Investors and consumers are pressuring companies to incorporate environment, social, and governance (ESG) practices into their culture and operations. ESG has gone from a nice-to-have feature to a must-have prerequisite as it influences investments and ultimately will be a deciding factor in winners and losers in the energy market. The pressure of ESG is being felt throughout the oil and gas value chain, with upstream facing the most scrutiny for its effect on the environment and midstream for its social impact and governance structure. Fig. 1 shows a qualitative assessment of the relative pressure on ESG for each segment in the value chain.
In addition, the following 10 key ESG trends in energy are based on the work and research from ADI Analytics. Specifically, the most pressure is seen in environmental areas, followed by social and governance issues. The oil and gas industry—refining and upstream, in particular—always have faced consistent environmental and related regulatory pressure. What is different now, however, is a growing push toward decarbonization. Similarly, oil and gas companies—midstream, in particular—have faced social pressures in the past, but these pressures have intensified recently. Finally, although larger oil and gas players have sophisticated practices in these areas, governance issues are back in the spotlight because several smaller companies have entered the shale and unconventional oil markets in North America in the past decade.
Environment
1—Upstream oil and gas seems to be under a microscope regarding the environmental issues, with flaring, wastewater management, and induced seismicity being just a few concerns raised by stakeholders. Large operators are investing in decarbonization and in carbon capture and storage projects and have improved transparency in reporting key metrics pertaining to emissions. The Oil and Gas Climate initiative, a consortium of major oil and gas companies and national oil companies, was formed to accelerate the industry’s response to climate change primarily through technology-innovation investments and advocacy.
2—Historically, midstream operators have avoided the brunt of ESG scrutiny levied at the energy industry, but recent spills and methane leaks have become a concern as noted by the temporary suspension of the Dakota Access Pipeline. Even as the massive shale infrastructure buildout nears its end, stakeholders are pushing for uniform reporting of incidents, spills, and emissions across operators.
3—Despite the environment-friendly credentials of liquified natural gas (LNG), pressure is mounting for more transparency in emission reporting, reductions in methane leakage, and sustainable practices in sourcing natural gas. LNG buyers also have focused on sustainability; BP recently sold cargoes of its “green LNG” into Europe, and Shell offset emissions from cargoes sold into South Korea and Japan. Similarly, reporting is becoming important as operators and LNG carriers such as Cheniere and Flex LNG recently produced their first ESG and corporate responsibility reports.
4—Environmental scrutiny of refineries has moderated after decades of pressure to produce low-sulfur and cleaner fuels. Long-term focus is shifting to renewable hydrogen and renewable fuels as governments across the world are seeking to reduce emissions in populous cities.
5—Utilities have expedited coal-fired power-plant retirements because of poor economics and low utilization rates in favor of natural-gas-fired power plants. Many utilities have set carbon-reduction targets and have planned significant investments in renewables and battery technologies as they prepare for a coal-free future in the long term. In the near term, utilities are trying to reduce fugitive gas emissions across their assets.
Social
6—Constructing new pipelines in socially sensitive areas, such as those owned by indigenous people or in the Northeast, is challenging. Local and national pushback aimed at the TransMountain and Dakota Access pipelines was a wakeup call to many midstream operators who often checked environmental boxes but did not seek to understand the social ramifications of their projects.
7—Interest in small-scale LNG peak shaving plants is increasing because of rising public opposition to new pipelines in regions such as the Northeast. It has become easier to get approval for additional peak shaving capacity than it is to build new pipelines. LNG peak shavers are primarily concentrated in the Northeast but are becoming more prominent in other markets with limited access to pipeline infrastructure and rising energy demands.
8—Natural gas once was thought to be a bridge fuel, but, now, utilities are facing pressure from consumers and policymakers to accelerate the transition to renewable energy sources. The increased scrutiny has slowed natural-gas-fired power-plant investments.
Governance
9—Upstream operators have begun implementing internal governance processes and board-level oversight of ESG issues. Management accountability of ESG, including diversity, is becoming necessary and a portion of bonus incentives is being tied to reaching ESG metrics. As stakeholders monitor commitments to ESG, it is important for operators to have investments and strategies reflecting what they are communicating to stakeholders.
10—Increasingly large midstream companies are converting from the general partner/limited partner (LP) structure to C-corps and are eliminating incentive distribution rights (IDRs), which were unfavorable with the LP structure. Simplifying structures and removing IDRs lower the cost of capital and enhance corporate governance by reducing conflicts of interest amongst general and limited partners. Kinder Morgan, Oneok, and Williams are among the more notable companies to convert to a C-corp.
These 10 ESG trends in energy markets will have important and broad-ranging implications. A few of the implications are the following:
- Investment dollars already constrained in the traditional oil and gas markets will now flow to projects and companies with robust and materially relevant ESG practices. ADI’s recent work has shown that even private equity investors will turn down opportunities entirely because of ESG considerations.
- Company practices around ESG communications, reporting, and data analytics will have to evolve and mature rapidly. Over the years, ADI has helped oil and gas operators prepare for, secure, and improve performance on global sustainability benchmarks—the Dow Jones Sustainability Index, in particular—and such recognition, coveted already, is going to become more difficult without sophisticated data analytics, communication strategies, and reporting practices.
- The upcoming US presidential election could dramatically accelerate the ESG movement if there is a change in the administration, but, regardless, it will do little to slow down the current pace. In recognition of this, ADI is supporting scenario planning and war gaming exercises with its clients to understand the role of a dramatic shift in pressure around ESG that could help senior executives clarify their options and identify specific no-regress near-term initiatives.
- Innovation will be the most-critical lever to achieve material, step-change improvements in ESG performance. Oil and gas companies recognize this and, therefore, have been investing aggressively in early-stage start-ups through various venture capital vehicles. However, adoption of these technologies within oil and gas operators has been the Achilles heel of these efforts. Thoughtful, science-based approaches to drive new technology scale-up and commercialization is an area where ADI has recently helped a few corporate venture capital groups.
- Finally, talent management will have to reorient to accelerate the pipeline of leaders as well as competencies to meet ESG goals. In recognition, ADI’s clients have sought its support to benchmark their talent management practices relative to the top tier’s best practices and develop appropriate training and leadership programs.