Shareholders, Investors Driving Fossil Fuels’ Embrace of ESG

The energy transition now fully upon the natural gas industry has been years in the making, but one three-letter acronym is poised to accelerate the business’ embrace of change at an unprecedented pace. Producing hydrocarbons is a capital-intensive endeavor, and investors carry massive leverage in the challenge to contain matters of environmental, social and governance (ESG) concerns.

The rumblings of small-scale retail investors building passive retirement income, as well as institutional investors with millions of dollars of other people’s money to deploy, reached a crescendo as the 2014 industry downturn lingered.

The waning years featuring extreme weather, a pandemic and attention to social justice issues have only exacerbated the problems facing U.S. businesses, especially those that extract fossil fuels.

“The institution of environmental, social and governance values and metrics represents a true revolution in how corporations are managed, measured and operated,” said Lisa Rushton, a partner in the environmental practice with law firm Womble Bond Dickinson. “This sea change will continue to drive companies away from the familiar framework of short-term profits toward success that is not only defined by profitability, but also by a ‘sustainable’ and measurable contribution to the betterment of society at large.”

Climate changing

Many activists met the phenomenon of hydraulic fracturing with fears that the practice used to extract fossil fuels would harm the quality of water, air quality and healthcare. And while the industry addressed some concerns—one Halliburton Co. executive infamously sipped fracking fluid from a champagne glass during a 2013 conference in Quebec—much angst remains.

But now, the industry is not cheekily dismissing the naysayers. Executives are recognizing that there are challenges, and they are up to the task of addressing them.

“This new paradigm breaks a long-established mold,” Rushton said. “While ESG is perceived by some to be difficult to implement, and it may seem like a profit-killer, the irony is that for most companies that implement ESG programs, including those within the oil and gas industry, it has the opposite effect.”

Pioneer Natural Resources CEO Scott Sheffield was an early adopter of limits on the flaring of natural gas associated with oil production in the Permian Basin. Shortly after returning to the top job at Pioneer in 2019—just as news reports and satellite data unveiled the scope of flaring in the Permian Basin—Sheffield deployed a comprehensive methane leak detection and repair program that includes routine aerial surveys. The firm reported in August that annual flaring is down to less than 1% of its production.

Following the example of Sheffield’s outspokenness on flaring—with a frequent refrain that it is a “black eye” on the industry—most large U.S. independents and their major counterparts have signed onto the World Bank’s initiative to end routine flaring by 2030.

But their work is not done. Indeed, Sheffield warned his peers at a 2020 NAPE Expo in Houston, a major oil and gas trade show, that if the industry does not manage its carbon footprint, it risks losing investors.

By the end of 2020, the world’s largest institutional investors including BlackRock Inc., State Street Global Advisors and The Vanguard Group warned producers they must realign their corporate strategies on ESG matters. These major investors together own roughly 20% of U.S. oil and gas exploration and production company shares, and they say they will vote against board members if ESG concerns—including the social and governance aspects—are not management priorities.

Those heavyweight financiers have pledged their support for the goals of the Climate 100+ initiative, which include the adoption and implementation of the recommendations set by the Task Force on Climate Related Financial Disclosures. Members of the initiative hold some $50 trillion in assets under management.

“Of all the lessons we’ve learned during the ongoing pandemic, one that deeply concerns me is the consequences that systemic risks can have on our society, on people, on our schools and businesses, and on global financial markets,” State Street CEO Cyrus Taraporevala said in a letter to executives. “While few predicted the havoc COVID-19 would wreak, the same cannot be said about the growing threat of climate change, which has become increasingly important to investors."

Ahead of the COP26 gathering in Scotland in late 2021, Tim Eggar, chairman of the UK’s Oil and Gas Authority, issued a challenge to the industry to respond to the global issues ahead.

“Clearly, climate change is happening right now. That debate is over,” he said. “The framework, the license to operate for the industry, has changed fundamentally and—unlike the oil price—forever.”

Social and diverse

As social unrest and diversity questions permeate general culture, the energy industry is under a microscope. Catalyst researchers found that women account for 22% of employees in the oil and gas industry worldwide: women make up 27% of entry-level positions, 17% of senior and executive-level positions, and just 1% of CEOs.

Industry analysts say that diversifying executive leadership is more than doing the right thing—it’s also the financially prudent step.

In its Delivering Through Diversity report in 2018, McKinsey and Co. found that companies in the top quartile for gender diversity on their executive teams were 15% more likely to experience above-average profitability than companies in the fourth quartile. For ethnic and cultural diversity, the 2017 findings showed 33% likelihood of outperformance on profit margins.

Corporate realignment with shareholders

Kimmeridge Energy Management Co. reported a lack of corporate accountability and alignment with oil and gas shareholders in research produced last year. 

“The public [exploration and production] sector is broken, and the root cause of the problem is a lack of alignment between executives and shareholders,” the report’s authors wrote. “The misalignment that begins with skewed incentives and low insider ownership is compounded by boards who appear unwilling to hold management teams accountable. Executive compensation remains elevated irrespective of performance and there is virtually no threat of dismissal.”

The scathing examination—coupled with other shareholder angst about unprofitable corporate growth and dwindling dividends—put several companies on notice.

And now analysts are taking their turn at recognizing progress.

