ESG is an acronym that stands for Environmental, Social & Governance.
It describes companies and investment styles that comply with the widely applied goals and stipulations of the three general areas of management.
Environmental means greater use or production of renewable or cleaner energy along with less impact in waste and materials use.
This isn’t a drag on companies like energy and utility companies because they drive more growth and income from renewable and cleaner energy production.
Social concerns incorporate practices involving more stakeholders in corporate decisions. It means that companies are more aware of their impacts on communities as well as consumers.
It can be a grab bag for lots of other causes, but at its core, social responsibility should result in more favorable views of companies and treatments by governments and customers.
Governance includes better recognition of shareholders’ rights.
This means independent boards of directors, more transparency in executive compensation and greater disclosure of company activities and financial conditions.
I’ve always supported these principles including separate CEO and Chairman of the Board positions as well as greater disclosure throughout the year, with less reliance on the very small print in the footnotes.
Not a Loser
You might think that by imposing additional ESG rules and standards, these companies would be laggards in the stock market.
Nope. If you look at the S&P ESG Index compared to the S&P 500 Index over the trailing three years, you’ll see that ESG outperformed the general market.
S&P ESG & S&P 500 Indexes Total Returns — Source: Bloomberg Finance, L.P.
But like so many things these days, ESG investing has become polarized. This has led to the US Department of Labor proposing a rule change under the Employee Retirement Income Security Act of 1974 (ERISA), which governs pension and retirement accounts run for the benefit of US company and organization employees and retirees.
The proposal would restrict companies and fund managers from investing with any restrictions on investment that might deviate from prudent performance.
But this is really unnecessary. ESG investing is quite lucrative. Now, ESG can be a bit squishy in interpretation, but there’s plenty to like as an investor right now.
In addition, there is a surge underway by beneficiaries of pensions and endowments to force fund managers to follow ESG. This is bringing more and more capital into ESG stocks and related funds, adding to potential returns.
One of the areas of ESG that is particularly attractive to me is environmentally friendly businesses, particularly in the utility and energy markets. And this is about to get a whole lot more profitable under new Internal Revenue Service (IRS) rules that are going to apply to a line item of the Bipartisan Budget Act of 2018 (BBA).
Specifically, it involves section 45Q, which was first put forward back in 2008 but never really got clarification. It involves Carbon Dioxide (CO2) capture, storage and use.
Under the new IRS rules, companies can earn a tax credit that’s transferable and saleable for $35 per ton of CO2 captured; $35 per ton that’s used for feedstock for chemicals, fertilizer or enhanced oil recovery (EOR) fracking; and $50 per ton for non-EOR storage.
One of the major sources of CO2 industrial production is coal-fired power plants. This means utilities will become beneficiaries under section 45Q. And in turn, as part of the CO2 capture, they would enhance their ESG scoring, attracting more capital at the same time.
Xcel Energy (NASDAQ:XEL) and NextEra Energy (NYSE:NEE) still operate coal plants and would be in line to collect or sell the credits. These companies are already significant forces in the renewable energy markets.
Both of these utilities have vastly outperformed the general utilities market over the past five years. XEL yields over 2.5% and has returned over 120%, while NEE yields over 2% with over a 175% return. The S&P Utilities Index returned just over 59% over the same period.
Xcel Energy & NextEra Energy Total Return vs. S&P Utilities Index — Source: Bloomberg Finance, L.P.
Beyond utilities, the oil and gas fracking market is also a winner. Using captured CO2 and deploying in EOR not only bolsters field yield but it also comes with the credit.
This may be a boon to the tenants of the landlord of the Permian Basin, Viper Energy (NASDAQ:VNOM). It yields over 3.5% and will gain further credibility from its tenant/operators as well as more royalty income with the enhanced yields.