Here’s why ESG investing will impact the oil and gas landscape in 2021.

Environmental, Social, and Governance (ESG) investing is rapidly becoming one of the most visible and durable megatrends in the oil and gas industry as momentum builds behind efforts to promote renewable energy, sustainability, and the energy transition. The pressure of ESG is being felt throughout the U.S. oil and gas value chain with the upstream sector facing the most scrutiny for its impacts on the environment, and the midstream for its social impact and governance structure.

Even amid the COVID-19 pandemic, which has had rattled global economics around the world in such a short time, investors are viewing the crisis as a major turning point for ESG investing in the long term alongside traditional financial metrics. In the energy industry, the perception of ESG has shifted from a nice-to-have feature to a must-have pre-requisite as it’s greatly influencing the way investors invest in the industry, which may ultimately determine winners and losers in the market going forward.

Against this backdrop, Opportune Managing Director Amy Stutzman offers her thoughts on why ESG matters to the oil and gas industry, how companies can differentiate themselves from their peers, what companies can do now to be proactive in addressing ESG issues, and to set out a strategy, and more.

What is ESG and why does it matter to the oil and gas industry?

Stutzman: ESG stands for Environmental, Social, and Governance. ESG, or sustainability, refers to corporate activities that would maintain or enhance the ability of the company to create value over the long-term. It includes both financial and non-financial aspects of a business such as environment, human capital, social capital, innovation, leadership, and governance—those types of initiatives. A sustainable business strategy would be a company’s plan to improve performance along with those initiatives and create value over the long-term.

So, why is it important to the oil and gas industry? Well, first of all, I think, contrary to what it seems like we read in the news where you see the industry majors making investments in renewables and green energy initiatives, I don’t think sustainability excludes the continued development of fossil fuels. So, I think ESG is an opportunity for our industry to tell their story. It’s important to tell that story because there’s been a shift in the investment community and ESG impacts access to capital more than it ever has before.

For example, there’s been an increase in ESG funds, which are investing in companies that are committed to sustainability, and those are tied to ESG ratings. There are also performance-based sustainability-linked bonds and loans and that market is growing and it’s expected to continue to grow because of investor demand. And, investors and consumers, as you’re reading in the news, are more focused on ESG risk. More consumers will boycott or make buying decisions based on social issues as an example. It’s just something that has really increased in our culture in general. So, it has ultimately impacted the flow of capital.

Institutional investors would tell their private equity firms that they won’t provide capital unless ESG requirements are met. The most widely discussed example of that is BlackRock where the CEO Larry Fink wrote a letter to CEOs in early 2020 where he was stressing the importance of sustainability initiatives and reporting and stated BlackRock would vote against any management and boards that aren’t making sufficient progress on these initiatives. Other investors have made public statements and, of course, your private equity firms have followed suit.

We’re seeing and hearing a lot of chatter from the large integrated oil majors about their stated ESG goals and strategies, but when it comes to the mid-sized and smaller independent E&P operators who operate on razor-thin margins, what are some things they can do around ESG to differentiate themselves among their peers as we head into 2021?

Stutzman: I think the important thing to do in 2021, if you haven’t already, is to get started and be proactive in addressing ESG issues and setting a strategy. We have clients call us, even small producers, and they’ll say, “Hey, my investors are asking for an ESG strategy and reporting. Can you help me get started?” So, I would anticipate receiving that question and I think having a response and showing that you’re thinking about these initiatives proactively can still be a differentiator, especially for small companies.

I think the best way to start is to determine what you’re already doing and document it. Look at your peers and see what they’re doing. You can also be proactive in engaging in conversations with your investors and other stakeholders and your community to see what the priorities for them are and how you could address them. So, then you can start to determine where you have gaps and how should you evolve and improve over time.

What are some of the challenges and opportunities independent E&Ps face in the current environment in terms of ESG that may be different from their larger peers? How can they address these challenges effectively in 2021?

Stutzman: I think that this is an opportunity for oil and gas companies to tell their stories and positively impact the market perception of the industry because the industry already does so much for the environment and is already giving back to the communities that they work in. It’s just maybe not something that’s been tracked or reported, so I think there’s a gap in market perception to some extent on what’s happening.

