Shivaram Rajkopal reviews the new rule and asks whether we need something similar for non-ESG funds as well. He worries whether funds can get still get away with vague disclosures unless the SEC ramps up enforcement.

Shivaram

<p>Close on the heels of the climate disclosures for companies, the SEC has issued a much-needed proposal on standardizing ESG disclosures for ESG funds. I believe greenwashing is rampant in ESG funds as I have documented in <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3826357">academic</a> papers with colleagues and in <a href="https://www.forbes.com/sites/shivaramrajgopal/2021/10/04/is-there-truth-in-advertising-of-esg-funds/?sh=116ba46d4171">Forbes columns before</a>. The DWS greenwashing scandal is potentially just the tip of the iceberg.</p>
<p>The new ESG funds rule is a 350 odd page document. I just finished reading most of the salient requirements. I realize that the SEC has also issued a rule on naming of funds. I will address that rule in another column.</p>
<p>In essence, the ESG fund disclosure rule proposes the following changes:</p>
<h2>Types of funds</h2>
<ul><li>The SEC defines three types of ESG funds: integration, ESG-focused and impact investing. These labels have well defined parameters.</li></ul>
<ul><li>ESG integration is defined as funds that consider one or more ESG factors alongside other non-ESG factors in decision making.</li></ul>
<ul><li>ESG-focused strategies rely on one or more ESG factors by using them as a significant or a main consideration in selecting investments.</li></ul>
<ul><li>In this sub-category, the strategy may involve <strong>(i)</strong> exclusionary screens for tobacco, guns etc.; <strong>(ii)</strong> inclusionary screens such for investing in pro-DEI companies; <strong>(iii)</strong> tracking an ESG index; <strong>(iv)</strong> an attempt to achieve a specific impact; <strong>(v)</strong> proxy voting for ESG issues; <strong>(vi)</strong> engagement with issuers; or <strong>(vii)</strong> other actions.</li></ul>
<ul><li>An Impact Fund seeks to achieve a specific ESG impact.</li></ul>
<h2>Overview of strategy and ESG use in investments</h2>
<ul><li>Funds are required to provide an overview of their ESG strategy, how the fund incorporates ESG factors in its investment decision (screens, percentage in terms of net asset value to which the screen is applied, why the screen applies to less than 100% of the portfolio, reliance on internal methodology, third party data or a combination of both, reliance on third party frameworks such as U.N. SDG principles and name of the index the fund tracks and how that index uses ESG factors).</li></ul>
<ul><li>An impact fund must also disclose how the fund measures progress towards the specific impact, including KPIs (key performance indicators), the time horizon the fund uses to check for progress, and most important, and the relationship between the impact the fund is seeking to achieve and financial return.</li></ul>
<h2>How the fund votes its proxies or engages with companies</h2>
<p>The fund must describe briefly how it engages with firms or votes its proxies on ESG issues. This may be a clever way of detecting “proxy washing” given recent evidence that ESG funds <span class="unknown__pt__mark__5fcbd662f60b">do not even vote in favor</span> of ESG proposals in shareholder meetings.</p>
<h2>Detailed guidance on a few KPIs</h2>
<ul><li>Disclose the percentage of ESG voting matters during the reporting period.</li></ul>
<ul><li>With ESG engagement, the fund should disclose the number or percentage of issuers with which the find held ESG engagement meetings and total number of ESG engagement meetings. On page 82, the SEC goes to the extent of saying “employees (should) memorialize the discussion of ESG issues, for example, by creating and preserving meeting agendas and contemporaneous notes of engagements relating to ESG issues to assure accurate reporting on the number of engagements.” Good strike against “engagement washing.”</li></ul>
<ul><li>ESG focused funds that consider environmental factors have to disclose (i) carbon footprints; and (ii) weighted average carbon intensity (WACI).</li></ul>
<ul><li>Carbon footprint is defined as [(current value of the portfolio holding of say Apple Inc./Apple’s enterprise value) * Apple’s scope 1 and 2 emissions is total GHG emissions]/current portfolio’s NAV. Note the absence of scope 3 emissions here.</li></ul>
<ul><li>WACI is defined as (current value of Apple’s holding/current NAV) * (Apple’s scope 1 and 2 emissions)/Apple’s total revenue).</li></ul>
<ul><li>Scope 3 emissions need to be disclosed separately, if available or estimable in a reasonable manner. I wish the SEC would ask funds to disclose the margin of error they expect in these KPIs, especially if funds rely on third party vendors estimates of scope 3 emissions.</li></ul>
<h2>Index funds</h2>
<p>The SEC requires all index funds, regardless of whether the fund tracks an ESG-related index, to report identifying information about the index. This is potentially important as investors increasingly buy baskets of stocks, or indexes, as opposed to individual stocks. I often joke with students that the king/queen of Wall Street today is the index maker. If an index maker decides Tesla is in the S&amp;P 500, its value is probably assured to double or more. But there is virtually no regulatory oversight of how an index is constructed. Perhaps, collecting data is a first step in that direction.</p>
