By Drew Lichter, (alichter@mobiusriskgroup.com)

Over the past several years, Environmental, Social, and Governance (ESG) policies have become increasingly important for corporates in general and energy and commodity producers and end users in particular. Investors and other stakeholders increasingly expect a corporate commitment to environmental sustainability. 

There are three pillars of a successful environmental sustainability program: Regulatory compliance, achievement of corporate stakeholder priorities, and financial optimization. Achieving and balancing these sometimes conflicting goals requires expertise in physical energy management, fundamental and quantitative analytics, and both energy and emissions trading.

When designing an ESG program, the first step is accurately measuring your carbon footprint. This is largely driven by power burn for most industrial firms, and in the downstream uses of their production output for producers and midstream companies. As a result, the ability to digest and analyze energy production and usage data is a key factor in measuring environmental impact. Moreover, production disruptions due to both price volatility and Covid-19 have made a real time view of relevant data increasingly important.

The second step is achieving an in-depth understanding of corporate environmental goals. While most have a mission statement, this needs to be viewed through the lens of potential mitigation opportunities. Is it important that renewable energy is purchased from facilities you have financed, or is purchasing power on the open market along with credits or offsets an acceptable alternative? Many voluntary credits finance projects with social benefits beyond green energy. Is this important, and if so what premium are you willing to pay?

Next, both potential projects and market-based alternatives need to be evaluated both financially and for their suitability in meeting corporate sustainability goals. Financial analysis should be focused not only on initial costs, but also liquidity, risk, and optionality. Analysis should not be based on price projections from unknown sources or stale market data. Just because there are non-financial goals in play doesn’t mean you want to overpay. This doesn’t help the environment, it just transfers your shareholders’ money to for-profit developers and trading houses.

Once analysis is complete and an initial strategy is determined, you move on to the execution phase. As with other hedges, one of the largest costs will be dealer spreads paid, and the illiquid nature of both projects and some financial products makes sharp execution even more important. This requires trading knowledge of power and emissions markets, the right data, and contacts with financial and non-financial liquidity providers. 

Executing the initial strategy is the starting point, not the finish line. As with any hedge, a dynamic approach should be employed, with both regular adjustments to volume based on production levels and periodic adjustments to strategy based on power and offset market conditions. If production increases, additional mitigation efforts may be required, and if it decreases you may have excess credits that can be monetized in the marketplace. In addition, as these are traded markets they can be optimized. Take the case of a corporate who evaluates two Voluntary Emission Reduction (“VER”) packages, both of which are priced at $7/ton and meet corporate sustainability goals. They purchase VER package A. Six months later, the price of package A goes to $11/ton while package B remains at $7. Provided they both remain viable from an ESG perspective, there may be an opportunity to swap package A for package B and monetize the $4 differential. Similar strategies exist with solar versus traditional RECs, and in markets with associated futures such as EUAs, storage and basis arbitrage windows will periodically open.

Energy production and heavy industry are and will remain essential to the domestic and global economy. While the transition towards a greener economy presents challenges, it also presents opportunities for the firms nimble enough to embrace the chance to drive environmental sustainability through their supply chains.