How to Play ESG?

by Overheard Wall Street

Outline:
  • Intro
  • ESG Investing - What is it?
  • ESG Universe
  • How to Play ESG?
    • Brookfield Renewable Partners (BEP)
    • Engine No. 1 – (VOTE)
  • The Ending Note

Intro

Unless you live under a rock, which you might be inclined to do given the current market environment, you have heard of ESG investing somewhere in your investing career. Before the pandemic, it felt like no one knew the difference between ESG and MSG (one has to do with food processing…) but since COVID hit, investors, companies, and governments are all making a more concerted effort to make sure that we are using our investment dollars to help move towards a more balanced future in which the Earth doesn’t collapse in a trashy ball of space dust. There's an ever-growing number of investment opportunities in this space and before we highlight a few great ideas, let’s take a minute to understand the space better.

Global Sustainable Fund Assets (US$Bn)

ESG Investing – What is it?

ESG stands for Environmental, Social, and Governance. It means that investors are looking beyond just EBITDA and cash on the balance sheet to understand how the business practices of certain companies will impact our collective futures. The dawn of ESG investing, some say, can be traced back to the Deepwater Horizon oil spill by BP in 2010. This event opened the world’s eyes to some of the extremely harmful business practices in place at the time. I think Dawn soap is still using oil-covered seals as a major part of its marketing campaign today, almost 12 years later!

Initially, ESG investing was about not giving your retirement dollars to these companies, like BP, that were pursuing questionable business practices for the sake of profit. Who doesn’t feel like a champion when you tell your friends at the gym that you chose NOT to invest in a company everyone knew was hurting baby seals?!

Because of the lack of institutional adoption, ESG investing never really took off until 2020 and 2021. Nowadays, when you look at ESG investing options there is no concern over giving up investment return for the sake of taking a stance – the world has evolved so much that now ESG investing has a multitude of facets that go beyond just excluding “bad” companies.

Now, ESG investing can range from purposefully driving dollars toward companies on the forefront of sustainable energy to funding companies committed to board diversity and minority-owned operations to proxy voting making “bad” companies move in the right direction. The options are almost endless in this space today and they continue to grow.

   

ESG Universe

The universe for ESG investment today spans multiple galaxies. No longer are investors restricted to exclusion-only investing to play in this space – now the choices continue growing and expanding and changing. Within the ESG space, there are areas of focus that come to mind – the most obvious being a singular focus on one area of Environmental, Social, or Governance (or, all three!). But to go even a step deeper – within each of these silos of investment, investors can decide if they want to exclude bad players or invest in top-ranked ESG players. They can decide to be actively engaged with the company through proxy voting or take a back seat to voting. They can invest in companies that are driving change in the market, or secondary players who want to follow suit but not lead the charge.

The list of options and opportunities in the ESG universe makes this short write-up look like a post-it note. But since we only chose to write up two options specifically, it is helpful to highlight a few other names and their unique impact:
  • Tesla Motors (TSLA): namely an electric vehicle manufacturer, TSLA has raised so much awareness for the need to transition away from combustion engine vehicles that even the dinosaurs of the auto industry have taken notice and made changes to speed up their EV production and services.
  • Pax Ellevate Global Women’s Leadership Fund (PXWIX): a fund focused on investing in women, driving change in both the boardroom and on management teams to show more gender diversity, and elevate incredibly smart and talented women into positions they deserve.
  • Calvert Global Water Fund (CFWIX): investing in companies that are driving positive change to help ensure that everyone everywhere has access to clean water.
  • Coinbase (COIN): a cryptocurrency exchange driven by the decentralized nature of blockchain technology to bring access to everyone, everywhere. Imagine a world where anyone can send funds to their family in a different country without risk of government intervention or worrying about foreign exchange rates – this is the world Coinbase is building.
  • iShares ESG Aware USA ETF (ESGU): a traditional ETF that excludes companies that rank lowest on ESG rankings and invests in those that score highest.

   

How to Play ESG?

The investment options we have chosen touch only a small potential of the entire field available for investment. We wanted to focus on stocks and ETFs that provide an easy first step into ESG investing. These are not investments that are going to look wildly different from other companies/ETFs in the hopes that everyone can see how approachable this space can be and how the opportunity to invest with an ESG mindset does not mean we need to give up returns.

Brookfield Renewable Partners develops and operates a portfolio of renewable energy producers that kicks off a traditional utility-grade dividend yield and still provides ample room for future growth through their investment activities. Engine No. 1 ETF is comparable to an index fund tracking the S&P 500 with one key differentiator: a dedicated team focused on company engagement through proxy voting without excluding even the worst offenders in the hopes of facilitating change without the added cost of active management.

1. Brookfield Renewable Partners (BEP)

Brookfield Renewable Partners spun off from Brookfield Asset Management, one of the world’s largest alternative asset investment managers, and operates the world’s largest publicly traded, pure-play renewable power platform. The portfolio of assets consists of hydroelectric, wind, solar, and storage facilities spanning the globe. If you ever wanted to own a utility company focused entirely on renewable energy – this is your pick (and currently, your only option).

Bull Case
  • Diversified Approach to Renewable Energy: BEP access to actual renewable energy utility-grade operations spanning multiple lines of renewable power that continues to expand while maintaining a healthy balance sheet.
  • Utilities Grade Dividend Payout: BEP currently pays a 3.7% dividend yield and has only made plans to increase this over time. Similar to utilities operating in conventional energy sectors, Brookfield is making a strong case for continued cash flow growth by paying out ~70% of earnings.
  • Locked in Revenue: Within the renewable energy space, utilities and producers engage in Power Purchase Agreements (PPA) to facilitate the buying/selling of energy. BEP has locked in PPA’s for an average of 15 years – which provides stability to their earnings potential through longer-term contracts.
  • Stable Energy sources: hydroelectric power is the only renewable energy source that is capable of providing baseload power (the minimum amount of power needed to supply the electrical grid at all times) and it accounts for more than 50% of Brookfield’s portfolio.