<h1>A few reactions to the new ESG funds disclosure rule:</h1>
<h2>1. No SEC definition of ESG</h2>
<p>I am glad that the SEC does not define ESG. That is an evolving term and its best to leave the definition to the individual fund. The European <a href="https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019R2088&amp;from=EN">Sustainable Finance Disclosure Regulation (SFDR),</a> on the other hand, defines a sustainability investment as</p>
<p>“an investment in an economic activity that contributes to an environmental objective, as measured, for example, by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy, or an investment in an economic activity that contributes to a social objective, in particular an investment that contributes to tackling inequality or that fosters social cohesion, social integration and labour relations, or an investment in human capital or economically or socially disadvantaged communities, provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance”</p>
<p>The EU <a href="https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/eu-taxonomy-sustainable-activities_en">green taxonomy</a> establishes six environmental objectives: (i) climate change mitigation; (ii) climate change adaptation; (iii) the sustainable use and protection of water and marine resources; (iv) the transition to a circular economy; (v) pollution prevention and control; and (vi) the protection and restoration of biodiversity and ecosystems. Hence, a green investment presumably has to address one of these six objectives.</p>
<p>This is classic “principles” versus “rules” debate and for a change, we, in the U.S., have opted to be regulate principles and leave the details to individual funds. Of course, the hope is that enforcement can take care of slippages or creative use of principles.</p>
<p>I personally find the EU approach a bit too restrictive for several reasons. First, brown assets or sin stocks are effectively disbarred from this definition. The definition of what is a sin stock is worryingly inconsistent. If tobacco is not a sustainable investment, why are cannabis not barred? Why is nuclear power and natural gas barred? How do we decarbonize without relying on nuclear power? Second, SFDR and the Green taxonomy appear to penalize investments in brown firms where the asset manager may be engaged in constructive dialogue. Third, what does “do not significantly harm any of those objectives” mean in practice?</p>
<p>Before you think these are wonky discussions, I get reminded time and again by my investment banking friends that a lot of serious money follows SFDR and EU green taxonomy-based classifications. Hence, sectors that are not in favor will, on the margin, lose access to some capital.</p>
<h2>2. Don’t we need this for all funds?</h2>
<p>I have written before about the <a href="https://www.forbes.com/sites/shivaramrajgopal/2020/06/10/whats-behind-the-label-quality-esg-value-growth/?sh=613941806922">fluidity of labels</a> in the world of funds in general. For instance, what exactly does a fund focused on “quality” do? What is a “value” fund? What is a “growth” fund? Many investors now rely on a private vendor, <a href="https://www.morningstar.com/">Morningstar,</a> to assign these labels to funds. Who is Morningstar accountable to? Is there enough competition in such classification services? I cannot help but imagine that most fund investors would like to know what “quality” factors, for instance, were considered by fund management and how did the fund manager differentiate across these factors? As an investor, I want to know, for instance, if the fund manager engages with management or votes against say dividend payments for an aspirational “growth” stock such as IBM that might have underinvested in the future?</p>
<h2>3. What might the pricing implications of these three classifications be?</h2>
<p>After the dust settles, one has to wonder how funds will sort themselves into these three categories (integrated, focused and impact). Will most simply choose the category with the least onerous disclosure requirement (integrated, for instance)? Will we see enough impact funds given the relatively specific disclosures needed to track impact? Will such a sorting affect the pricing of the stock or debt instruments that these funds hold?</p>
<p>I suspect asset managers will come up with their own internally defined standards, benchmarks and thresholds to decide which of the three categories to pick. Will self-selection into the three categories and subjective applications of these definitions lead to even less comparability than before? Are the distinctions between the three types of funds sharp enough to affect pricing in capital markets? How will investors respond to these new rules? Will they push asset managers to deliver more impact funds than the weaker integration funds? These questions are worthy of research and debate in the coming years.</p>
<h2>4. Can funds still hide under vague disclosures?</h2>
