On June 14, 2021, S&P Global Ratings published a commentary, "The Energy Transition: ESG Concerns Are Starting To Present Capital Market Challenges To North American Energy Companies," that discussed recent bond issuance trends, their implications for credit quality, and future capital market access. Our research indicates investors' growing focus on environmental, social, and governance (ESG) factors and credit risk could be affecting demand and pricing for oil and gas companies' new debt issuance, although these companies continue to have ample market access. Furthermore, rising stakeholder support for greater investment by oil and gas companies in renewable energy infrastructure has forced changes in board compositions and institutional investor divestments.
In response to investor inquiries that followed publication of this commentary, we are expanding our insights by answering the following questions:
Frequently Asked Questions
Can you provide more detail on how you calculated funding cost differentials for companies within the energy sector?
To analyze funding cost differentials, we reviewed primary market bond issuance yields of North American bond issuance from Jan 1, 2019, through May 1, 2021, from the energy sector. We included oil and gas and midstream companies with investment-grade issuance during the period and excluded oilfield services companies.
In order to group these firms according to their relative carbon intensity, we referred to the S&P Global Trucost carbon-to-revenue metric (GHG Intensity Direct and First Tier Indirect) from 2019. Using this metric, we grouped the companies into quartiles of relative carbon intensity and compared the issuance of the top and bottom quartiles. In our groupings, we also considered whether greenhouse gas (GHG) emissions were sufficiently disclosed, according to S&P Global Trucost.
To test if differences in the composition of new issues from those in the top and bottom quartiles of carbon intensity could explain the differences we saw in the averages for new issue debt, we estimated the cost of new issue debt during the period for the issue rating, tenor, and the company's carbon intensity. By including a variable to control for the carbon intensity of the issuer, the adjusted R-squared increased modestly to 0.9246 (from 0.9176), and we found that the beta coefficient for the carbon intensity variable was significant at the 0.01 level.
Based on our estimates, the financing cost for the average North American energy company in the lowest carbon intensity quartile was about 153 basis points (bps) lower than that of the average issuer in the highest carbon intensity quartile, with the composition of issue ratings in either quartile accounting for about 78 bps, and the carbon intensity of the issuers in either quartile accounting for about 75 bps. Compared to a hypothetical energy company with average carbon intensity within the GICS energy industry group that has also sufficiently disclosed its carbon emissions, these 75 bps account for a yield that is about 22 bps tighter for the top quartile and a yield that is about 53 bps wider for the bottom quartile.
While this review of funding costs was based on a recent sample of issuance from a relatively small pool of energy companies, these findings suggest to us that the capital markets might be beginning to differentiate companies based on perceived ESG risk.
How will the apparent funding cost differentials affect ratings?
We believe it is still too early to pick ESG winners and losers from a credit perspective, as increased capital spending on clean energy solutions might not generate returns for several years--potentially weakening near-term leverage ratios--and it is difficult to know today which solutions will ultimately gain acceptance by consumers. However, it is clear that stakeholders are demanding greater transparency and clearer strategies for dealing with the energy transition, which is beginning to emerge in funding cost differentials, although these companies continue to have ample market access. Longer term, we believe oil and gas companies will have to figure out how to address the environmental concerns expressed by their stakeholders, or risk the continued widening of spreads and shortening of tenor relative to the broader corporate market. Longer term, we believe oil and gas companies will have to figure out how to address the environmental concerns expressed by their stakeholders, or risk the continued widening of spreads and shortening of tenor relative to the broader corporate market; as of now, the funding cost differential is de minimus in terms of our credit ratios and ratings.
Will oil and gas producers need to cut production to meet their emission targets? If so, will OPEC fill the void?
The answer will depend on which strategy each company chooses for achieving its emissions reduction goals. If a producer follows the European major approach of transforming its business model to provide more energy from renewable sources, than its oil and gas production will most likely decrease. If a company takes the U.S. major approach of decarbonizing its own production process, or capturing carbon from customers, then there will be less of an impact on its production. These scenarios assume overall global oil demand remains essentially flat.
We continue to believe that oil and gas will remain a part of the global energy landscape, albeit likely with a smaller slice of the pie than today. Thus, we expect oil and gas demand to be met by the lowest-cost producers. This group will likely include national oil companies--both within and outside of OPEC--whose costs are low in part due to the ongoing financial and other government support to local companies in the energy sector.
Are you seeing investors taking stronger actions on Canadian oil sands producers relative to U.S. producers?
