Total time: 36:17

Bob: Hello everyone, this is Bob Smith, President and Chief Investment Officer of Sage Advisory. Today I am fortunate to be able to visit with Dan Romito of Pickering Energy Partners to discuss the realities and challenges of energy transition in today's world as seen from the perspective of an ESG sensitive and knowledgeable member of the U.S. energy sector. Dan is a consulting partner at Pickering where he focuses on quantitative ESG strategy and implementation. Over the course of his career, Dan has advised several hundred private companies, public issuers, and asset managers on how to optimize capital deployment strategies and employ ESG related directives. His experience and research on ESG and shareholder activism have been featured in a variety of global periodicals including Harvard Business Review, the Harvard Law School Forum on Corporate Governance, CNBC, Bloomberg, Global Investor Magazine, and IR Magazine, just to name a few. He is currently a board member on the energy ESG Council, and is a professor at Marquette University, where he teaches ESG implementation, strategy, and certification. Clearly, Dan's experience and research make him eminently qualified to tackle our discussion topic for today, which is U.S. energy transition, identifying the realities, priorities, and attainable goals. Welcome, Dan.

01:41

Dan: I appreciate you having me. Thanks, Bob.

01:43

Bob: I'd like to begin our discussion by learning a little bit about Pickering Energy Partners and why you're concerned about this ESG related challenges of energy transition.

01:54

Dan: Sure. So, to give a brief introduction to the firm, Pickering Energy Partners rolled out about two years ago, it was obviously started by Dan Pickering, who came from Tudor Pickering Holt. And his long-term vision of the firm was to create an energy focused financial services firm. But the new caveat to that was he wanted to focus on the entire spectrum of energy, knowing full well that energy does include energy transition. So, while we do focus on conventional energy, we also have an energy transition focus. And at a core, we are investors and advisors, we just have a variety of conventional clients coming back to us and saying, what do I make of this ESG thing? And then we have a variety of customers, who are predominantly more technologists saying, how do I get into the energy space? So almost the meeting of the minds in that respect, which is actually a great way segue to your question on challenges. So first off, the quality of data that exists within the ecosystem isn't necessarily living up to a standard that we'd like. There's a variety of bias. There's a variety of opaque methodologies, there's a variety of subjectivity within the “data.” And in many ways that skewed the narrative. And part of that skew is, unfortunately, in many respects, energy transition has become more of a political conversation. You know, you would think it would be dominated by conversations on innovation, technology, evolution of current practices. And obviously, there's some of that, but it's very much been infiltrated in some ways by a political agenda. And obviously, what that implies is when it becomes political, it's polarizing, and I think that muddies the waters in terms of investment.

03:40

Bob: So Dan, let's talk about the energy setting we find ourselves in today and the and the realities that we must confront as a country, as consumers, stakeholders, you know, within this kind of sweeping effort for energy transition. So, give me your sense of kind of where we are today.

04:01

Dan: Yeah, it's obviously a complex question and could take to our podcasts and in terms of country, consumer and stakeholder, let's narrow it down to the top three per category. So from a country standpoint, the energy transition brings up incredibly critical and important considerations on national security. In terms of global supply regarding the minerals and the materials needed to execute transition related technology that presents issues from a national security standpoint, we can talk about that more. But in many cases on the global scene, you're essentially seeing an arms race, evolve in terms for how do we get the materials and the raw materials, frankly, that's needed for the energy transition. There's also inflationary pressures, clearly, we're living through that right now as a result of some decisions that have been made. But empirically speaking, there's a distinct mathematical correlation between energy affordability, and then inflationary pressures. There's a distinct correlation between the amount of renewables that are utilized for energy consumption and the cost the cost of living in that respect. So, from a country standpoint, there's a lot more complex geopolitical and socioeconomic considerations that we have to be mindful of not just looking at energy transition within a vacuum. From a consumer standpoint, it sort of relates to the, to the country perspective. But if you look at energy affordability, that is a socioeconomic consideration, you have portions, large portions of the U.S. where median income isn't necessarily incredibly high, right? The median income in the U.S. I believe, is right around $80,000. A Tesla is anywhere between $70 and $95,000, just in that example, alone, it's not like everyone can go and buy a Tesla. And frankly, there's not enough raw materials available for that to even happen. But from a consumer standpoint, we have to be very mindful of the impending optionality. Right? I mean, so if you're looking at what a consumer has in terms of the option, you know, they turn on the switch, and the lights come on, they don't necessarily care, like what goes into that. They just want it to work. And there's infrastructure considerations. There's the grid considerations, there's implementation of adaptation, things like, those things don't happen overnight. So, we have to be very mindful of how you adopt consumer behavior in that respect. And then just access to everyday needs. And you're seeing this play out now.