<p>Despite these attempts to regulate disclosures, I worry that funds can get away with vague noises about factoring in ESG into their investment decisions. I suspect including words such as “low carbon” or “ESG” or “sustainable” might be enough for the first category of so-called ESG integration funds. I suspect these disclosures are not required to be audited or assured. The SEC will have to carry a big enforcement stick to make these disclosures credible and to truly clean up greenwashing.</p>
<h2>5. Isn’t G universal?</h2>
<p>One of the consequences of leaving ESG undefined is the worry that every fund manager likely takes “G” into account before investing in a company. Does that make every fund an ESG fund?</p>
<h2>6. Has the SEC overemphasized E?</h2>
<p>I understand emissions are relatively easy to measure for an environmentally focused fund but has the SEC overemphasized emissions at the cost of other environmental or even social and governance metrics. The contrast with the EU is stark though. Lack of data is a significant concern for the so-called PAI (principal adverse impact) indicators that the EU is asking for such as those related to the fund’s and hence the portfolio company’s share of energy consumption from renewable and non-renewable sources, activities negatively affecting biodiversity, water and water emissions, violations and compliance with human/labor rights initiatives, and gender pay gaps. Perhaps the SEC has struck the right balance in pushing for KPIs that are collectible rather than ask for aspirational metrics that will inevitably attract criticism from commentators opposed to mandatory disclosure.</p>
<h2>7. No carbon offsets allowed</h2>
<p>On page 98, the SEC states that “the proposed rules do not permit a fund to reduce the GHG (greenhouse gas) emissions associated with a portfolio company as a result of the company’s use of purchased or generated carbon offsets.” This is obviously a good move designed to curb greenwashing. In our review of carbon pledges of oil and gas firms, we routinely found firms relying on offsets at least to promise a path to net zero. Will the fund manager have to sort through the emissions reports of every firm she holds to undo the impact of offsets? Perhaps third-party data vendors will start collecting which firm relies on offsets to report net emissions.</p>
<h2>8. Will focus on current GHG divert capital away from future GHG reduction?</h2>
<p>Many sectors are GHG heavy today such as oil, cement and steel. But, many of these companies are working furiously towards a greener future. On top of that many of the components that these industries make facilitate energy transition such as the use of steel in say wind turbines. Will the focus on GHG divert capital, on the margin, away from these transitional sectors?</p>
<h2>9. A technical quibble about value weighting GHG portfolio measures</h2>
<p>One of the dangers of value-weighting GHG measures for the portfolio is the volatility in the prices of sin stocks. Imagine an ESG fund that holds oil stocks. Let’s say that oil, and hence, the underlying oil stocks, treble in value over a year but the overall portfolio is unchanged. The value-weighted emissions from oil stocks will hence look much bigger than they might have relative to last year although the emissions per se or the environmental impact of the company has not changed.</p>
<h2>10. Asking for investor preferences</h2>
<p>Here is one European innovation that I find intriguing. MIFID II requires that <a href="https://www.esma.europa.eu/press-news/esma-news/esma-consults-review-mifid-ii-suitability-guidelines">asset managers ask</a> investors about their risk tolerance, financial objectives and sustainability preferences. This is perhaps one of the few regulatory attempts to discover what the real investor actually wants when she buys funds. You could always argue that the very act of buying the fund tells us what the investor cares about, but I am not so sure. How many go merely by the label of the fund rather than fully investigate whether the fund fully satisfies their risk tolerance or preferences? The SEC might want to consider a similar idea.</p>
<p>So, that is my first look at the<strong> SEC’s new ESG fund</strong> disclosures supplemented by <strong>comparisons to the European SFDR, RTS and MIFID II requirements.</strong> These requirements are a welcome first step in policing exaggerated marketing claims about ESG and in providing consistent, comparable disclosures that diligent investors can actually rely on. Comments welcome, as always.</p>
<p><em>This article is also published by <a href="https://www.forbes.com/sites/shivaramrajgopal/2022/06/06/a-first-look-at-the-secs-new-esg-funds-disclosure-rule/?sh=505db0ddb346">Forbes</a>. Energy Voices is a democratic space presenting the thoughts and opinions of leading Energy &amp; Sustainability writers, their opinions do not necessarily represent those of illuminem.</em></p>


A First Look At The SEC’s New ESG Funds Disclosure Rule

The most common question I get asked in an ESG Investing class is: “How should we integrate ESG thinking into financial analysis of a company?” The frustration behind this question comes from several sources. 