To date, institutional investor retrenchment from the Canadian oil and gas industry has been less direct than the shareholder activism that has occurred in the U.S. Some large foreign institutional investors have reduced their investment in several Canadian oil and gas companies, particularly those focused on oil sands development and production, due to their concerns about the producers' ability to reduce their emissions profiles. The development of Alberta's oil sands resources contributed more than a 60% increase to the province's total emissions between 1990 and 2019. Based on 2019 reported data, Alberta accounted for 38% of Canada's GHG emissions. As institutional investors increasingly focus on net zero emissions targets for their investments, Canada's oil and gas industry will need to make tangible progress in reducing GHG emissions to stall the momentum of possible shareholder dissent. To date, a large number of Canadian institutional investors have maintained or increased their investments in Canada's energy sector; however, there is significant foreign ownership of Canada's largest oil and gas companies. In apparent acknowledgement of investor concerns and the real need to reduce emissions from their operations, five of Canada's largest oil sands producers announced, on June 9, 2021, their intention to work together to reduce emissions from their oil sands operations. Failure to achieve their published emissions reduction targets could be a catalyst for further investor dissent. Foreign investor ownership of Canada's senior oil and gas producers is certainly large enough to influence operational stewardship and corporate governance; however, recent shareholder actions in the U.S. clearly demonstrate the potential influence minority shareholders could have if companies fail to keep pace with established legislative climate change goal posts. Although not yet published, there is anecdotal evidence suggesting Canada has not met its 2020 emissions reduction target, which requires the country's total emissions fall to 635 megatonnes of carbon dioxide equivalent from its reported 730 Mt CO2 eq. generated in 2019. As Alberta's emissions represent a meaningful component of Canada's total emissions, with the oil and gas industry being a significant contributor to the province's total emissions, it is imperative that Canada's largest oil and gas companies achieve their stated targets.
Do you expect U.S. oil and gas companies to pursue ESG bond issuance, potentially sustainability-linked bonds with targets tied to emissions reductions?
While it's hard to say what any one company is likely to do to address its environmental footprint, the growing diversity of the sustainable debt market does create new opportunities for issuers that might be treated with skepticism if they were to enter the green bond market. In 2021, we've already seen a surge in sustainability-linked bond (SLB) issuances, and these can be tailored to a specific issuer, tying coupon pricing to key performance indicators (KPIs) that are appropriate for the issuer and the sector. An oil and gas player need not deploy the funds from the issuance to a specific type of project, or so the logic goes, if it can demonstrate progress on a KPI it selects, such as Scope 3 emissions. It creates an alignment of interests, and potentially a pricing advantage for observed environmental performance, which is different than a green bond.
But SLBs do not necessarily represent a Pollyanna response for oil and gas issuers. Just as green bonds issued by oil and gas companies might be viewed as suspect because of uncertainty surrounding the use of proceeds, SLBs might also rankle an ever-growing class of investors fearful of funds being deployed to fossil fuel projects. And it also calls into question what the correct KPIs are: an investor who will concede 15 bps off the coupon is likely to want some assurance that this KPI, and the risk it ostensibly solves, are financially material and, for most ESG-oriented investors, they'd also want to understand that it is environmentally (or socially) material.
Given the relative low coupons on recent green, social, and sustainability-linked bond issuances (due to demand), how do you anticipate demand over time given this low return?
Any study of the sustainable debt market is currently undermined by a relative lack of data; put simply: Too small a sample size. Even in 2020, a record year for sustainable debt issuance, the global figure did not reach [US or C currency?]$550 billion. We expect the quantum to exceed $700 billion in 2021, but the market currently lacks sufficient liquidity to draw out relative pricing patterns. Despite some evidence in the U.S. secondary market of a pricing advantage associated with sustainable debt issuance, a pronounced coupon advantage has yet to materialize. Still, the following points suggest that demand for these issuances should continue to grow in the next few years:
- Investors are increasingly savvy about connecting climate risk (both physical and transitional) to financial outcomes; the prospect of significant stranded assets worries them. For more carbon-intensive industries, it seems likely that continued investment in these sectors will rely on companies committing to decarbonize in some way, and both green bonds and SLBs can, if crafted correctly, help achieve this commitment.
- A recent SEC report detailed numerous unnamed ESG-oriented investors as not sufficiently matching their practices for selecting investments with their advertising or reputation. To the extent that these investors, or any for that matter, need to provide evidence of their own commitment to mitigating climate risk, indicating what percentage of their portfolio is in sustainable debt could help.
- The growing diversity and innovation within the sustainable debt market means that a greater number of issuers and sectors have viable means for accessing sustainability-oriented companies. For instance, in 2020, we saw a 7x-8x surge in social bond issuance in response to the COVID-19 pandemic; many of these companies would have been unconventional green bond issuers. Similarly, the growth in sustainability-linked issuances means that companies with substantial GHG or pollution footprints can reap a benefit for bringing these under control without investing in classically green projects that might be unnecessary for them at present.
- The Energy Transition: ESG Concerns Are Starting To Present Capital Market Challenges To North American Energy Companies, June 14, 2021
- S&P Global Ratings Takes Multiple Rating Actions On Major Oil And Gas Companies To Factor Greater Industry Risks, Jan. 26, 2021
- The Change To The Industry Risk Assessment For Exploration & Production Companies And What It Means For Ratings, Jan. 25, 2021
- Industry Risk Assessments Update: Jan. 25, 2021
This report does not constitute a rating action.
|Primary Credit Analysts:||Michelle S Dathorne, Toronto + 1 (416) 507 2563;|
|Carin Dehne-Kiley, CFA, New York + 1 (212) 438 1092;|
|Secondary Contacts:||Michael T Ferguson, CFA, CPA, New York + 1 (212) 438 7670;|
|Evan M Gunter, New York + 1 (212) 438 6412;|
|Jon Palmer, CFA, New York;|
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