ESG strategies contribute to decline in energy investments, Goldman says

ESG strategies have contributed to a serious decline in energy investments by focusing too much on divestment from fossil fuels and not enough on investment in renewable power sources, according to a senior researcher at Goldman Sachs.

“The focus on decarbonisation is correct, but I think it needs to be driven by more investment, not divestment,” Michele Della Vigna, Goldman’s head of natural resources research, says.

“The key is to move away from divesting oil and gas towards more investment in renewables and in low carbon.”

That’ sthe “key issue” that the ESG community “needs to face,” he says.

The capital allocation patterns of investors targeting environmental, social and governance goals have contributed to a global lack of expenditure on energy, which has been particularly damaging to economically vulnerable corners of society, according to the Goldman analyst. He estimates that energy spending is 25% lower than it was between 2010 and 2014, when it was about $2-trillion.

BloombergNEF estimates that reaching net-zero greenhouse gas emissions by the middle of this century represents an investment opportunity equivalent to almost $200-trillion, or about $6.7-trillion each year. By comparison, $2.1-trillion was spent in 2021, according to BloombergNEF.

BloombergNEF has also calculated that for every $1 spent on fossil fuels, at least $4 should go to low-carbon energy supply by 2030. “Right now, the ratio is about 1:1,” says BloombergNEF analyst Claudio Lubis in London.

“So the key message is, instead of focusing on divestment and stopping doing things, we need to rapidly ramp up investment into low-carbon energy supply to displace fossil fuels,” Lubis says.

The underinvestment in the energy sector “is very concerning,” Della Vigna says. “And though energy Capex is rising, I don’t think it’s rising fast enough to fill in the gap of 10 years of underinvestment.”

He also questions ESG investors’ tendency to focus on absolute emissions as a guide for allocating capital, rather than emissions intensity, which measures an entity’s carbon footprint relative to its total revenue.

“Anything that pushes companies to produce less energy, like just focusing on absolute emissions, for them, I think, runs the risk of prolonging this energy crisis,” he says.

CONTENTIOUS ISSUE

It is a dynamic that has coincided with decades-high inflation, rising inequality and a polarising debate around the merits of ESG. The investment strategy’s role in shaping energy markets has become a particularly contentious issue since Russia’s invasion of Ukraine.

The war has stifled energy supplies and turned an economic cycle of low inflation and low interest rates on its head. Commodity prices soared, and ESG funds faced their worst year since the acronym was coined two decades ago.

Frantic efforts by European governments to wean themselves off Russian supplies have since helped drive gas prices down to pre-war levels. That has created a sense of relief across the West, as the ripple effects of lower energy costs start to trickle through to other prices. The risk, however, is that the development leads to a lull in momentum towards the energy transition, Della Vigna says.

“We still face a very tight gas market and it is in the interest of Europe and the rest of the world to continue to accelerate the renewable buildup as quickly as possible. I think it’s very dangerous to be complacent here.”

Goldman Sachs expects capital expenditure on energy to rise 15% this year. But given inflation, capex should actually be as high as 30%, Della Vigna says. “What needs to happen is an acceleration of renewable spending on one side, but also normalisation of the spending in hydrocarbons on the other.”

That rise in spending now has a considerable tailwind in the form of the Biden administration’s Inflation Reduction Act, which was passed into law last August. Though the US government’s initial estimates indicated it would spur about $370bn in green spending, Della Vigna says that Goldman calculations show the actual figure could be as high as $3-trillion over the coming decade.

“The Inflation Reduction Act (IRA) has given extraordinary visibility on long-term returns for renewable technologies,” Della Vigna says. “That is the biggest positive development in the entire renewable space probably for the last decade.”

Europe, meanwhile, has always “been at the forefront of the clean tech innovation,” he says. But to stay there, “it’ll probably need to sweeten some incentives, especially in areas like green hydrogen, carbon capture, and bio energy.”

“Extending some of these incentives to broader industries and making them more consistent across the continent will make Europe more attractive and more similar to the IRA in the US,” Della Vigna says.