Alvarez & Marsal released its Oil and Gas Exploration and Production Compensation Report in October 2021. The industry consultants found clear and profound change in how many natural gas operators reward executives so that their financial success better reflects the business’ performance and lines up with the rewards doled out to shareholders.

• Many entities are shifting away from using growth metrics such as production and reserves to focus their efforts on expenses, promoting health, safety and environmental metrics, and cash flow.

• Application of ESG metrics continues to grow; the typical weighting for such metrics is between 10% and 20% of the overall annual incentive plan (of the 39% of companies that use ESG metrics). 

• Time-vesting restricted stock / restricted stock units and performance-vesting awards are the most common forms of long-term incentive compensation, utilized by 67% and 59% of companies, respectively. For performance-vesting awards, relative total shareholder return is the most common performance metric, used by 89% of companies.

To be sure, natural gas companies are making strides toward aligning the interests of management with those of shareholders. Royal Dutch Shell became the first oil major to link ESG to executive pay, earmarking 10% of long-term incentive plans (LTIP) to reducing carbon emissions in 2018. BP followed suit. While trailing their European peers, U.S.-based Chevron Corp. and Marathon Oil Corp. were first out of the North America energy gate to add greenhouse gas emissions targets to executive compensation plan.

“We can’t underestimate the impact that investors will continue to have for the next couple of years,” said Phillippa O’Connor, a London-based partner at PwC and a specialist in executive pay.

Stepping up

EQT is the largest U.S. gas producer, and its purchase of Alta Resources, which closed in July 2021, raised the firm’s total net production during the first quarter to 5.4 billion cubic feet per day (Bcf/d), eclipsing Exxon Mobil Corp.’s tally and accounting for roughly 6% of all U.S. gas production.

Short-Term US Natural Gas Energy Outlook - October 2021

Toby Rice is one of the original “shallenials,” a cohort of ambitious and talented young engineers who are leaning on technology to drive profits up and emissions down.

“Reducing methane emissions is a foundational component of our mission to be the operator of choice for all of our stakeholders, a responsibility we embrace as the country’s largest producer of natural gas,” said Rice, president and CEO of EQT Corp.

“Natural gas is capable of playing a key role in accelerating a sustainable path to a low carbon future, both domestically and abroad. To position natural gas as a decarbonizing commodity of choice, however, it is incumbent on industry participants to embrace a modernized approach that deploys best available technology for emissions measurement and management.”

The Energy Information Administration (EIA) expects U.S. gas production to average 92.9 Bcf/d during second-half 2021—up from 91.4 Bcf/d in first-half 2021—and then reach 94.9 Bcf/d in 2022 on the strength of supportive commodity prices. 

U.S. gas exports—of both liquefied natural gas (LNG) and pipeline gas—are setting new records. The agency is forecasting U.S. LNG and pipeline gas exports to rise from a combined 14 Bcf/d in 2020 to 19 Bcf/d in 2022. Pipeline exports to Mexico increased from 5.4 Bcf/d in 2020 to nearly 7 Bcf/d a day in June 2021.

Adding scope

Occidental Petroleum Corp. is pressing ahead of its peers to solve the industry’s emissions problem. The company last year unveiled an ambitious plan to offset carbon dioxide (CO₂) from the combustion of its oil and gas by 2050.

Most viable U.S. independents and majors are working on methods and technologies to limit Scope 1 and Scope 2 emissions. But Occidental stands alone in crafting a technological plan to shut in Scope 3 emissions. Meanwhile, ConocoPhillips has pledged to advocate for a price on carbon to offset Scope 3 releases.

Scope 1 emissions represent those emitted by the fuel combustion that occurs in vehicles, furnaces, boilers and other equipment; these are direct emissions from controlled sources. Scope 2 covers the indirect emissions from purchased electricity, steam, heating and air conditioning; they are consumed by those who control the Scope 1 category. Scope 3 emissions account for the rest of the value chain, such as transporting the hydrocarbons and delivering them as fuel or other products. Historically, producers have argued the category is tricky to quantify and, moreover, it is unfair to hold them accountable for how customers use their products.

For many businesses, Scope 3 emissions compose more than 70% of their carbon footprint, according to Deloitte analysis. For example, a manufacturer may have a accelerate its emissions release by extracting, producing and processing its raw materials.

Occidental is building the world’s largest direct air carbon capture facility, which will have the capacity to suck up to 1 million tons of CO₂ from the atmosphere annually.

The facility in the heart of the Permian Basin is intended to support Occidental's existing enhanced oil recovery operations; the CO₂ would be injected into aging reservoirs to boost recovery rates and permanently store carbon underground.

Dozens of carbon capture technologies have been deployed around the world, according to the Global CCS Institute. Combined, these facilities have the capacity to capture and store 97.5 million tons per year of CO₂. Still, that is a fraction of the 33 billion tons of CO₂ annually produced by global energy consumption, according to the International Energy Agency (IEA).

The upshot

• The natural gas industry has recognized the importance of ESG concerns and is moving rapidly to address them.

• Some of the leading executives in the industry are warning peers of the need to reduce their carbon footprint.

• Many natural gas companies have shifted away from executive compensation based on production and reserves to metrics aligned with ESG values.
   

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