<p>The most common question I get asked in an ESG Investing class is: “How should we integrate ESG thinking into financial analysis of a company?”</p>
<p>The frustration behind this question comes from several sources. Investors complain that ESG reports are often long, voluminous, and often full of fluff. These reports are typically sparse of quantitative data. When it exists it typically shows up in stand-alone tables that lack context and in a PDF document that makes it hard to access and use the data. Worst of all, these data may or may not be relevant to understanding sustainability, both from a financial or a social or an environmental standpoint. For instance, the definition of what is material in the ESG world or not has caused much angst. The SASB has defined materiality narrowly with respect to investors or capital providers. Such a definition is consistent with the securities laws but potentially not fully consistent with what a social activist considers material.</p>
<p>Other market participants lament that financial accounting systems are not integrated with ESG reporting systems. In an ideal world, basic policies, systems, procedures, and controls should exist to both produce high quality data and to permit reliable and enforced external audit for both financial and ESG reports. Some argue that we need a much smaller number of standards, may be just one, as opposed to the multitude from TCFD, SASB, GRI and the like. The recently formed ISSB is perhaps one step towards such an evolution. As of now, the only area where there is some sort of global consistency with somewhat acceptable levels of reliability is in relation to climate. Even that will probably take a long time.</p>
<p>Until the Nirvana state of One standard for reliable ESG data is achieved, I have a few suggestions to begin addressing the integration question.</p>
<ul><li>Read the risk factors in a firm’s 10-K carefully. Ask whether the hyper-defensive lawyers who dream up every excuse for the firm to get sued refer to ESG factors. If they do not, we have a problem:</li></ul>
<ol><li>Either the firm is burying its head in the sand with respect to ESG risks.</li></ol>
<ol><li>Or, we, as investors, have indulged in wishful thinking in that ESG factors are unlikely to pose a material valuation risk in the near to medium term.</li></ol>
<ul><li>If you do find reference to ESG factors in the risk list, open the sustainability report and look for concrete data points that will help you translate those risk factors, preferably into dollars and a tentative time frame over which the risks will bite.</li></ul>
<p>Let’s test this hypothesis with Coca Cola. Coco Cola is particularly interesting to me given my <a href="https://www.forbes.com/sites/shivaramrajgopal/2021/12/01/is-coca-colas-shareholder-value-negative/?sh=79dcb62a42a4">prior work</a> on negative externalities imposed by the company. The company lists 45 risk factors. I identified 14 ESG related risk factors listed by Coca Cola in its 2020 10-K. Remarkably, there are several red flags related to “P” or the impact of the product on society, a term that <a href="https://www.forbes.com/sites/shivaramrajgopal/2021/12/19/does-philip-morris-international-pmi-provide-the-managerial-playbook-for-western-oil-majors/?sh=ec2f07a8ce21">Philip Morris International</a> has come up with in their sustainability report.</p>
<p>Here is the list of the 10-K risk factors:</p>
<h1><strong>E factors:</strong></h1>
<p>1. Increasing concerns about the environmental impact of plastic bottles and other plastic packaging materials could result in reduced demand for our beverage products and increased production and distribution costs.</p>
<p>2. Water scarcity and poor quality could negatively impact the Coca-Cola system&#x27;s costs and capacity.</p>
<p>3. Increased demand for food products and decreased agricultural productivity may negatively affect our business (E and P).</p>
<p>4. Climate change and legal or regulatory responses thereto may have a long-term adverse impact on our business and results of operations.</p>
<p>5. Adverse weather conditions could reduce the demand for our products.</p>
<h1><strong>S factors:</strong></h1>
<p>6. If we are unable to attract or retain a highly skilled and diverse workforce, our business could be negatively affected</p>
<p>7. If we are unable to renew collective bargaining agreements on satisfactory terms, or we or our bottling partners experience strikes, work stoppages or labor unrest, our business could suffer.</p>
<p>8. Obesity and other health-related concerns may reduce demand for some of our products.</p>
<h1><strong>P factors (missing from ESG):</strong></h1>
<p>9. If we do not address evolving consumer product and shopping preferences, our business could suffer.</p>
<p>10. Product safety and quality concerns could negatively affect our business.</p>
<p>11. Public debate and concern about perceived negative health consequences of certain ingredients, such as non-nutritive sweeteners and biotechnology-derived substances, and of other substances present in our beverage products or packaging materials, may reduce demand for our beverage products.</p>
