A Tutorial On ESG Investing In The Oil And Gas Industry For

Former Vice President Mike Pence is not a professional investor. In fairness, neither am I. Good investing is a difficult and complex thing to do. So let me say, without any intended irony or sarcasm, that I’d like to provide some insights into investing in the oil and gas industry. My focus is on how to integrate risks associated with environmental, social, and governance (ESG) factors into the investment process.

I know that Mr. Pence and many in his circles are vehemently opposed to ESG. It could be that they simply see this term as meaning something different than I and many others do. In an investment context, ESG factors are just one element in the investment process which starts with how capital is allocated across asset classes (e.g., public equity, public debt, and private markets) and across countries (e.g., developed vs. emerging markets). For public equities decisions must be made on the weighting of value vs. growth stocks, sector weightings, within each sector which companies to include, and whether to overweight or underweight them.

Traditional oil and gas companies are value stocks. These companies are headquartered and operate in a wide range of countries, some quite problematic in a variety of ways. Given the nature of the industry and where it operates, how well a company is managing ESG risk factors is very important in making investment decision.

I want to make clear that I am not an advocate of divestment and exclusion. With Professors Shivaram Rajgopal and Xing Jie, I have recently published a Working Paper which clearly shows that exclusion has no impact on companies in the oil and gas industry. Much better is for investors in oil and gas companies to work with them to adapt their business models to the necessary energy transition in order to ensure their ability to continue to create long-term value for their shareholders. Many are already doing so, including ExxonMobil, which earlier this year announced “its ambition to achieve net zero greenhouse gas emissions for operated assets by 2050, backed by a comprehensive approach to develop detailed emission-reduction roadmaps for major facilities and assets.”

The purpose of this piece is to offer an olive branch to those concerned that ESG is somehow a pernicious force undermining America. I’ve heard from some Republican friends (yes, I have some and happily voted twice for Republican Charlie Baker for Governor of Massachusetts) that my piece “Grift Capitalism: The GOP’s Brilliant Strategy For Ripping Off Ordinary Americans” simply added fuel to the partisan fire that is polarizing America. I pointed out that I didn’t start this.

Mr. Pence did. He fired the first salvo in his May 26, 2022, letter to The Wall Street Journal by saying that “an insurgent shareholder, backed by BlackRock, the world’s largest asset manager, forced Exxon Mobil to put three environmentalists on its corporate board.” In my piece, I pointed out that this is factually wrong. These three directors have deep oil and gas industry experience, something heretofore missing from ExxonMobil’s board of directors. At the time shareholders voted for directors, BlackRock owned seven percent of the shares. It takes a lot more than seven percent to elect three new board directors, so a lot of other major shareholders must have also seen the value brought by these new directors.

We are seeing how different political views can infuse different meanings to the same word, as we’re seeing with “ESG.” It is clear that Mr. Pence is using the word “environmentalist” in a pejorative sense. For me it is more of an accolade, consistent with its definition in the Oxford dictionary: “a person who is concerned about the natural environment and wants to improve and protect it.” As a boy who grew up in Colorado, I understand the importance of protecting America’s lands, waters, and forests. I’m sure Mr. Pence does so as well.

In an energy policy speech he gave on May 10, 2022 he bemoaned that “Those three are now working to undermine the company from the inside.” Again, it is useful to bring some facts to bear in light of such strong, even unsettling words. Since Engine No. 1 launched its campaign in December 2020, ExxonMobil’s share price has outperformed its closest peer, Chevron (not burdened by such directors) by 57 percent and more than doubled on an absolute basis. Clearly, these three directors with deep energy industry experience are exactly the kind ExxonMobil needs to help it meet its stated net-zero emissions from operated assets by 2050. I suspect that by now Chairman and CEO Darren Woods is glad to have them on his board. It is worth noting that on July 22, 2022, BlackRock bought nearly one million shares in the company. This suggests to me their confidence about the direction the company is moving in. Who buys share in a company it’s trying to undermine?

