ESG Ratings Miss the Mark on Some Utility Stocks

How environmentally friendly is a company that enables entire states to utilize renewable energy and lower their carbon footprints for generations? According to some ESG1 ratings firms, not very friendly at all.

ESG ratings of an individual company can vary significantly from one ratings firm to another. This blog is not meant to disparage an entire ratings industry, which has been a helpful guide for many investors. But when it comes to grading utility companies, some ESG ratings firms miss the mark. The following example of a utility company we cover highlights the bigger picture some ratings miss.

At Reaves, we cover a company that is on the tail end of completing a strategic transformation, increasing investment in regulated transmission and distribution operations and pivoting away from power generation assets. Some of the ESG ratings assigned to the company overlook what this transition means for the business.

In the past three years, the company has reduced its ownership in power generation assets by 76% and has no intention of making further investments in coal generation. As of February, the company has also reduced carbon dioxide (CO2) emissions from a 2005 baseline by 80%. As the company has pivoted the business from generation to distribution, power generation assets now comprise less than $2 billion of the firm’s $42 billion in total assets.

Despite significant emissions reductions and commitments to further de-carbonize and minimize the environmental impact of its operations, ESG rating agencies observe that of the remaining $1.9 billion of power generation assets owned, $1.7 billion and 3.1GW are coal powered. The disproportionate percent of existing coal-fired generation seems to warrant a negative overall environmental rating from some ratings agencies.  

We believe the ratings agencies miss a more important point: Roughly 95% of its assets and earnings power comes from electricity distribution and transmission, and these services underpin the entire economy’s transition to a lower carbon footprint.

As a quick utilities primer, electricity distribution involves the movement of electricity from a utility to individual houses or businesses. Transmission is longer range. Think of it as a superhighway, moving energy across states and regions. Both distribution and transmission are essential to lowering the carbon footprint.

At the distribution level, the aforementioned utility is responsible for one state’s initiative to encourage heat pump installations – a device that lowers household energy use in the winter and summer. This same company will be the one connecting electric vehicle charging stations to the distribution grid so that electric vehicles can proliferate in the future.

The transmission efforts for said utility company are even more impactful for the environment. Electricity transmission is essential to allowing renewable energy generation to come onto the grid and displace fossil fuel-sourced power. The utility company in our example will connect offshore wind energy to the grid. Other utility companies are also transmitting wind and solar power across the energy superhighway.

Could Utility Companies be Due for a Re-Rate?

Given progressive social and governance policies, and an environmental impact that is quite positive – if misunderstood – we believe the weight of evidence of what utilities are doing to make the energy grid greener will catch on with ESG ratings firms and other investors.

Over time, we expect data used by ratings firms to become more standardized and for company ratings to also become increasingly more industry specific, rather than a one-size-fits-all approach. As a growing investor base relies on those ratings, we also expect individual companies to engage ratings firms more heavily in explaining their business.

As this happens, we believe it should lead to an ESG re-rating that is more reflective of many utility companies’ role in making the energy grid greener. Investors who were familiar with the underlying company in the first place should benefit when the environmental positives associated with these businesses gets reflected in the rating.

 

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Reaves Asset Management is an investment adviser registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940. Registration does not imply any skill or training. Reaves is a privately held, independently-owned “S” corporation organized under the laws of the State of Delaware.

The information provided in this blog does not constitute, and should not be construed as, investment advice or recommendations with respect to the securities and sectors listed. Investors should consider the investment objective, risks, charges and expenses of all investments carefully before investing. Any projections, outlooks or estimates contained herein are forward looking statements based upon specific assumptions and should not be construed as indicative of any actual events that have occurred or may occur.

1 Environmental, social and governance (ESG) criteria are a set of standards for a company’s operations that socially conscious investors use to screen potential investments. Environmental criteria consider how a company performs as a steward of nature. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, auditsinternal controls, and shareholder rights.

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