    

Catalysts
  • Brookfield is turning their focus toward Solar investment opportunities to diversify its portfolio and provide better opportunities for increasing cash flow as solar farms are cash-generating machines. While Solar accounts for roughly 15% of BEP’s cash flow, it has the potential to outpace hydro one day.
  • Renewable energy has lost favor recently but as energy has vastly outperformed all other sectors in 2022, it is ripe for cheap investment at today’s prices.

Risks
  • Locking in PPA rates may be subject to inflationary concerns as these contracts may lock in prices for the contract duration, or include only minimal price increases. Longer-term risks arise once contract terms have ended and Brookfield looks to merchant pricing (often significantly lower than PPA terms) for offloading their energy production.
  • As renewables become more mainstream, the assets that Brookfield is purchasing may become more expensive and less profitable, which could impact their growth potential.
  • Right now, renewable energy does not provide enough consistent baseload power to fully replace conventional energy sources.
  • Storage of renewable energy is closely linked to the further development of Solar projects, accounting for 34% of pending solar investments. If Solar cannot deliver up to expectations, it may drag storage capability down with it, which would further delay the adoption of renewable energy.

Key Metrics/Valuations (as of 5/20/22)
  • Current Share Price: $35.46
  • Wall St Price Target: $41.30
  • Market Cap: $22.9 billion
  • 2021 Revenue: $4.1 billion
  • 2021 EBITDA: $2.4 billion
  • 5yr Average Free Cash Flow per Share: $1.61
  • 5yr Average Price/FCF: 6.0x

Brookfield has plans to expand its wind and solar capacity by another 8.8 gW and 34.8 gW, respectively. And that’s just what they have planned for today. Their current goal is to invest $1 to $1.2 billion per year for the next 5 years to expand their portfolio.

Conclusion

Brookfield Renewable Energy Partners gives investors broad access to the renewable energy sector, a new space that has not yet fully proved itself, but with the consistency and cash flow of an old-school utility company.

      

2. Engine No. 1 – (VOTE)

Overview

For those who maybe don’t believe in the full power of ESG investing yet, Engine No. 1 provides an easy way for passive investors to "dip a toe in the ESG waters." Engine No. 1 spun off its highly successful hedge fund operation as an S&P 500 index ETF that has one additional factor: actively voting company proxies to facilitate positive change on all fronts. Engine No. 1 plans to engage with all constituents of the S&P 500 index through regular proxy voting, focusing on 20-50 high-level causes and 1-2 major shifts that require serious involvement each year.

Bull Case
  • Instigating change without paying for active engagement: The team at Engine No. 1 has experience getting board seats at large corporations through partnerships with majority shareholders. You may have heard of them in relation to Exxon, where they were able to partner with a large institutional investor, California Public Employees’ Retirement System (CalPERS), to replace 3 board members who were dedicated to a more sustainable and socially conscious future for Exxon.
  • Passive investment approach: VOTE tracks the S&P 500 as closely as any other index fund with a management fee that competes with Vanguard and Blackrock (. There is no excluding companies or changes from the S&P index weights. All of their work is through proxy engagement and management conversations, not through investment selection.

Catalysts
  • The success this team had in 2021 in bringing about change on Exxon’s board brought them firmly into the limelight within the ESG space. As more investors learn about ESG investing and pursuing their values through investment – VOTE is well-positioned to help investors ease into the space without significant tracking error or high management costs.
  • Rising tide lifts all ships: As active owners in a passive structure, Engine No. 1 believes that they can drive performance through their engagement with companies. Through this engagement, they believe that the companies will be able to improve financial results overall which will help improve stock prices and drive investor return over the long run.

Risks
  • Some are concerned over the fact that the partner at the forefront of Engine No. 1’s engagement with Exxon, Charlie Penner, left the firm at the end of 2021. But the team focuses on the fact that the energy and knowledge Charlie brought to the table were focused entirely on Exxon. The lessons the entire team learned through that process were taken to heart to facilitate further engagement going forward.
  • The firm, and team, are very new to the investing world since the fund’s inception in December 2020 as a hedge fund and starting an ETF in June of 2021. There is always risk associated with new funds starting, especially in turbulent times like 2020 and 2021.

Key Metrics (as of 5/20/22)
  • Management Fees: 0.05%
  • Net Assets: $306 million
  • YTD Return: -19.11%
  • SPX Return: -18.14%

Conclusion

For those looking for an active approach to ESG investing at passive index-tracking prices, VOTE is a great option. You won’t even realize you are investing to facilitate the change you want to see in the world with how easy this approach is. But if you want to stay informed, VOTE provides excellent articles showcasing their proxy voting strategy and highlighting some of the big names where they are driving positive change. With the rise of passive investing and efficient market hypothesis, why not pay an additional 2 bps in management fee to have your index fund also working towards improving the earth?

The Ending Note

The world has just started to get on the ESG train, and the potential ahead is vaster than many realize. Everyone says that Crypto investing is in the “early innings.” If you believe that, then you should absolutely believe that ESG investing is in a similar position. The amount of change to this space seen over the last 3 years alone proves that investors are hungry to see their investing dollars drive positive change in the world. And that change is not limited to Environmental impact alone – there are endless possibilities to invest in companies, and funds, that want to see positive social change or better company governance to protect all stakeholders, not just shareholders.

     

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