6:35

Dan: If, for example, renewables penetrate the market, and that has inflationary pressures on everyday living, you know, how is that going to impact just how we live our everyday lives for the “common person”? And I'm sure we'll talk about that a little bit more. And then, from a stakeholder perspective, I think, why ESG and the energy transition, in some respects has been considered controversial is I mean, it is littered with hypocrisy. And I'll be the first one to acknowledge that, You have an obsession with the focus on climate and in some respects, that's totally warranted. But then you have other companies who are going out of their way to promote climate yet, where they're operating in certain countries, the human rights policy isn't necessarily up to par. And that leads to other questions, too, is, you know, at some point, we have to take a strong look at, there's going to be other portions of the world that need fossil fuels. Like that's just the reality. Where they get that from, or where they get that source from has real life implications. If they get that from a country that doesn't necessarily share our values in terms of human rights and water stewardship, and just biodiversity – well, you're just making the problem worse, you might be fixing it in a small portion of the world, but you're enhancing it in a larger portion of the world. And then in terms of investor priority, you know, I always joke with clients, that there is no magical pool of capital at the ESG rainbow. You know, you go through these motions, and you go through these exercises, and it's not like you're afforded a pool of capital at the end of the day, financial return and ROI still matter.

08:11

Bob: Yes, I think we are a little bit complacent here in the United States about, you know, the idea of energy transition, because I don't really think the average consumer is that well informed about what that entails. But you know, the fact is that all of these things kind of blend into the issue of energy transition in some form or another. And that takes me to my next question, because we so often hear about the concept of net zero in relation to energy policy, corporate behavior, public benefits, and Lord knows several other things. And I'm wondering if you could reflect on the concept briefly, as to how we, as investors and stakeholders should think about it. Is it a realistic goal? And if so, in what context? If not, what then?

09:05

Dan: Yeah, I tend to look at it. I mean, it's interesting, the way that you position the question, because it's commonly placed as is it realistic? And you know, that would imply a binary yes or no. And I think it's more a function of probability. Is it possible? Yes. Is it highly unlikely, probably so. Like, I think the probability of attaining anything net zero by 2030, or 2050, the odds aren't necessarily on our sides, and in most cases, 2030, or 2050, seems somewhat arbitrary. So when I say the probability is low, it's for very empirical reasons. Number one, the CEO tenure as cynical as it sounds in the United States is not very long, right that the average tenure of the publicly traded CEO in America is just under five years. So in many ways, it's very convenient. It's very easy for a CEO today be like yeah, we're gonna be net zero by 2050. Right. Exactly. And, and it's also ironic because you want the capital markets to have a long term focus in mind. The other component too, and it goes back to my comments on the political motivations. You know, I have a really hard time when the political agenda is implemented in financial slash strategic execution because as I alluded to before, political agenda implies right or wrong. Financial and strategic imply what is the pragmatic balance on both sides to find a solution that has far more benefits than cost, whether it's financial, externalities, etc. But when you have that political component implemented, you're going to satisfy, in most cases, the most vocal of the vocal, and then you start to see the implementation of what I lovingly referred to as fluff, quote unquote, fluff. And I saw this today, like, for example, I went on Google to say, where is the Van Zandt hotel and at the bottom, Google says “carbon neutral since 2007”. Carbon Neutral really is a term that's been invented in like the last three years, maybe that's been gracious, it wasn't around in 2007. You see, a lot of companies claim that they're carbon neutral, and all they did is plant trees. So you sort of have more of the marketing and the PR implementation, which is fine. And there's a place for that. But if you're talking about how do we evaluate investment opportunity with an energy transition and conventional energy, because we'll talk about this, obviously, but those two aren't necessarily mutually exclusive. The fluff really muddies the water and makes things a lot harder to understand. Offsets, the sky's the limit. And what I think you'll begin to see in many ways, is larger companies probably are going to put net zero targets in there, they're going to misallocate capital by trying to get to net zero purely from an efficiency standpoint, find out the hard way it can't be done. They're going to rely on offsets. And so that offset perspective or that offset option, I should say, almost becomes a liability. We put this promise in place by 2030. We're not even close to getting it. We will be crucified from a reputational standpoint, so we have to get it somehow, let's allocate capital to offsets to claim that we are net zero. Well, there's an opportunity cost to that allocation, could you have invented with the money or the capital that you utilize to buy offsets, could that be to R&D, to a better product, to other efficiencies, to a VC arm, like there's just a higher opportunity cost in that respect. And so if you're looking at it purely from a financial standpoint, that would imply like tough decisions and the minimization of opportunity costs and capital and excuse me optimizing certain investment decisions that by no means, implies that you should do anything at the detriment of another group. But it does imply that maybe some reputational equity, in some cases will be prioritized over sound financial decision making.

