Fossil Fuels Pose New Compliance Headaches for Hedge Funds

Compliance will be a major issue for hedge funds and other organizations that have capitalized on the fluidity of fossil fuel divestment.

07 January 2022 4 min read
by Alex Viall

The divestment from fossil fuel assets has been an ongoing trend for nearly a decade. Today that push to divest has engulfed a myriad of public institutions, from universities to pension funds and major companies. On top of this, with the increasing focus on Environmental, Social and Governance (ESG) compliance, the urgency has only grown despite a lack of agreed upon guidelines.

This confusing scenario of public pressure coupled with a lack of standardization has left a gray area of which some organizations have taken advantage.

One of the major takeaways from the COP26 global climate summit in Glasgow in November was a commitment to create a framework for assessing the impact of the sustainability and ethical practices of a company. This could quickly become a problem for those hedge funds and other organizations that have capitalized on the fluidity of fossil fuel divestment. Compliance may not be an issue now for those parties, but it will be a major issue soon.

The Oil and Gas Market

Like other large markets, the global fossil fuel market felt the pain created by the pandemic. Restrictive controls meant challenges for organizations throughout the industry. Since the rollout of vaccinations and the relaxation of some of these restrictions, however, the global oil and gas market has seen growth.

Today’s global economy is still heavily reliant on natural gas and oil for its energy needs. Already, the demand for oil is back to 95% of pre-COVID levels, according to a recent report by Deloitte. And analysts at S&P Global Platts forecast that global oil demand will continue to grow slowly throughout this decade. This makes the divestment dilemma more acute for companies amid pressure from a range of stakeholders.

As the market continues to recover from recent setbacks, there will be money to be made. Organizations who prioritize profit don’t have a strong legal reason to avoid this industry as of this moment.

A Market Opportunity

According to the Financial Times, hedge funds that traditionally skirt public scrutiny have been getting more involved in oil and gas because of the potential return on investment.

As companies and universities shed fossil fuel assets, hedge funds have been more than willing to buy at a discount. Hedge funds that have decided to enter this unique situation however, are putting themselves at a greater risk than just the traditional market uncertainties. With the growing focus on ESG, these organizations may be setting themselves up for a visit from regulators.

A Push Towards ESG

Hedge funds are currently able to invest in fossil fuel companies that have lost public support because of the lack of a globally accepted framework for disclosures. As of this writing, the sheer amount of voluntary guidance around becoming ESG compliant is arguably overwhelming.

Though ESG standards have been under development for two decades, we have seen a step closer to global standards with the announcement of the IFRS Foundation’s International Sustainability Standards Board (ISSB) at COP26. The ISSB has been created to develop this framework for global sustainability reporting standards. This trigger point should serve as a warning to those hedge funds who have seen divestment as an opportunity to improve their portfolio’s fiscal health.

Future of Compliance

ESG compliance may not yet be an established approach, but regulators are taking it ever more seriously. For example, Bloomberg law reports that the SEC is intently looking to improve the disclosures that public companies make to investors concerning climate change, human capital, and diversity, both in the workplace and on corporate boards.

ESG compliance is something that all financial institutions are going to have to get to grips with and, despite some positive returns for those active in the fossil fuel industry, getting compliant is more important. While full divestment from industries such as oil, coal, and gas has created a potentially profitable situation for some, companies and hedge funds need to be aware of ESG regulations and be proactive about becoming compliant.

For more insights on ESG on the future of regulation, read our blog Fund Managers Should Pay Attention To Warning Signals From COP26.

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Published 07 January 2022

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Alex Viall Director, Regulatory Intelligence

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