On challenges, obviously one of the biggest is resources, especially for smaller companies. So, implementing an ESG strategy and tracking performance obviously takes time, human capital, and ultimately financial resources, not only to implement the initiatives but also for getting systems in place to track and report on them. We wrapped up 2020 and it was a year in which G&A reductions have been a great focus for the industry given the current market.

So, how do you address that challenge? I think you start small and then scale up over time. From what I’m hearing in the market and from private equity, there’s not an expectation of perfection in year one but rather the expectation is that companies are engaging in the issues and showing progress over time.

What kinds of things should mid-sized and/or small E&P companies do now to tell their ESG “story” and get involved in the broader conversation? In other words, should they be more transparent with how they disclose their emissions/diversity/governance/etc., financial reporting requirements/guidelines (i.e., FASB/SASB), investor relations, etc.?

Stutzman: Yes, they should be transparent and proactive in telling their story and reporting on ESG. As for reporting, that’s an area that also poses somewhat of a challenge in part due to the fact there are multiple standards and frameworks currently available and it’s just difficult to sort through and understand those. And the various standards make it difficult to compare results among peers, so there’s not really one standardized way to report on these initiatives right now.

The industry is working to address this challenge. For example, there are several trade organizations, including the American Petroleum Institute, the Petroleum Equipment Services Association, and others that are providing resources for their members to help them implement and report on ESG initiatives. We see most companies using SASB (Sustainability Accounting Standards Board) standards, which we like because they’re industry-specific and investor-focused. The SASB standards were developed over time through a formal process that included input from the industry and stakeholders, and it has specific metrics that companies can use to track items such as greenhouse gas (GHG) emissions, air quality, and water usage.

What kinds of things are investors and shareholders requesting from independent E&Ps in terms of ESG, and what kinds of priorities are emerging for these types of companies?

Stutzman: As an example of this, in September 2020, Kimmeridge, which is a private equity firm focused on the upstream oil and gas sector, published a whitepaper that outlined five very specific principles that they believe should be adopted by the companies they invest in. Those five principles included things like eliminating flaring, reducing, and monitoring methane GHG emissions and ESG reporting. So, we definitely see our clients in the industry focused on those items—first reducing flaring and emissions.

For even smaller companies there can be relatively cost-efficient ways to do this like replacing valves with newer technology or replacing older equipment. They’re looking at water usage, considering the volumes produced and what percent of that is recycled. Of course, if they can recycle water produced and then re-use it in fracking there’s an environmental impact there, but also an economic incentive because they can reduce operating costs.

On social, they’re focused on employee safety, as well as giving back to the communities that they work in. This is one area again where I think there’s a big gap in negative public perception and the positive impact that this will have on companies and their employees have on their communities. I grew up in Oklahoma where we have a lot of oil and gas in our state and so I’ve seen from my whole life the impact that companies have—even simple things like the sheer number of volunteer hours that employees give to different not-for-profits and social initiatives in the community.

As far as governance, there’s a focus on diversity equity inclusion, which isn’t surprising given the cultural importance of this issue. I also see a focus on ensuring that ESG is really embedded in the culture and the tone at the top and that would ultimately drive the success of implementing ESG initiatives and the improvement over time. So, maybe said a little differently, it can’t be just a check-the-box exercise. Senior management really needs to show that ESG is an important and long-term strategy of the organization.

More broadly, what overarching trends/themes do you see occurring in the industry and how do you think it will ultimately define business success in 2021 and beyond?

Stutzman: I think we will continue to see more companies focus on net-zero emission targets. That’s something that has been trending here recently, particularly in Q4 2020. And I also think more investments in natural gas, which is expected to play a significant long-term role in the energy transition and clean energy, and I think that the new Biden administration will also impact that. I think it’s clear that ESG is here to stay and I think it will continue to become an ever-increasing part of the conversation that companies are having with their investors.

In 2020, we’ve seen over time that a larger part of quarterly earnings calls, for example, is being devoted to ESG and I think that just continues to increase. I think it’ll be interesting also to watch how the reporting standards converge and how that ultimately makes it easier for management, investors, and analysts to compare performance and evaluate progress, which I think will have an overall impact on the broader ESG conversation as time goes on.