Mr. Pence closes his letter to the WSJ by saying, “Most important, the next Republican president and GOP Congress should work to end the use of ESG principles nationwide. For the free market to thrive, it must be truly free.” I was a tenured professor at the Harvard Business School so I’m hardly an enemy of the free market. I believe it has an essential role to play in allocating capital to earn the best risk-adjusted long terms possible to support the financial needs and retirements of all American, in Red states and Blue. ESG principles help achieve this.

Let me start by asking the question, “What would it mean to ‘end the use of ESG principles nationwide’?” The most solid foundation for ESG integration into fundamental investing is the work of the Sustainability Accounting Standards Board (SASB). Full disclosure: I was the Founding Chair. Simplifying a complex story, SASB’s principles are now embedded in the work of the International Sustainability Standards Board (ISSB). This is a great example of how America ingenuity and leadership is contributing to improving the investment process all over the world.

In short, SASB identifies the “material issues,” as defined by the SEC, which matter to investors because they impact enterprise value creation. Not every ESG issue does. These vary by industry, so SASB developed an industry classification system comprised of 11 sectors which subdivide into 77 industries. Industry Working Groups comprised of company representatives and investors in each industry determined which issues were material out of a total list of 26 subdivided into five categories: Environment, Social Capital, Human Capital, Business Model & Innovation, and Leadership & Governance. For any industry, only a small subset of ESG issues is material.

To help investors deliver the best returns, SASB developed a “Materiality Map” which is in the public domain for free. Extractive & Minerals Processing is one of the 11 sectors and it is comprised of eight industries: Coal Operations, Construction Materials, Iron & Steel Producers, Metals & Mining, Oil & Gas—Exploration & Production, Oil & Gas—Midstream, Oil & Gas-Refining & Marketing, and Oil & Gas—Services. Here I will summarize the material issues identified for each of the four oil and gas industries. The obvious question is which of these material ESG risk factors aren’t relevant from a value creation perspective and are there others which are that are not on the list?

Let’s quickly go through each industry, using a diagram to capture what SASB has identified as material for value creation.

First is the most controversial one: Oil & Gas—Exploration and Production. Companies in this industry “explore for, extract, or produce energy products such as crude oil and natural gas, which comprise the upstream operations of the oil and gas value chain.” Ten of the 26 issues are material. Not surprisingly, four of them are environmental ones. The removal of which of these ESG principles would be good for long-term value creation? For example, could an oil & gas company that doesn’t care about air quality or its ecological impacts maintain its license to operate given all of the sensible regulations in place in America and around the world? Similarly, are human rights & community relations and employee health & safety unimportant to value creation? And surely management of the legal & regulatory environment and critical risk management are important as well.

Next up is Oil & Gas—Midstream with only five material ESG principles. “The industry consists of companies involved in the transportation or storage of natural gas, crude oil, and refined petroleum products.” Demonstrating the sensible nature of SASB’s ESG principles, water & wastewater management is not on the list because water is not important in midstream production. But ecological impacts still is should a pipeline break. Because this is such a highly automated process, there isn’t a single material issue in the categories of social capital, human capital, and business model & innovation. Like Exploration & Production, critical risk management is important. But different in Leadership & Governance is the inclusion of competitive behavior due to potential monopolistic, i.e., non-free market behavior. Not on the list are business ethics (no risk of bribes in midstream) or management of the legal & regulatory environment (where there is much less concern due to the safe nature of this automated process).

Following the value chain structure of this industry we have Oil & Gas—Refining & Marketing with nine material issues. These companies “refine petroleum products, market oil and gas products, and/or operate gas stations and convenience stores, all of which comprise the downstream operations of the oil and gas value chain.” Again, reflecting the importance of materiality in enterprise value creation, there is a difference here on the environmental dimension. Contrary to the previous two industries, ecological impacts is not material. But, unlike them, waste & hazardous materials management is due to the nature of this process. Similarly, because it is more labor intensive on the production line, employee health & safety is also material. Unique to this of the four oil & gas industries is product design & lifecycle management. This is important for adapting to changing customer demands for how they are using oil & gas for the manufacturing, distribution, and disposal of their products. Like midstream, competitive behavior is an issue. As for exploration & production, management of the legal & regulatory environment is material. Critical incident risk management is important, as it is for the previous two industries.

