ESG Isn’t Ready For The Energy Transition

Investing based on Environmental, Social and Governance criteria (ESG) continues to gain following. Committing capital to companies that strive to do good appeals. Naturally, every company claims ESG credentials – because the criteria are so flexible it’s an inclusive definition. My favorite is Lockheed Martin’s regular membership of the Dow Jones Sustainability Index. If a company that builds machines to blow up people and things can have an ESG portal, it demonstrates the infinite flexibility of ESG.

Blackrock offers 30 socially responsible funds and leads AUM in the space with $60BN.  Investors are often surprised to learn that energy stocks are included, but for example, the $25BN iShares ESG Aware MSCI USA ETF (ESGU) has a 3% weighting to energy. Conventional ESG thinking is that companies that handle fossil fuels, which provide over 80% of the world’s energy, are not deserving of the ESG imprimatur. But Blackrock invests in pipeline corporations such as Williams Companies. Natural gas offers the greatest opportunity to lower CO2 emissions, by displacing coal. The EU looks as if they’re finally reaching the same conclusion, via changes to their taxonomy that would classify it (along with nuclear) as clean energy based on meeting certain criteria.

Although ESGU’s energy weighting is a pragmatic choice, the energy transition will create challenges for those who seek a moral purpose from their investments along with outperformance. Evy Hambro, Blackrock’s global head of thematic investing, sees the energy transition boosting infrastructure spending. Hambro recently said, “What we’re likely to see is strong demand that will keep prices at very very good levels for the producers for many years into the future, and that could be decades.”

Hambro expects prices for copper, cobalt and other minerals vital to electrification to enjoy a long bull market. But spending on infrastructure will also boost traditional energy demand, because concrete, steel and other inputs won’t suddenly be produced using windmills.

This creates a conundrum for ESG funds. Positioning for a world that’s decarbonizing implies a much bigger allocation to Basic Materials, which along with Energy is only 5% of ESGU’s holdings. Apple, Microsoft, Google and Amazon are almost 20% of their portfolio. Many observers question the move to carbon neutrality these companies and others claim. Apple manufactures consumer electronics; Amazon delivery trucks are ubiquitous, and all have cloud-based offerings that require server farms consuming vast amounts of electricity.

Given the infinite flexibility of ESG funds, their most important attribute has been relative outperformance. This has been driven by fund flows, and there are signs this tailwind may be easing. As we noted last year (see Pipelines Are ESG) ESGU was beating the S&P500 for a couple of years. Its portfolio only deviated modestly from the index, demonstrating how many ESG-eligible companies there are. But over the past few months ESGU has started to lag.

The energy transition is fundamentally inflationary. This is axiomatic – reducing emissions will cost money, raising the price of energy. Otherwise we’d already live in a world full of solar panels and windmills. The energy crisis roiling Europe, a result of poor planning and too much dependence on windpower, is a case in point. ECB member Isabel Schnabel recently gave a speech warning about the inflationary effects of decarbonization.

ESGU is very highly correlated with the S&P500, because their holdings are so similar. Although it had modestly outperformed the market in the past, 2021 relative performance was negative. The past three months have been especially poor, leaving it 2.5% worse off over the past twelve months. This period of underperformance corresponds to heightened inflation fears with sectors like Basic Materials and Energy doing well.

ESG has long enjoyed a very flexible set of criteria. Relatively strong performance led some to believe that companies with high ESG standards were generating better performance metrics, such as ROE or profit margins. However, the evidence was never compelling, and more likely is that investor bias towards ESG funds has been self-fulfilling.

That may have started to reverse. It’s likely a portfolio designed to profit from a long bull market in commodities, as forecast by Blackrock’s Hambro and others such as Goldman’s Jeff Currie would look quite different from today’s ESG funds. The irony is that concern about climate change is high on the ESG checklist, and yet decarbonization may leave ESG funds underinvested in the sectors most likely to profit from this.

It’s fortunate that ESG is so flexibly interpreted, because if recent trends continue we’ll likely see new offerings that combine ESG with heavy commodity exposure.

We have three funds that seek to profit from this environment:

Energy Mutual Fund

Energy ETF

Inflation Fund

Please see important Legal Disclosures.

 

 

Print Friendly, PDF & Email

Important Disclosures

The information provided is for informational purposes only and investors should determine for themselves whether a particular service, security or product is suitable for their investment needs. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the disclosure, prospectus, and offering. Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. No representation is made with respect to the accuracy,  completeness or timeliness of this information. Nothing provided on this site constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments.  Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and do not reflect the deduction of the advisor’s fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios managed by SL Advisors as they have different underlying investments and may use different strategies or have different objectives than portfolios managed by SL Advisors (e.g. The Alerian index is a group MLP securities in the oil and gas industries. Portfolios may not include the same investments that are included in the Alerian Index. The S & P Index does not directly relate to investment strategies managed by SL Advisers.)

This site may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involves a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of SL Advisors LLC or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made. r

Certain hyperlinks or referenced websites on the Site, if any, are for your convenience and forward you to third parties’ websites, which generally are recognized by their top level domain name. Any descriptions of, references to, or links to other products, publications or services does not constitute an endorsement, authorization, sponsorship by or affiliation with SL Advisors LLC with respect to any linked site or its sponsor, unless expressly stated by SL Advisors LLC. Any such information, products or sites have not necessarily been reviewed by SL Advisors LLC and are provided or maintained by third parties over whom SL Advisors LLC exercise no control. SL Advisors LLC expressly disclaim any responsibility for the content, the accuracy of the information, and/or quality of products or services provided by or advertised on these third-party sites.

All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio.

Past performance of the American Energy Independence Index is not indicative of future returns.

Print Friendly, PDF & Email
0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published.

This site uses Akismet to reduce spam. Learn how your comment data is processed.