13:08

Bob: Well, I think it would be helpful to the audience to know because this is something that I don't think people wrap their brains around very much in terms of when we talk about carbon, carbo-, you know, removal and carbon reduction, we have to understand on a global basis that we are dumping 50 Giga tons of carbon a year is flowing into our atmosphere. And a lot of people are focusing their net zero efforts on essentially reducing flow, which is fine. But the real challenge is what exists, the stock of carbon in our atmosphere at this point is closer to 1.6 trillion tons. And so, for us to get to the temperature kind of goals that we've set for 2050, not only do we have to get the zero on the flow, but what do we do about the recapturing, and essentially the reduction of existing stock in the atmosphere? And isn't that more of an innovative technology capture rather than something to do with the production of hydrocarbons and fossil fuel?

14:17

Dan: I guess this is one of my frustrations like it's a perfect point you have, you know, that's why I say the energy transition cannot happen without the participation of the traditional energy group energy transition and energy, i.e. fossil fuels, hydrocarbon is not mutually exclusive. If you're looking for a group of people who know how to do that, or the most likely people who are capable of such an undertaking, look no further to energy. To be fair, you know, energy, the conventional players, by no means are angels. Like if you look at the shale boom, that was the most irresponsible destruction of value, probably not ever, but it's one of them. And so now you have executives, very mindful of the sins of the past. During the shale boom, we destroyed a lot of value we misallocated a lot of capital. Now we are interested to approach and address the energy transition. The last thing that we can do is waste capital or not earn an attractive ROI, because then we don't have any investor capital at all right like that is but you don't really necessarily hear that you hear most of the narrative is concerned with these evil polluters, these evil fossil fuel companies, let's get rid of them. Well, the detriment to that is those respective companies are throwing in a variety of resources, very substantial resources, people, time, money, sanity, into figuring out how to approach sequestration. The irony is that you have outside external groups dead set on restricting capital from them. And when you restrict those avenues of capital, it just makes it harder for them to accomplish the goals that the vilifiers want to accomplish in the first place like that irony in there is something that needs to be addressed far more than that.

16:03

Bob: Ok so let me shift gears a little bit. Because there are a couple of different subjects I want to get to. As sustainably focused investors, we’re tasked with the need to evaluate an ever widening range of ESG risk related data, third party analytical opinions for virtually every industry or company on the planet. And we do that because it's our fiduciary responsibility as investors, we want to know every risk that might possibly impact the capital value of our investments on behalf of our clients. But we do notice that there's a lot of biases in the datasets. And there seems to be a very large dispersion of opinion within given industries or for particular companies. And it's hard for investors to assess what is the more nice to know data, as opposed to the need to know data? So how do you relate to this in the energy sector in terms of what we should know, versus what people you know, like to know? And then what do you think about all these different opinions that people are issuing on ESG? As it relates to your industry, and perhaps particular companies within that industry?

