Concerns about climate change and broader sustainability issues have seen investors pour money into funds focused on environmental, social, and governance (ESG) at a record clip. Last year, investors allocated more than half a trillion dollars to such funds.

Yet 2021 was also a bumper year for fossil fuels. Oil and gas companies outperformed ESG-related stocks, with the iShares MSCI global energy producers exchange-traded fund (ETF) posting total returns of 43% last year, outpacing the iShares MSCI World ESG Screened UCITS ETF, which returned just 22%.

Oil majors have also been reporting hefty profits. Shell, for instance, saw its adjusted earnings for 2021 jump to $19.3bn from $4.8bn a year earlier as crude prices soared following a pandemic-induced slump. Having rallied 50% in 2021, US oil prices topped $90 a barrel in February for the first time since 2014. Meantime, the amount of electricity generated from coal hit a record high last year, according to the International Energy Agency.

All of that came as world leaders agreed to a target of net zero carbon emissions by 2050 in an effort to keep global warming below 1.5°C this century. To have any chance of hitting that target, countries need to reduce their dependence on fossil fuels and transition to low-carbon economies.

Curbing emissions exposure

Some financial institutions are already taking steps to curb their emissions exposures. HSBC, for instance, said it expects all of its clients to have a plan to exit coal by the end of 2023. The bank also said it intends to cut financing for thermal coal by a quarter over the next three years. BlackRock, the world’s largest asset manager, announced in 2020 a plan for its active funds to divest from any firm that generates more than 25% of its revenues from thermal coal. Since then, however, CEO Larry Fink has taken a different stance – don’t divest from fossil fuel companies, engage with them instead.

“The debate now is, is it better to divest or is it better to actually fund the transition and continue to be invested [in fossil fuels] and engage with the companies,” says Natalia Luna, Senior Thematic Investment Analyst for responsible investment at Columbia Threadneedle Investments. “There is generally an increasing view that it could be more results-orientated if you continue to invest selectively in these companies and engage with them to implement net-zero plans to decarbonize. As they are critical to reducing global emissions, stopping financing fossil-fuel companies with net-zero plans per se could be detrimental to achieving the net-zero goal.”

“Public market actors can sell their assets and burnish their halo for reducing their own portfolio of fossil fuels, but the assets continue to be operated and the emissions are the same or potentially even worse.”

Alyssa Giachino, Research Director, Project

While Luna doesn’t believe that funding will materially dry up for the biggest and strongest companies, smaller companies with weaker balance sheets may find it more challenging in the future.

Some asset managers are also giving heavy-emitting companies a chance to clean up their acts before divesting from any positions. Aviva Investors’ Head of Corporate ESG Research, Sora Utzinger, says Aviva has taken an ‘engagement-and-escalation’ approach with 30 of the most systemic carbon emitters across the globe.

“We are engaging with a diverse group of oil majors, miners, pipeline operators, and utility companies, asking for sufficient progress on a set of climate metrics,” she said. “We are committed to divesting from all equity and bond holdings if companies end up falling short of meeting our expectations.”

Sustainability-linked bonds

While labelled green and sustainable investment funds typically exclude traditional energy and commodity companies, a new type of green finance, known as sustainability-linked bonds, may enable such companies to access funds from those investors. Unlike traditional green bonds whose proceeds are ring-fenced for a specific green project, sustainability-linked bonds can be used for any purpose: repayments are tied to the borrower meeting certain pre-agreed sustainability targets – typically around emissions – with penalties for missing the targets such as having to pay higher interest rates. Issuance of sustainability-linked bonds rocketed last year, hitting $127bn – up from $12bn in 2020 – according to Climate Bonds Initiative data.

“What this is doing is letting these companies set wider organizational targets, but these investments require a lot of scrutiny,” says Henry Mason, Senior Research Associate at Calvert Research and Management. “We’ve seen a mixed bag in terms of the real ambition and credibility of sustainability-linked bond issuance that has come to market, but it’s an instrument that might allow for companies that are making material efforts to improve their emissions profile over the long term to access transition financing.”

Mason adds that investors are increasingly understanding that you can’t just invest in the top 20% of environmental performers; you need to also focus on the other 80% and drag them all up to the performance of the top 20%. “That includes companies that currently have a very high greenhouse gas intensity,” he says.

Another potential issue with public market investors exiting their fossil fuel holdings is that those assets will simply move into private markets where there is even less scrutiny.

“There is fossil-fuel financing across the capital markets and some of it is shrouded in secrecy, and that makes it really challenging to make concrete progress on emissions reduction and transitioning away from fossil fuels,” says Alyssa Giachino, Research Director at Private Equity Stakeholder Project, an activist group. “Public market actors can sell their assets and burnish their halo for reducing their own portfolio of fossil fuels, but the assets continue to be operated and the emissions are the same or potentially even worse.”

Private equity firms have ploughed roughly $1.1trn into energy assets since 2010, with about 80% of their energy holdings related to fossil fuels and just 20% to renewables, according to a Private Equity Stakeholder Project report.

Given the risk of the worst polluting assets simply being hived off into private hands, Giachino is calling for a more holistic approach that ensures the shift away from fossil fuels is underpinned by metrics and an implementable timeline, and holds private market investors to the same level of scrutiny as those in public markets.

“You can have all the solar in the world but, if it’s not sunny, it doesn’t work.”

Noah Barrett, research analyst, Janus Henderson

That transition from fossil fuels to cleaner energy such as renewables is not going to be straightforward. For starters, people need access to reliable energy – and that is not always possible at the moment with renewables.

“New wind and solar on a standalone basis is, a lot of the time, cost-competitive or even cheaper than traditional fossil fuels but unless you have some type of battery storage solution – which doesn’t really exist on a utilities scale – it’s not reliable,” says Noah Barrett, a research analyst at Janus Henderson. “You can have all the solar in the world but, if it’s not sunny, it doesn’t work.”

That doesn’t mean clinging to fossil fuels indefinitely. Thermal coal, for instance, will likely see demand rapidly dwindle as environmental pressures mount and coal production is phased out.

Emerging markets

“For access to financing, developed-market banks are under immense pressure to reduce or cease financing for the construction of a new coal plant or thermal coal mine,” says Barrett. “In emerging markets, financing may be provided by the government, but this may come under pressure as well. In short, access to capital is going to be an increasing concern for coal companies going forward.”

For oil and gas companies, demand is likely to hold up longer, not least because hydrocarbons are used for other purposes, such as plastics and fertilizers. In addition, companies from ExxonMobil to Shell have energy transition plans to ensure they remain relevant in a world of lower fossil fuel use.

“In the future, they won’t just be integrated oil and gas companies, they will be integrated energy companies,” says Barrett. “They may still produce some oil and gas somewhere in the world but they will also be involved in renewable fuels, maybe somewhere in the hydrogen value chain, perhaps carbon capture and storage, or renewable generation, whether that’s wind, solar, or geothermal. By 2050 each company will figure out what their niche is and what their competitive advantage is.”