By Toby Belsom, Director, Investment Practices, PRI
For the UK investor, it is difficult to underestimate the importance of Shell’s dividend cut last week – its first since the Second World War, triggered by the ”pace and scale of the societal impact of COVID19 and the resulting deterioration in the macroeconomic and commodity price outlook”.
The announcement contrasts with the news last week that BP is retaining its dividend (for the moment, at least). While each company comes with different corporate situations and balance sheets, they are both key dividend payers for the UK investor – stalwarts of the UK market.
Being based in London, I have a UK focus, but I suspect this type of announcement – marking a significant shift in strategy surrounding capital allocation – is being repeated across the energy sector in other capital markets. Though triggered by a collapse in demand and subsequent oil price decline, the announcement has a couple of different implications and challenges for investors integrating ESG issues into their processes.
The capital allocation issue is also key for the automotive sector, which also has heavy capital requirements and is suffering from significant disruption – in the near term from COVID-19, and in the medium term due to the energy transition. Noticeably Ford and General Motors have also suspended dividends in recent weeks. Though they have different balance sheet liabilities, like the oil industry, it needs long-term vision, a consistent regulatory environment and cash to invest to plan for the new climate reality.
For an investor in the oil or automotive sector, is sacrificing dividend pay-outs and buy backs – providing management teams with greater flexibility to invest in new technology and “shift the business model” – a worthwhile sacrifice reflecting the new normal of low oil prices, weak economic growth and an accelerating energy transition? Or would investors prefer cash back through dividends to spend elsewhere or reinvest in the sector?
It is too early to predict whether investors really want the big oil and car behemoths to become “big green”, or just return cash to be spent on something else. However, it once again highlights the increasing overlap between ESG issues and what might be considered a “traditional” investor issue – capital allocation.
One of the participants in our recent COVID-19 working group expressed this clearly when he outlined that this “dynamic needs to change in a post COVID-19 world. As responsible investors, that will mean taking the lead in helping the broader investment community to understand what responsible capital allocation and returns look like in terms of long-term business resilience and sustainability.” The need to integrate ESG issues into all aspects of asset valuation and portfolio construction appear to be significantly strengthening.
The dynamic needs to change in a post COVID-19 world. As responsible investors, that will mean taking the lead in helping the broader investment community to understand what responsible capital allocation and returns look like in terms of long-term business resilience and sustainability
The consistent underperformance of the oil sector has also highlighted the importance of integrating ESG issues into asset allocation – not just consideration at an individual asset level. In the US, the value of energy companies on the S&P 500 has shrunk to less than 5 per cent of the total index, from 11 percent 10 years ago. The sector has been a weak contributor to portfolio returns for over a decade in most markets. With the hiatus in the energy markets, asset allocators might want to review climate-related risk through forward-looking scenarios such as the PRI’s Inevitable Policy Response. But they should also think about different perspectives in relation to market exposures.
For example, not only do these announcements highlight the FTSE100’s significant weighting in on commodity stocks (especially integrated oil). But they also show the reliance of certain fund types (in this case the UK equity income sector) on income generated by sectors that are being transformed and disrupted by the energy transition. This is not solely an issue for equity markets. A “new normal” might have significant implications for analysis of sovereign credit for oil exporting nations.
Significant exposure to sectors, assets and sovereign issuers whose future and direction is already being challenged by scenarios such as those outlined in the Inevitable Policy Response should be in the cross hairs for asset allocators.
Returning to the Shell dividend cut last week – it strikes me that this is an interesting microcosm of that debate. Shell’s announcement has been made against the backdrop of energy market uncertainty, but does this also reflect the management’s team realisation that they need to fundamentally change their model to reflect the energy transition, rather than stick to the same playbook of capital return to shareholders and new production CapEx? Perhaps more importantly, will investors reward management teams that take difficult decisions reflecting what is increasingly looking like a “new normal”?
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