The fourth industry is Oil & Gas—Services with eight material issues. “Oil and gas services companies provide support services, manufacture equipment, or are contract drillers for oil and natural gas exploration and production (E&P) companies.” Not surprisingly, given materiality for shareholder value creation, the materiality profile is almost identical to Exploration & Production. This industry has no control over air quality, but it does over waste and hazardous materials management. Similarly, since it is not directly involved with establishing the licenses to drill, human rights & community relations is not material. Nor is business model resilience. Because capital requirements are low, it can easily adapt to changes in the business models of exploration & production companies.

What is not on the list for any of these industries? Here are a few: Environment energy management (that is their customers’ responsibility); six of the seven issues under Social Capital (e.g., customer welfare and customer privacy); employee engagement, diversity, & inclusion (a hot button for the anti-Woke crowd); supply chain management and materials sourcing & efficiency in Business Model & Innovation; and systemic risk management in Leadership & Governance (something very important in financial services).

And even though employee engagement, diversity & inclusion is not a material issue, let me give a shout out to ExxonMobil for its commitment to diversity and inclusion. It states that “ExxonMobil values the diversity of ideas, perspectives, skills, knowledge and cultures. A plural and inclusive work environment enables innovation and is a key competitive advantage.” Going further, and partially thanks to Engine No. 1, ExxonMobil now has a truly diverse set of 11 board directors, which now includes three with industry experience and four women, one of whom is black.

Again, I ask those concerned about ESG principles, “Which of these ESG risk factors for each industry do you think doesn’t matter to shareholder value and which do that aren’t included?”

We need to reduce the rhetorical temperature on both sides which is resulting in polarization that is tearing America apart, an America we all care about. Whatever our political preferences, one of the great strengths of America is to have diverse views we can discuss to reach a consensus on what is best for America. A dialogue which is, sadly, been rapidly slipping away. For those who believe we need to make America great again, this dialogue has to be restored.

Let me give Mr. Pence the benefit of the doubt. Running for President isn’t a game for the faint hearted. Particularly in the GOP given the former President whose destructive-to-America behavior has been made clear by the January 6 hearings (which I doubt will change the views of most Senate and House Republicans who fear Trump’s base). I give credit to Mr. Pence who stood tall and supported the Constitution, at the risk of his own life. More importantly, so does the Editorial Board of the WSJ, noting that “Character is revealed in a crisis, and Mr. Pence passed his Jan. 6 trial. Mr. Trump utterly failed his.”

I know Mr. Pence needs to move that base from Trump to him and I certainly hope he does so. Attacking ESG and invoking “Woke Capitalism” may be one way to do that, but it is coming at a cost to America as a whole. I hope this little tutorial makes clear that ESG principles are good for investing and a strong free market, not something that is contrary to them.

I also give Mr. Pence the benefit of the doubt on some of the details from comments he’s made. Perhaps some overly eager staff members and speech writers, who aren’t investment professionals or experts on ESG, simply didn’t do the proper research on what the reality is of the situation at ExxonMobil.

Here’s the olive branch in a war I didn’t start. I would be pleased to have a private or public conversation with anyone on Mr. Pence’s staff about ESG principles applied by both investors and companies. I’m happy to do the same with any other Republican who is nervous about ESG.

Look, I’m not naïve. I realize the chances are slim to none that anyone on Mr. Pence’s staff will ever read this. Chances are also small, but not as small, that staffers of other Republican elected officials at the state or national level will read it. If anyone does and wants to talk, I’m more than happy to do so. If you, like me, care about America, and I know you do, what’s the harm in starting this conversation?