<p>12. If negative publicity, whether or not warranted, concerning product safety or quality, workplace and human rights, obesity or other issues damages our brand image, corporate reputation and social license to operate, our business may suffer.</p>
<p>13. Changes in laws and regulations relating to beverage containers and packaging could increase our costs and reduce demand for our products.</p>
<p>14. Significant additional labeling or warning requirements or limitations on the marketing or sale of our products may inhibit sales of affected products.</p>
<p>The next step, of course, is to look for data on quantifying the dollar impact and the likely timing of when these risks might materialize.</p>
<p>As I have mentioned before, companies disclose next to nothing about labor. Hence, assessing the impact of losing talent (# 6) or a collective bargaining dispute (#7) will require significant legwork. A question for the SEC: “Why does a company that lists the potential loss of its skilled workforce disclose so little to enable an investor to quantify the impact of that loss on its cash flows?”</p>
<p>I have attempted to compute the social cost imposed by obesity (#8), emissions and non- recycled plastic bottles (#1) and water issues (#2) in my earlier piece. When and whether regulation or public/media pressure (#4, #11, #12, #13, #14) or changing consumer tastes that move away from sugary drinks (# 9) or investor action (surprisingly not flagged by Coca Cola) will make Coca Cola internalize the cost of the externalities it imposes is, of course, a key question for the investor. Is it a year, a decade, or a generation away?</p>
<p>My earlier analysis had missed the direct impact of climate change on the cost of agricultural inputs that the company relies on (#3) and the lower demand for the company’s products (#5).</p>
<p>What about investors that already incorporate the SASB’s framework and now have a new overwhelming list of 14 factors to consider? My approach is complementary to the SASB approach. Moreover, unexpected macro-economic events listed in some of the 10-K risk factors can change a double-materiality issue in the SASB’s framework (important to the firm’s valuation and its’ social impact) to a single materiality issue (important for the firm alone) and generate negative or positive alphas.</p>
<p>For instance, the pandemic became a point of dynamic materiality as investors’ perception of what is important to valuation and the firm’s workforce changed as the virus progressed. Oil prices have tripled in the last few months and oil stocks have generated positive returns. The demand-supply imbalance of oil might erode the pressure on governments to consider enacting a carbon tax to reduce emissions, which, in turn, will keep oil companies unaffected, on the margin.</p>
<p>An obvious limitation to my approach is that I start with risk factors, which, by definition, are value decreasing from an investor’s standpoint. What about all the positive externalities that a company creates? Sustainability reports might be a place to start thinking about the jobs and taxes that companies contribute or the innovation they come up. How much of these positive externalities are captured in stock price? We know that innovators rarely retain more than a small part of the value their R&amp;D generates for society. Perhaps positive externalities creates social and political capital with regulators and hence help the company postpone or avoid harsh penalties and fines, in case the companies get into compliance trouble. Is this social and political already priced in or likely to be in the nature? That is an open question worthy of more work.</p>
<p>What about risk factors not listed in the 10-K? I suspect climate-change will result in large capex spending of the replacement or maintenance kind. That is, companies have to internalize losses or outlays just to retain product market shares. This consideration is often missing in the 10-K warnings or tangentially alluded to as in #3 above.</p>
<p>In sum, I believe that mapping risk factors to the sustainability report is likely to be far more productive starting point relative to wading through the sustainability report in the hope of picking up signals about ESG risk factors that are material to the firm’s risk and future cash flows.</p>
<p>The biggest question the analysis begs for me is which of the 10-K based risk factors are covered in the sustainability report and which are not. The answer to that question, is itself a great take off point for an investor interested in integrating ESG factors into financial analysis.</p>
<p><em>This op-ed also appeared on <a href="https://www.forbes.com/sites/shivaramrajgopal/2022/02/01/how-to-integrate-esg-criteria-into-financial-analysis-the-case-of-coca-cola/?sh=6794513d284a">Forbes</a>. Energy Voices is a democratic space presenting the thoughts and opinions of leading Energy &amp; Sustainability writers, their opinions do not necessarily represent those of illuminem.</em></p>


How To Integrate ESG Criteria Into Financial Analysis? The Case Of Coca Cola

What is the future of Western oil majors as they battle increased scrutiny from socially activist investors, citizens, and governments? My suggestion is that they learn from the practices of Philip Morris International (PMI), the tobacco giant.