17:21

Dan: Yeah, I mean, so there's an interesting statistic, and I'm going to paraphrase it. But a couple years ago, the SEC themselves estimated that roughly 80 to 85% of data that's utilized in today's capital markets was created in the last five years. We are living in a world where digitalization and access to data and data lakes and data analysis and insert data cliche here, like that's just the world that we live in. And that's great. But that also implies a competitive or commercial opportunity. So there is incentive, especially in the ESG space, where the world of data is unstandardized, to showcase subjective opinion, and research, and almost masquerade it as, “data,” right? The lines that should separate data from research are increasingly becoming blurred, when they should be in this respect on polar opposites. You have a variety of rating agencies, God bless them, I understand the pursuit of revenue, we're all guilty of it, and it's an absolute necessity. But they in my opinion, are more concerned with establishing market share and competitive differentiation as opposed to empirical integrity. The result of that is across the board, and this is empirically proven, you know, the CFA UK society has actually done a fantastic job of showcasing the uncorrelated nature of ESG data. So in other words, you can be amazing with Rater A, and complete garbage with Rater B. And I think in energy, or frankly, any capital intensive business, but predominantly in hydrocarbons and fossil fuels, there's a lot of information out there that is masqueraded as data, when it's really subjective research, that is skewing the narrative. There's a lot of rating agencies out there that will rate sectors first, and then the companies within them, implying that energy is always going to be fighting with one arm behind their back. A lot of the data providers are influencing portfolio construction, predominantly on the ETF on the index side. So if I want a proxy for which companies constitute an ESG focus company, or carbon transition, or some sort of climate tech, clean tech, whatever tech, insert tech here, that prospective investor may not be getting the whole picture, because of the skewness and the bias of the data that exists. And that goes just to show I think corporates are learning this the hard way, that the onus really does fall on their shoulders to convey what economic reality is. It's costly and it's timely and it's resource intensive, but it's absolutely necessary, because number one, there's empirically proven to be bias in the data. Number two, is energy's a very complex business and a generalist investor is going to have a hard time understanding the competitive dynamics of energy as opposed to, you know, information technology or consumer discretionary. And then also, number three is if you're looking at where the world is going, and this is a sore spot for both of us, you know, in terms of institutional capital, almost 50% of institutional capitals index or ETF. Index and ETFs, the passive ETFs, for that matter, don't necessarily discriminate based on the financial characteristics or the attributes of management, they look at sectors. They're looking at sector, they're looking at market cap, they're looking at region, and they're like, oh, you meet those three criteria you're in, there is no evaluation of the long term strategic directive of management.

20:58

Bob: Your comments actually lead to my next question, which is on the SEC. And as we all know, they just released their initial information requests that they will be seeking from public companies as it relates to all of their climate risk management efforts in their public disclosures. Will that help the ESG analytical process? Or does that hurt or complicate the process from where you sit today?

21:30

Dan: The proposal is over 500 pages. I'm about 200 pages in reading it. But I've obviously reviewed several summary sheets. And then, you know, with the sort of attorney network that we've had, we've had several conversations. So full disclosure, I've read almost half of it. But I feel I'm pretty well suited to provide an opinion based on the summaries and the conversations that I've seen. I questioned the intent of the SEC, I questioned their intent. You know, the SEC is formulated, in part not in part, predominantly to promote clear and efficient markets. Does climate disclosure aid in creating a greater transparency to the investment decision making process? Well, we already have SK, right. So a management team is obligated within their registered documents to disclose what risks there are to the business. You will already have MD&A which management is going to have, you know, management discussion analysis, they're going to discuss certain attributes of the business risks of the business strategic directives of the business. You already have a variety of companies agreeing to up their game with sustainability reports. And when I say up their game, making them much more quantitative than just fluffy qualitative documents. I think the SEC has been incredibly motivated to do this, because of fossil fuel detractors. I think if you look at a group like Ceres, who puts out good empirical work and has a respectable position on fossil fuels, but you know, Gary Gensler is coming out to talk about the SEC climate disclosures, as a webinar that's sponsored by Ceres. So, you know, once again, going back to the cynic in me is what's the intention of the SEC, are you? Are you bowing to a detractor? Or is there a genuine feeling that you should implement greater transparency on that front? I think it muddies the water and the primary reason I think it muddies the waters, it's concerned scope three emissions. If they came out and said scope one, scope two, I wouldn't be thrilled but I could live with it. I think it would be reasonable. Scope three, to figure out an infrastructure, or a methodology for tracking the actions and the habits and the behaviors of your client base and your customers and your supply chain is daunting. I don't know what that proves. So back to my comment earlier on like risk versus return or cost versus benefit. Does having access to scope three emissions provide an investor with the means to make a more informed or better informed investment decision? I don't think it does. I think that respective investor can have a thorough and comprehensive conversation with management to understand what they're going to do to mitigate that. But the data point in of itself of scope three is not going to provide me additional context to make a better-informed decision. Engaging with management, understanding their strategic directive, understanding how management is going to compete in a decarbonizing world, right. I think the investment community has accepted that dynamic that conventional energy must figure out how to compete and sustain performance within a world obsessed with decarbonization. That is a tenant. I don't know If having a scope three number gives them a better idea of what that strategy actually entails.

