March 22, 2024 - ESG investing and the ratings that inform it have lost their lustre. That may not be a bad thing for companies in the energy and natural resources sectors. When it comes to the big strategic questions they face around decarbonisation over the coming decades, ESG offers limited useful insight.

But those questions have not gone away. The fundamentals of climate change have not shifted, and the threat it poses has not diminished. 

That is especially true in oil and gas, power and renewables, and metals and mining – sectors in which the ‘E’ part of the equation concerns existential matters.

Now more than ever, companies and stakeholders in those sectors need to answer the question – How are we positioned to navigate decarbonisation and the energy transition – both risks and opportunities – over the coming decades?

A key challenge for ESG, particularly in energy and natural resources, is that ESG ratings do not answer that question. They are, by definition, too narrow in scope to fully assess the potential impacts of a changing world. And yet, even within that narrow scope, too broad, simplistic, and confused to offer meaningful insight into company-specific risk.

ESG ratings have their place, of course. But on that fundamental question, they will only ever be a high-level starting point, at best.

What is Needed?

What is needed to answer that question is a detailed, nuanced approach that presents a comprehensive picture. An approach which includes the salient aspects of ESG – carbon emissions in particular – but goes much deeper. Which ignores the parts of ESG that are less relevant – the ‘S’ part of the equation for example (important for stakeholder management, but not a material factor in transition and decarbonisation strategy). But incorporates the critically important element that ESG misses altogether – fundamental analysis of the businesses that will see companies through transition (or not).

In measuring how companies are positioned to navigate energy transition, Wood Mackenzie considers the most – and only the most – crucial aspects of corporate sustainability. Company ratings are based on commercial, forward-looking metrics across three pillars:

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· Transition assesses carbon exposure and transition strategy

· Portfolio assesses the quality, longevity, and resilience of underlying businesses

· Platform assesses financial position

The central philosophy underpinning this approach is that there are many routes to corporate sustainability; that there is no ‘one size fits all’. It is a very different approach to ESG ratings and presents a very different picture. More relevant to how companies manage their business. And a more useful measure of how they stack up against one another.

That value-driven, ‘many routes’ approach explains why, in oil and gas for example, companies as diverse as Saudi Aramco and Equinor rank alongside one another near the top. Why ExxonMobil’sXOM -0.2% acquisition of Pioneer strengthened, rather than weakened, the company’s standing. And more to the point, why companies with high ESG ratings might rank low in this new index, and vice-versa.

Beyond ESG

For companies involved in natural resources, ESG’s apparent fall from grace may be seen as welcome news. But to act on the notion that investor sentiment on climate has shifted (true or not) would be folly. No-one in these industries should be confusing investor sentiment for science. All should be working to strengthen sustainability.

Most of the companies in the energy and natural resources sectors are. And the ‘many routes to sustainability’ philosophy is increasingly evident in their evolving strategies and portfolio choices. The course corrections that Shell and BP made in 2023, for example. ExxonMobil’s acquisition of CCUS giant Denbury. Rio Tinto, Teck, and Vale exiting thermal coal. Anglo American developing renewable capacity in South Africa. Ørsted’s change of pace in offshore wind. RWE and ENGIE’s strategic commitment to portfolio diversity.

Nevertheless, the confusion that has characterised this discussion since the Paris Agreement was signed is not going away. Companies still struggle to develop, articulate, and deliver strategy for energy transition. And shareholders still struggle to understand the challenge and to assess how companies are positioned to manage it. ESG has served only to muddy those waters.

Now more than ever, companies and their stakeholders need to answer that fundamental question – How are we positioned to navigate decarbonisation – both risks and opportunities – over the coming decades?