<p>What is the future of Western oil majors as they battle increased scrutiny from socially activist investors, citizens, and governments? My suggestion is that they learn from the practices of Philip Morris International (PMI), the tobacco giant. <a href="https://www.pmi.com/sustainability/integrated-report-2020-digital">PMI’s 2020 sustainability report</a> states that “more than one billion people worldwide…and around the same number will smoke in 2025.” The report goes on to say that the addressable market of 1 billion customers worldwide has stayed constant since 2010. The World Health Organization projects this to be constant for at least another five years because nicotine is a highly addictive substance. Similarly, oil has similarly addicted customers. Despite all the promise of renewables, we have not managed yet to reduce the demand for oil. </p>
<p>Tobacco worldwide is dominated by five listed companies: Altria, British American Tobacco (BAT), Imperial Tobacco (IMP), Japan Tobacco (JT), and PMI. The biggest player is the state-owned China National Tobacco Corporation (CNTC). CNTC has a market share of 46% and PMI of 14%, the largest of the listed companies. Also important is Indian Tobacco Company (ITC) which is 30 percent owned by BAT. In the world of oil, akin to CNTC, state owned enterprises (SOEs) or quasi-SOEs such as Aramco of Saudi Arabia and Rosneft of Russia produce around 50% of the world’s oil. However, we have hundreds of Western oil companies in business now. My guess is that we are likely to witness consolidation in this group or purchases by private buyers, such as private equity firms. The oil SOEs are generally untouchable. Roughly 60% of PMI’s 2020 revenues are collected by the Government as excise taxes ($47 billion of $76 billion). Appropriate carbon taxes, if implemented, would also account for a large proportion of the revenue of Western oil majors in the next decade or so.</p>
<p>So, if you are Chevron and you could peek into a crystal ball, what does the future hold? Is there a managerial playbook for how to transform yourself and still be a relevant, thriving viable company over the coming decades? I do not mean to minimize the differences between oil and tobacco. Cheap oil has transformed lives, especially in the developing world, for the better. Without cheap oil, China and India would not have been able to lift millions out of poverty. But I am deeply concerned that <a href="https://earth.org/most-polluted-cities-in-the-world/">13 of the top 15 most polluted cities i</a>n the world are from India, where I am writing this from.</p>
<p>Many, if not most, of Western asset managers bucket tobacco and oil under the “excluded” category without fully appreciating nuances in companies within oil or tobacco. If I were the CEO of one of the large Western majors, I would study PMI’s transformation closely. In this piece, I contrast the practices of PMI with that of <a href="https://www.chevron.com/-/media/shared-media/documents/chevron-sustainability-report-2020.pdf">Chevron</a> as a counter-example.</p>
<p>But before doing so, let me be clear. Putting aside the addictive pleasure people derive from smoking, cigarettes damage health and cause many deaths every year. Hence, one could argue there’s little good that can be said about the cigarette business. And while PMI is executing the major business transformation I describe below, it still sells hundreds of millions of cigarettes every year. My intention is to draw managerial lessons for oil from tobacco and provoke a deeper conversation about business transformation, as opposed to endorsing or criticizing either the tobacco or the oil business.</p>
<h1><strong>Prepare for a scenario where your main product is completely phased out</strong></h1>
<p>PMI’s competitors focus on expanding their portfolios and offering more choice to their customers. PMI, in contrast, aims to switch out of cigarettes completely, by offering both choice and better alternatives to customers via heated tobacco products branded as IQOS. It has set a target of booking more than 50 percent of its revenues coming from reduced risk products (RRPs) by 2025, thereby dramatically cannibalizing its cigarette business. Remarkably, New Zealand has <a href="https://www.bbc.com/news/world-asia-59589775">banned the sale of cigarettes</a> to anyone born after 2008. PMI is well positioned to exploit that ban. I am not suggesting that the sale of oil will ever be banned but PMI’s business transformation is worth understanding. <a href="https://www.chevron.com/-/media/shared-media/documents/chevron-sustainability-report-2020.pdf">Chevron’s 2020 sustainability report</a> talks a lot about general trends in the oil market but has little by way of strategy for how to deal with the sunsetting of oil in the future.</p>