25:08

Bob: I think for a lot of reporting companies, the scope three requirement may indeed be a bridge too far. I don't think we've seen the end of the debate. Indeed, it may even find its way into the courtrooms. And so for me, it's an open item. I think, though, in certain ways what the SEC did was to at least help narrow the analytical bandwidth in terms of what they're looking for, what they deem as important, and indeed what investors should consider to be important. And in this way, perhaps they provided for many a shortcut to the need-to-know stuff upon which to make an informed decision. I'm just wondering what your take might be on that.

25:55

Dan: Yeah, it's, I mean, look, if there wasn't action being taken from the investment community, I could probably be convinced that scope three should be incorporated. But if you look at the activist engagements on behalf of Elliott, Third Point, you know, Engine No. 1, all the all these investors, you know, their primary motivation was not to increase or enhance, you know, environmentally focused matters with those companies. It was you're an energy company, a conventional energy company, that now has to figure out how to compete in a decarbonizing world, we are not convinced that you have a strategy in place to be successful with that. And so with the number of activist engagements, and with the number, or the trend we see in proxy voting as it relates to environmental concerns, once again, it goes back to I don't know if scope three is necessarily required, I think the investment community, you know, let the markets be the markets like they will figure that out. I also feel in many ways, you know, it's to your point earlier, like index and ETF, passive ETF, is almost a self-fulfilling prophecy. You have inflows, you have to proportionally allocate the inflows according to sector designation, market cap designation. So, you know, if the market is 40 to 50% passive, is that necessarily a good thing for the energy transition or for energy companies to expedite their strategic focus energy?

27:31

Bob: Sure. Well, you know, it's interesting, you bring that up, because Sage every year, we do a stewardship survey of all the ETF providers. And in our questionnaire, we ask them about how they vote if, in fact, they do vote their proxies, or do they engage? And on what issues are they voting with shareholders as opposed to management and those questions will be asked again this year. And you know, in the shadow of the SEC release in the shadow of the debate that's going to ensue, those particular companies have immense power to shift the needle, and where we're headed with regard to these disclosures. So it's going to be very interesting to see what the responses are this year that we received in this area in particular.

28:21

Dan: Yeah, I mean, it's going to be a fascinating exercise in just traditional economics, like incentive structure, right? Does scope three disclosure or any disclosure in the environmental incentivize a company to either expedite their strategic pivot, or to induce a strategic pivot. But going back to regulatory burden, that is a negative incentive, if anything, because there is a political element within the energy transition argument. It could have the tendency, and we see this and it's unfortunate, but it's just the natural occurrence is some companies will dig in their heels and be like, no, we're going to be unapologetic. And we're going to pursue as business as usual. Whereas if there are positive incentives in place, it wouldn't convince everybody. But it at least be my opinion, you'd have greater success and getting everyone on the same page, implementing strategy, having something actionable. And, you know, you begin to see positive incentives. And this is another thing that's not really brought up, you know, some of the largest E&Ps and fossil fuel focus companies have VC arms that are only focused on energy transition. You have Shelby VC, Chevron, VC, Hughes VC, all these corporate venture capitalist firms don't want anything to do with hydrocarbons or fossil fuels. They want to do everything with carbon. And like one of my colleagues and me we have this running joke, where a year ago we couldn't get anyone to talk about carbon, right? No one wanted to talk about carbon like you want talk about carbon? No. You want to talk about carbon? No. Please, can we talk about carbon? No. This year we can't get anybody to shut up about carbon. And some of the most thoughtful ideas are coming from these engineers that were like 20/25 years in the field, you know, on oil rigs or wells or whatever. And now they're exclusively focused. And so that goes back to the example of don't restrict capital, because that that funnels down if Exxon and Chevron and Baker Hughes are successful, they have more capital, theoretically, but going back to investor pressure to funnel into their venture capitalist firms and just think you don't need regulation, you don't need scope three to accomplish that.

