May 31, 2022

Tesla’s ESG Reckoning: Why You Can’t Just Look Through the “E” Lens

A recent rebalancing of the S&P 500 ESG Index[1], excluded Tesla (TSLA) due to poor performance on the “S” (social) and “G” (governance) standards.  Specifically, S&P said, “While Tesla may be playing its part in taking fuel-powered cars off the road, it has fallen behind its peers when examined through a wider ESG lens.” In other words, the “S” and the “G” matter too.

We saw this play out at a recent energy and climate-focused conference where one speaker proclaimed, “it’s about the carbon, stupid,” paraphrasing a slogan from the 1992 Clinton presidential campaign.  But this was met with a bit of a stiff-arm from a senior state-level energy regulator who reminded everyone that cost, safety, and reliability, are just as important to many of the citizens of their state. This speaks to the “S” of ESG.

All this got us thinking about the companies we invest in and how, in some respects, regulated pipelines and power utilities are the original ESG investment.  These companies are the legal monopoly energy infrastructure providers regulated at the state and federal level.  As privately funded, publicly traded entities, these companies must satisfy regulators that the public benefits of their investments outweigh the public costs in order to receive their allowed rates of return on shareholder equity.  Since the regulators (executing laws passed by the legislature) assess environmental impact, safety, reliability, resilience and cost and the shareholders assess management’s ability to deliver the allowed rate of return, all three elements of ESG are required.

Our portfolio selection process puts a large weighting on the strength of the management team and a track record of safety, sound governance, constructive regulatory relationships and performance quality, all of which we’ve found tend to underpin the steady and growing earnings and dividends we seek as total return investors.  Put another way, EIP has been concerned about the sustainability of shareholder returns long before ESG investing was a thing[2].

On the “E” front, utilities have been reducing their environmental impact for decades.  The electric power sector single-handedly drove 76% of U.S. carbon emissions reductions since their 2007 peak[3].

On the “S” front, utilities deal daily with products that can harm or kill, making safety of paramount importance.  The industry’s safety record is not infallible, but, more importantly, from our perspective, there are large differences in safety between companies that can be directly attributed to who is running them.  Cost and reliability also differ significantly between companies.  Some of those differences are based on location; the cost-of living is simply higher in the Northeast than in the Midwest and some areas have more severe weather than others.  But there is a measurable impact from the management teams as well.  As we said in our testimony before the Senate Committee on Energy and Natural Resources on July 12, 2018, “Investors in regulated businesses do well when all the stakeholders involved with these assets do well.  We have found that means safe reliable energy at a low cost to the consumer with the least impact on the environment.  By contrast, companies that give short shrift to issues of worker and public safety, system reliability and environmental stewardship also tend to be poor allocators of capital, have higher operating costs and usually have poor relationships with regulators and other stakeholders.  They also tend to have lower shareholder returns.”

Nonetheless, the utility model is not perfect.  Its largest benefit is its elimination of duplication of infrastructure, so we don’t have three sets of poles and wires or natural gas pipelines running along every road in every neighborhood. This lack of competition is replaced with a cost-plus model that reduces risk to equity and debt holders thus lowering the cost of financing to the customer.  These two silver lining attributes, however, come with a cloud.  The cost-plus-return for investors creates a moral hazard of “the more you spend, the more you make,” which has led to poor capital allocation during some historic periods.  The solution, we think, is regulation that incentivizes goals and outcomes rather than rewarding costs incurred.  We publicly advocated for Performance Based Ratemaking (PBR) before the Senate Committee on Energy and Natural Resources, as well in written testimony we’ve filed with the Federal Energy Regulatory Commission.  Our PBR advocacy has often put us at odds with some in the industry, in particular the major trade and lobbying organizations.  To be clear, we’ve never suggested throwing out the existing regulatory construct; but we do support adapting that 20th century model to meet modern needs.

Interestingly, Last Week Tonight with John Oliver on May 16 took aim at the electric utility sector, challenging its protected monopoly status as the antithesis of customer choice that consumers enjoy with virtually every product they buy.  Oliver criticized the cost-plus return on investment model for rewarding monopoly companies with a guaranteed return on every capital dollar spent, called out regulatory capture, and selectively pointed to several poorly run utility companies and recent failed mega-projects to cement his narrative.

While we believe condemning an entire industry for the bad behavior of a few of its members is overreach, we agree with much of its core message.  In particular, near the end of the segment (and you have to watch closely), John Oliver called for greater accountability through the use of economic incentives, specifically calling for performance-based ratemaking, the very thing EIP has been advocating for some time.  Leave it to a comedy show to take an arcane utility issue mainstream.

And while energy and ESG are now the subjects of the editorial and Op-Ed pages nearly every day, the regulated utility model is a useful window through which to view the competing demands of a clean environment and an energy system that is low-cost, safe and reliable.  ESG is rapidly evolving and moreover means different things to different people and its role in investment strategy varies from asset manager to asset manager.  But recent events are a reminder that ESG is comprehensive in its scope and to some degree represents all stakeholders.  So don’t be surprised when the petroleum industry begins advocating to their stingy shareholders who demand capital discipline and environmentalists who demand less carbon emissions that we need more drilling because… wait for it… lowering energy prices is an important part of the “S” of ESG.

[1] The S&P 500 ESG Index (SPXESUP) is a broad-based, market-cap-weighted index that is designed to measure the performance of securities meeting sustainability criteria, while maintaining similar overall industry group weights as the S&P 500.
[2]  EIP notes that it invests in other energy infrastructure companies as well as utilities that may not be considered by others as ESG investing or investments. However, it does place the same weighting on governance and safety with those companies as it does with the utility investments that it makes.
[3] As of 1/1/21. EIA. Electric Power Sector is represented by the electric utilities members of PHLX Utility Sector Index (UTY): The PHLX Utility Sector Index (UTY) is a market capitalization-weighted index composed of geographically diverse public utility stocks.

The above is Energy Income Partner LLC’s (EIP) opinion and such opinions may change without notice or duty to update. The information is based on data obtained from third party publicly available sources that EIP believes to be reliable, but EIP has not independently verified and cannot warrant the accuracy of such information. References to a particular company or funds are for informational purposes only and are not an offer to purchase or sell or a solicitation to purchase or sell a particular security, company or fund.

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