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ESG Trends Create Massive Arbitrage Opportunity

Environmental, social, and governance (ESG) is becoming increasingly popular among public investors. However, BlackRock Chairman and CEO Larry Fink recently warned that we must bring private capital along on the journey to net-zero or risk the “biggest capital arbitrage in our lifetime” if fossil fuel companies continue to fall into private hands.

Let’s look at the growing popularity of ESG investing in the public markets and the risk of hydrocarbon assets falling into the wrong hands.

Be sure to check out our ESG Channel to learn more.

Investors Embrace ESG

Global sustainable mutual fund assets hit a record high of nearly $4 trillion at the end of the third quarter of this year. According to Morningstar, the global sustainable universe has grown by more than 51% to 7,486 funds during the quarter. Most of the growth came from Europe following new disclosure rules governing ESG investment criteria.
Energy transition topped thematic fund inflows in Q3 2021

Energy transition topped thematic fund inflows in Q3 2021. Source: MSCI

Europe’s Sustainable Finance Disclosure Regulations (SFDR) set specific rules for how and what sustainability-related information financial market participants and advisors must disclose. The goal is to prevent the ‘greenwashing’ of financial products and advice to help investors meet their sustainable investment objectives.

In February 2021, SEC Acting Chair Allison Herren Lee directed the Division of Corporate Finance to enhance its focus on climate-related disclosure in public company filings. The agency hopes to update its 2010 guidance to take into account developments in the last decade and further improve climate disclosures in the U.S.

Be sure to check our Portfolio Management Channel to learn more about different portfolio rebalancing strategies.

The Dark Side of ESG

Public companies are under pressure to divest their fossil fuel assets, given the massive capital inflow into ESG funds. BP (BP), Chevron (CVX), Shell (RDS-B), ExxonMobil (XOM, Eni (E), Equinor (EQNR), and others have sold more than $100 billion worth of fossil fuel projects to private companies this year alone. Many of these assets are being sold at fire-sale prices as disclosure rules hit.
Big oil continues to sell hydrocarbon assets

Big oil continues to sell hydrocarbon assets. Source: FT

BlackRock Chairman and CEO Larry Fink points out that the transition is problematic because hydrocarbon assets are moving from transparent public to opaque private companies. These private companies face much less scrutiny over their activities, squeezing as much production as possible without disclosing the environmental consequences.

In addition, many of these private companies could make a fortune from investor enthusiasm over ESG trends. ESG-compliant assets are becoming overvalued as oil majors divest at fire-sale prices, while private companies are snapping up fossil fuel projects at a steep discount. The result is a massive arbitrage that could be counterproductive.

The Bottom Line

ESG investments have become increasingly popular over the past couple of years. As regulators step up disclosure requirements, many fossil fuel companies are selling their hydrocarbon projects to opaque private companies that face less regulatory scrutiny. These companies make fewer environmental disclosures and could have a worse impact.

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Dec 02, 2021