30:39

Bob: Yeah. Well, that takes me to my last question, because I really enjoyed the conversation. But I think we'll end on this question. Energy exploration, production distribution, if it is anything based on your comments today, it is a capital intensive business, we know that. But we also know that history teaches us that unencumbered and kind of affordable access to the capital markets is essential. It's an essential element for innovation, for growth, for economic prosperity. And what we've seen here in recent times, both internationally but also domestically, that there's a lot of efforts to impede the energy sectors’ access to capital markets, and to keep it affordable. And you know, I'm looking at this, I'm saying, is this helpful or harmful? And, you know, there's a good debate going on about that. But is this really helping us to get to the COP26 kind of 2050 goals? Or is this actually shooting ourselves in the foot?

31:40

Dan: I think it's a combination of both like, like most things. I don't want to be a hypocrite within this conversation and operate on both ends of the spectrum. I have this bipolarity thing going on. Um, general thoughts? I tend to think let the markets operate unencumbered from regulatory burden, I think regulatory burden gets in the way, not only because it forces people disproportionately to dig in their heels. But I think regulatory burden also it's like, my example of scope three, does that incentivize people to engage in the energy transition? No, I think if anything, it will be almost utilized as a witch hunt, to see, to point out certain companies that are trying to figure out energy transition, right. The irony, like here's a data point for you as a final thought. It's empirically proven, and this is done by Harvard who divested from fossil fuels. But it's been empirically proven that green patents, the most green patents produced come from the energy space. So I wish energy companies did a better job of telling their story. I wish energy companies didn't necessarily have to pay for the sins of the past. Let's be very clear. There were some very large mishaps that they had. And, you know, that's very unfortunate, but you shouldn't have to pay for the sins of your father, so to speak. And then number two, or I guess, number three, on the other side of the aisle, you know, that entity is so ingrained with vilifying fossil fuels, and hydrocarbons. Either they have blinders on, or they don't want to acknowledge the economic tenant the economic importance of fossil fuels and hydrocarbons within the economy, right. And then you have to leverage shareholder constructionist or engagement, whatever you want to call it, to ensure that there's an incentive structure to where that management team is figuring out how to navigate the company in a world that is obsessed with decarbonization. An energy company in a fossil fuel or hydrocarbon company, in its conventional sense, will not survive through the energy transition, right? They will evolve. The same way that like I was making this joke like IBM, what's a business machine? NCR? National cash register, no one has a cash register except my four year old daughter. We will look at Exxon, Chevron, Conoco, the works as they used to do this. And then now they do this. And fossil fuels and hydrocarbons will be a component of that, because it has to be. So hopefully, the data evolves in a fashion towards more objective. And then the energy to tractor community understands the efforts that the fossil fuel and hydrocarbon space is putting in place, but still maintains an aggressive patience, let's call it. But to be fair, the fossil fuel and hydrocarbon companies must fully acknowledge like we have to figure this out like being you know who we are for the sake of who we are is not going to cut it. You're not going to win capital that way.

34:50

Bob: Well, I think our discussion today actually took a pretty good whack at trying to figure it out. I think that you provided us and our audience with some very interesting insights, some ideas, maybe some opposing views. Okay it's a debate, it's a conversation, it's ongoing and Dan I want to thank you very much for sharing that with us today.

35:12

Dan: I appreciate you having me I love the conversation, thank you.

35:16

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