Saturday, October 30, 2021
ESG and Shell
As has been widely reported, Third Point/Dan Loeb is arguing that Shell should split its green assets from the brown assets, on the theory that the brown assets are currently undervalued by the market. According to the Third Point letter:
We believe all stakeholders would benefit from a plan to:
Match its business units with unique shareholder constituencies who may be interested in different things (return of capital vs. growth; legacy energy vs. energy transition)
This should involve the creation of multiple standalone companies. For example, a standalone legacy energy business (upstream, refining and chemicals) could slow capex beyond what it has already promised, sell assets, and prioritize return of cash to shareholders (which can be reallocated by the market into low-carbon areas of the economy). A standalone LNG/Renewables/Marketing business could combine modest cash returns with aggressive investment in renewables and other carbon reduction technologies (and this business would benefit from a much lower cost of capital). Pursuing a bold strategy like this would likely lead to an acceleration of CO2 reduction as well as significantly increased returns for shareholders, a win for all stakeholders.
Shell argues – and apparently some of its large investors agree – that you can’t split them up that easily. Part of the claim has to do with how the different sides of the business are integrated, and part of it has to do with cash flows, namely, that the brown assets are funding the green ones. As Matt Levine points out, though, investors themselves could do that if they wanted to – they could take the cash they make from the brown assets and plough it back into green investments:
Loeb’s basic mechanism here is: Take the cash flows from legacy oil drilling, give them to shareholders, and let the shareholders invest them in clean energy if they want. Van Beurden’s is: Take the cash flows from legacy oil drilling and let him invest them in clean energy. In a sense this is the most traditional of all activist conflicts: Should corporate managers be trusted to plan for the long term, or should they give money back to shareholders and let the shareholders invest it elsewhere for the long term? Traditionally this conflict is about the financial value of the managers’ long-term plans. Now it’s also about who — oil-company executives or hedge-fund managers — has a better plan for the world’s transition to clean energy.
Except there’s actually more going on.
For starters, I just have to note that Loeb’s letter repeatedly mentions making Shell better for “all stakeholders,” and rapidly achieving decarbonization, which is apparently an attempt to appeal to ESG strategists and possibly take a leaf out of Engine No. 1’s playbook, but that’s actually not the strategy at all. Loeb is in no way trying to make energy “greener.”
What he is doing, though, is regulatory arbitrage. As he points out, Shell is getting demands to be greener from governments and the public generally. As he says:
Some governments want Shell to decarbonize as rapidly as possible. Other governments want it to continue to invest in oil and gas to keep energy prices affordable for consumers. Europe paradoxically wants both!...
Shell has ended up with unhappy shareholders who have been starved of returns and an unhappy society that wants to see Shell do more to decarbonize.
Spinning off the brown assets shouldn’t alleviate that pressure – the pressure should just shift to the brown assets – but Loeb knows it won’t. Because. I strongly suspect, the brown company would be private, or be taken private, or would sell a lot of assets to private vehicles, where there would be a lot fewer disclosure obligations and a lot less regulatory and public scrutiny, and the brown company would be able to market itself to a smaller group of equity investors who are perfectly happy to drill baby drill as long as it keeps the cash flows coming.
This is why lots of public companies, under pressure from ESG activists, are just transferring brown assets to private companies where they get a lot less flak.
And that’s why BlackRock, for example, has argued that even private companies should be required to disclose climate information. As I previously quoted BlackRock’s letter to the SEC, “To avoid regulatory arbitrage between public and private market climate-related disclosures, we believe that climate-related disclosure mandates should not be limited to public issuers.”
But there’s a deeper subtext here. As I’ve previously written a book chapter about and posted about, ESG investing has different meanings. Sometimes, it’s a theory of shareholder value – companies will be more profitable in the long run if they are more socially responsible – and sometimes, it’s a theory that even if it’s bad for the companies individually, they should be socially responsible, because that’s what investors want. And investors might want oil companies not to maximize wealth because they are people who have to live on the planet and breathe air and not drown, or they might want it because the “bad” oil company is contributing to climate change that harms the rest of the portfolio, so that from a purely wealth maximizing perspective at the portfolio level, some companies should individually take a hit.
Anyhoo, Loeb’s attack on Shell is a test of these theories. Because if ESG is about value at the company level, you’d expect investors to rally behind him – split Shell, let everyone pursue the projects they think are most valuable. But if ESG is about stopping companies from doing bad but profitable things, investors should oppose his plan, because if the brown assets are hived off (likely into an opaque private vehicle) then ESG investors won’t be able to influence them.
I look at Third Point as a traditional hedge fund activist with one goal in mind, making itself money. Not that there is anything wrong with that. So, you need to take its marketing pitch with a few grains of salt. In any event, I really doubt the brown asset company will go private. At this point in time, that is where the money is. My guess is that the brown asset company will look more like ExxonMobil, a highly valuable public company in a time when oil prices have stabilized and are rising. This is the value that Third Point wants to unlock. Unloading the green company would unlock that value. Third Point does not describe the green company in flattering ways, suggesting it can only generate "modest cash returns." I also disagree with Third Point that a lower cost of capital will result for the green company. After all it will be a riskier company financially as it will not be able to generate a lot of cash to cover its debt service.
Posted by: Bernard S. Sharfman | Oct 30, 2021 6:40:45 AM