relative outperformance.
So, What Does This Mean For Chemicals – Is It All About Relative Good Looks?
Unlike the oil companies, the chemical industry still has underlying growth – although the future slope of that growth is certainly a subject for debate today. At the same time, despite some quite large carbon footprints, the ESG, and particularly the climate activism, focus has been targeted towards Energy (Coal first and Oil second). But it is not safe to assume that will last. In Exhibit 6 we show again the carbon footprint by company, but add a few names – Linde for comparison with Air Products and BASF for comparison with Eastman, DuPont and PPG – BASF has more commodity, higher carbon businesses than either DuPont or PPG, but does not have the footprint of Eastman’s coal gasification facility in Tennessee.
Exhibit 6: Sources for all of these data are corporate sustainability reports – they are intended to include Scope 1 and Scope 2 emissions, but there is no guarantee that each company is using the same measurement techniques and criteria. We suspect that they are a good relative guide, however.
Note that many of the chemical companies have a much larger carbon footprint per share than Chevron and Chevron’s number is adjusted up to reflect the carbon footprint of the oil products sold, which is higher than the volumes produced.
Also note that in the chart above we do not include Scope 3 emission (these are the emissions from the users of the products made). Both Dow and Chevron disclose estimates. Dow’s is roughly 2.7x its Scope 1 and 2 emissions; Chevron’s is around 10X its Scope 1 and 2 emissions, which should not be surprising – burning a transport fuel in an engine has a much higher carbon footprint than producing it.
So, the $64,000 question is whether an ESG portfolio manager is interested the static measure or pace of change. This is not determined in Exhibit 1, but comparing Exxon and Chevron as an anecdote rather than proof, Chevron appears more EGS friendly in its communications with stakeholders and with its stated intent. Both companies are still very much in the Oil business.
Discussion 1: Industrial Gases
In Exhibit 7 we show stock performance for Air Products and Linde – with Air Products pulling away recently. Air Products made a lot of noise in September about its CO2 reduction goals and has also announced the hydrogen project in Saudi Arabia, but a close examination of the Linde sustainability data would suggest that their CO2 reduction and green hydrogen ambitions are similar. Air Products has made more noise publicly – a bit like Chevron has versus Exxon. Air Products is getting a higher multiple today than Linde and others in the Industrial gas space, this is despite having the higher carbon footprint.
On the Governance side, Linde ticks the separate Chairman and CEO box, but likely loses because of redomiciling to the UK.
It would be interesting to see what valuation changes would occur if one of the industrial gas companies embarked on a tangible investment/plan to reduce their carbon footprint – would the initiative raise their ESG profile – given the multiple discount, Linde may have more to gain by such action than Air Products today.
Exhibit 7: The comparison here is not as direct as we would like given that Linde is domiciled in the UK and still has some pro-forma adjustments for the on-going integration of the merger. Air Products has been more self-promotional in the area of environmental initiatives, despite both companies having similar plans
Discussion 2: Olefins
There is really not that much information in a Dow versus LyondellBasell chart yet – Exhibit 8 – and we would suggest several reasons – as there are puts and takes on both sides.
- Dow loses on Governance because it does not have a separate Chairman and CEO
- Dow wins on Carbon footprint per share – if anyone is paying attention today.
- Both companies have broad ambitions on carbon footprint and recycling, but LyondellBasell is invested already in recycling in Europe
- LyondellBasell could cut its carbon footprint meaningfully by selling or closing its refinery, but has added new capacity for ethylene in China this year and has a new PO unit under construction as well as a new polyethylene facility. Plus, the company just acquire 50% of the new Sasol complex for ethylene and polyethylene. On a pro-forma basis, LyondellBasell’s carbon footprint is rising meaningfully
Exhibit 8: The data timeline is shorter in the exhibit because we do not have comparable Dow share price data prior to the spin from DowDuPont.
We suspect that the very recent outperformance from Dow has nothing to do with ESG goals or carbon and more to do with the debt being added to LyondellBasell’s balance sheet.
Similar to the industrial gas companies, both LyondellBasell and Dow are stating intent with respect to CO2 but neither has a positive initiative of the scale of Air Products proposed investment in green hydrogen in Saudi Arabia.
Unclear But Important Decisions Ahead
If ESG is a relative game, which assumes that sector neutral funds ultimately attract plenty of ESG money, then it does become a case of trying to look like the most attractive horse, even if you are in the glue factory. ESG funds may kick out some industries and still claim effective sector neutrality (so out goes coal and tobacco and weapons of mass destruction, or just weapons), but energy, chemicals and other industrials and materials will stay, and there may well develop a huge premium for the winners – Air Products’ 1 year out PE ratio is 12.5% higher than Linde’s today (Source: Bloomberg) – having covered both closely and loosely for more than 20 years, Air Products is not the better company and does not have the better strategy – it does have a better narrative.
On the commodity side it may come down to a two or three horse race in each market cap range. With the most overtly E&S friendly winning out and gaining value as a result. A large cap ESG manager with a sector neutral find does not need to own Dow and LyondellBasell. Nor does he or she need to own, Linde and Air Products or Eastman and Celanese. Some sort of ESG arbiter is likely to become increasingly relevant and perhaps it is just about messaging, but we would suggest it will come down to actions.
- More organized recycling programs that have tangible investments and alignment between all stakeholders – large enough to matter (which is likely the challenge). If the LyondellBasell/Suez initiative was making money, the venture would be disclosing the next location(s)
- Conversion to renewable or renewable plus battery or hydrogen power. In our opinion hydrogen makes more sense as an energy flywheel for the bulk chemical industry, but renewable power investment needs to increase meaningfully again for this to become a practical reality.
- Carbon capture and sequestration – while not cheap, it is the simplest way to change the carbon footprint of a product or process that is unlikely to be replaced quickly.
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