<h1><strong>View sustainability as an opportunity for innovation and publish a scorecard of business transformation metrics</strong></h1>
<p>Many oil majors consider sustainability as an externally imposed development that they have to deal with. Instead, disrupt the business from the inside and view sustainability as a way to differentiate yourself from the competition. This is more than empty sloganeering. PMI publishes goals and metrics related to (i) the number of adult users that have switched to IQOS; (ii) the number of markets where IQOS is sold; (iii) proportion of revenue from smoke free products (a sizeable 24%); (iv) proportion of R&amp;D devoted to smoke-free products (99%!) apart from the traditional sustainability metrics such as (i) the number of IQOS devices recycled (84%); (ii) reduction in scope 1+2+3 emissions; (iii) supply chain practices; and (iv) not marketing to youth. The competition, by and large, continues to focus on traditional cigarettes and is likely to be not ready for an outright ban on cigarette sales that may be on the horizon, if New Zealand is an early indicator.</p>
<p>To transform itself, a business must conduct a holistic review and overhaul its business model to include extensive changes in the firm’s operations and value chain and the way the firm interacts with society. This is captured in PMI’s “<a href="https://www.pmi.com/statement-of-purpose">Statement of Purpose</a>” signed by every member of its board of directors. I do not know of any U.S. company that has done so, including all the signatories to the Business Roundtable’s “Statement of the Purpose of a Corporation” which I’ve <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3609056">written</a> about before. My analysis with Aneesh Raghunandan suggests that the BRT signature is more greenwashing than substantive.</p>
<p>I do not get the impression that Chevron has thought seriously about sustainability as integral to its corporate purpose. Their sustainability report talks about investing $3 billion by 2028 to advance their energy-transition strategy. That number is 2.5% of $15 billion <a href="https://www.chevron.com/stories/chevron-announces-$14-billion-capital-and-exploratory-budget-for-2021">annual capex spending</a> extrapolated to 2028 ($3/($15*8 years). Chevron seems to have targets for zero flaring by 2030. These are relatively low hanging fruit in oil and gas whereas a well-defined net zero aspiration is much harder. Chevron’s definition of net zero would only cover scope 1 and 2 emissions only, not scope 3, in any case. Moreover, Chevron’s targets seem to be anchored on emissions per barrel (intensity measure) as opposed to total emissions.</p>
<h1><strong>Make the Chief Sustainability Officer (CSO) report to the CFO</strong></h1>
<p>One of my simple litmus tests aimed at assessing whether a firm is serious about sustainability is to check who the CSO reports to. In PMI, the CSO, Jennifer Motles, reports to the CFO, Emmanuel Babeau. This enables better integration of ESG drivers into business strategy and hence mutually reinforces the link between financial performance and sustainability. It also serves to have the same high quality internal control and measurement systems for sustainability reporting as for financial reporting. Chevron has appointed a vice president of strategy and sustainability but he appears to report to the <a href="https://www.chevron.com/stories/bruce-niemeyer-named-chevron-corporate-vice-president-of-strategic-planning">president of Chevron North America Exploration and Production</a>.</p>
<h1><strong>Embed sustainability priorities in executive accountability</strong></h1>
<p>Viewing sustainability as central to business strategy makes it easier to integrate sustainability drivers into executive compensation goals. I have <a href="https://www.forbes.com/sites/shivaramrajgopal/2021/04/29/are-companies-tying-ceo-pay-to-esg-because-its-not-linked-to-performance/">written about half-hearted</a> or non-existent integration of ESG drivers in compensation plans earlier. PMI links executive compensation to at least two sustainability metrics: (i) revenues from business transformation related to net revenues of smoke-free products; and (ii) non-combustible product volume. Chevron’s 2020 proxy statement <a href="https://www.chevron.com/-/media/shared-media/documents/chevron-proxy-statement-2020.pdf">links executive pay to reductions of flaring</a> and methane intensity, which are great initial steps, but the targets could become much more aggressive.</p>
