BP's Loss is Sustainability's Gain?
Several lessons have come out of the Deepwater Horizon disaster, not least of which has been how unprepared most investors were for the implications of such an event. Despite several warning signs in BP’s recent environmental record, the scale of the crisis and consequent fall-out for the company has been shocking to most observers.
The BP debacle has also drawn attention to the extraordinary degree of influence that one company can extend over large swathes of the global economy. A blue chip stock, sitting solidly in the FTSE 100 index, BP PLC is held by large numbers of institutional investors around the world. Defined benefit pension schemes in the UK, for example, are thought to hold 1.5% of their assets directly in BP, with US institutions also heavily invested. A recent announcement by the Norwegian Government Pension Fund Global that it has lost €1.1 billion on its 1.75% stake in the company has highlighted the negative financial impact for these funds. According to the UK’s FairPensions, a non-profit that lobbies for responsible investment, the Deepwater disaster has been “a stark illustration of the potential consequences of a neglect of ESG risks”.
Pension funds which employ passive investment strategies cannot simply sell BP while it remains part of a core index. It is not easy, in any case, for large institutions to divest their entire holdings in a single stock without negatively influencing the market and pushing the price down still further. So does this mean that, like the banks before it, BP has become “too big to fail” ... and, even more than that, “too big to sell” ?
If that is the case, what can investors do to protect the value of their assets ? In the view of FairPensions, it is clear that investors should use their position as shareholders to engage with companies to ensure that risks are identified and properly managed, in order to prevent future disasters. Indeed, many analysts believe that this is a turning point for responsible investment. Events in the Gulf of Mexico will cause investors and managers to become more aware of how ESG related risks can be material to a company’s performance. This will drive them to push for changes in corporate disclosure that will help investors better understand these risks.
Where investors are clearly in for the long haul with a company, moreover, it is only logical to migrate from a short term investment horizon that maximises quarterly profit, towards a long term, “sustainable” approach. Shareholders have an opportunity to influence companies in ways that optimise their long term interests and maximise sustainable value. In the case of BP, however, the reputational damage done to the company by the events of this summer may well have repercussions that long outlast the cost implications of the clean up.
I have long argued that it is foolish to try to disentangle environmental risk from basic business risk, especially in the case of an energy or mining company. It would be a positive outcome if BP’s travails in fact encourage greater integration of environmental and other so-called “extra financial factors” into investment analysis alongside mainstream financial metrics.
It is becoming widely recognised that investors must seek to estimate the value of externalities and to quantify potential risks whose probability is low, but which may incur very high costs. For BP, the US$20 billion escrow fund that it and the Obama government have established to compensate for environmental and livelihood costs in the Gulf may be only a small part of the total losses it faces. Successful incorporation of ESG in an investment process could be a differentiator: SRI analysts have experience of identifying defensible benchmarks and creating metrics and models that assess ESG factors.
Corporate reporting on environmental, social and corporate governance risks still needs to improve. Before the BP spill, analysts simply did not have enough information about the risks involved in deep water oil rigs to come to a reasonable view about the likely nature and associated externalities of any future accident.
In an attempt to generate more detailed disclosure, Ceres (a network of investors, environmental groups and non-profits in the US) recently organised a letter writing campaign to major energy companies, asking for information about their risk oversight measures, including spill prevention and response plans, for their offshore oil operations around the world. According to Ceres, none of this information is available in companies’ public filings, but it is clearly of material interest to investors.
While it is probably unreasonable to expect any analyst to have predicted the Deepwater Horizon disaster, specifically, analysts who focus on ESG risks were arguably in a far better position to see the warning signs. For several years, BP had been censured for its environment, health and safety record. KLD Indexes removed BP from its Global Sustainability Index in 2007 and from its Global Climate 100 Index the following year. Significant safety failures at some refineries, as well as spillages and pollution issues, revealed major operating problems, summed up by RiskMetrics as “indications of underlying management deficiencies and an inadequate risk mitigation capacity that negatively impact production estimates and the company’s reputation.”
In assessing a company’s full risk profile, investors need to have a proper understanding of the potential likelihood of any incident, but also the potential risks associated with how the company will manage the consequences of a disaster. The ability to respond rapidly and effectively requires very robust management systems, clear transparency and full disclosure.
Research by a US investment bank some years ago demonstrated that the share prices of energy companies which suffered a natural disaster, but clearly disclosed the reasons for the disaster and the steps taken to manage and correct it, rapidly recovered from initial losses. By contrast, it was arguably the perception that BP management was trying to hide the full extent of its problems that really turned public opinion, and consequently the US government, against the company.
ESG managers will take the lead in pressing for full disclosure from companies in these circumstances, and in pushing them to take responsibility for their suppliers and contractors. The BP disaster has also demonstrated the importance of understanding how companies are able to manage the media in the wake of a disaster, and how they respond to local and national politics which influence events.