<h1><strong>Cultivate a culture that welcomes not rebuffs challenge</strong></h1>
<p>The CEO of PMI, Jacek Olczak, states “I cordially invite you to question, to challenge, and above all to engage with us as we remain focused on making our company one that is centered on sustainability and a higher purpose.” I have not seen or heard of such a culture among the oil majors, except perhaps a bit for Exxon <a href="https://curexxon.org/wp-content/uploads/2021/12/CURE-Exxon-Mid-Term-Report-Card.pdf">after the Engine no.1 initiative</a>.</p>
<h1><strong>Gather and publish data on the whole value chain</strong></h1>
<p>PMI’s business transformation is based on an in-depth understanding of the global tobacco and nicotine value chain. Seventy thousand data points on this chain are published in their Tobacco and Nicotine <a href="https://www.pmi.com/who-we-are/tobacco-facts/tobacco-database#:~:text=The%20Tobacco%20and%20Nicotine%20Database%20is%20a%20collection%20of%20data,is%20not%20specific%20to%20PMI.&amp;text=The%20database%20includes%20more%20than%20130%20variables%20across%20191%20countries.">database</a> and covers information on number of farms, volume of cigarettes manufactured, and government revenues from excise for over nine years. I have never seen anything similar in the world of oil and gas.</p>
<h1><strong>Make multi-stakeholder engagement the norm</strong></h1>
<p>Business transformation depends on the cooperation of stakeholders- from supply chain to regulators, consumers, employees, investors and the finance community, and civil society. In each case, explain why you engage, how you engage and what are the key issues that are discussed. PMI does this well, but I have not seen something similar in oil and gas.</p>
<h1><strong>Don’t shy away from negative externalities imposed by the firm</strong></h1>
<p>Most oil majors barely engage with “single materiality” issues or sustainability factors that are important for enterprise value creation for investors. “Double materiality” refers to risks and opportunities material from a financial and non-financial perspective especially, negative and positive externalities created by the firm for which the market does not hold the company accountable. PMI advocates for adding “P” (the impact of the product) to ESG, an aspect that ESG ratings ignore. I have <a href="https://www.forbes.com/sites/shivaramrajgopal/2021/12/01/is-coca-colas-shareholder-value-negative/?sh=79d06f2342a4">written</a> about this in the case of Cola Cola. PMI, perhaps on account of Big Tobacco’s long history with regulators and lawsuits, has been far more pro-active in dealing with health related problems created by the burning of tobacco when smoking a cigarette. Oil and gas could do far more.</p>
<p>In sum, if sustainability is truly imbedded in corporate purpose, strategy and implementation is better integrated with all aspects of business. If sustainability is viewed as a value imposed by activist investors or outsiders, as seen by most of the oil and gas industry, a company’s ESG efforts will always come across as disjointed and sometimes aimed at spin or even greenwashing. The oil and gas majors would do well to understand how PMI has been transforming itself over the last decade or so.</p>
<p>As a business school professor, I am always drawn to managerial lessons one can glean from companies that have battled a similar crisis before. Tobacco, to some extent, has been there and done that. Oil would do well to learn from Tobacco.</p>
<p><em>This article is also published on <a href="https://www-forbes-com.cdn.ampproject.org/c/s/www.forbes.com/sites/shivaramrajgopal/2021/12/19/does-philip-morris-international-pmi-provide-the-managerial-playbook-for-western-oil-majors/amp/">Forbes</a>.</em> <em>Energy Voices is a democratic space presenting the thoughts and opinions of leading Energy &amp; Sustainability writers, their opinions do not necessarily represent those of illuminem.</em></p>


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Shivaram Rajgopal

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