9B14N020 INVESTING SUSTAINABLY AT ONTARIO TEACHERS’ PENSION PLAN Cory Tanaka wrote this case under the supervision of Professor Robert D. Klassen solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. This publication may not be transmitted, photocopied, digitized or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) cases@ivey.ca; www.iveycases.com. Copyright © 2014, Richard Ivey School of Business Foundation Version: 2014-09-10 Wayne Kozun glanced out his office window at the winter storm that was rapidly approaching. As 2014 began, he was considering two investment opportunities brought forward by his team, and was trying to understand how to ensure that the principles underpinning responsible investing were incorporated. As a senior vice-president of the Ontario Teachers’ Pension Plan (OTPP), he knew that the environmental and social performance of companies could be a critical influencer of long-term investment outcomes. As a founding member of the Canadian Coalition for Good Governance 10 years earlier, and more recently, a signatory to United Nations-supported Principles for Responsible Investment (PRI), OTPP viewed these issues as increasingly pertinent to long-term fund performance. But translating principles into systems and action in public equities continued to be an elusive proposition. Two investment opportunities in the oil and gas industry — a key investment sector for OTPP — looked very attractive, given the relative strength of oil prices and the promise of expanding international markets. Recently, a growing stream of controversies surrounding oil sands extraction, pipeline safety and environmental protection had raised concerns. Moreover, while both companies offered attractive riskadjusted returns, neither had a sterling record in environmental, social or governance (ESG) performance. Kozun was still unsure how precisely to quantify the impact of these ESG issues and translate them into a more informed investment decision. Jim Sikora and Scott Cheng, both portfolio managers covering the oil and gas and utilities sectors at OTPP, walked into Kozun’s office with supporting analysis for the two potential investments. As the storm outside arrived, the three sat down to review all the information. ONTARIO TEACHERS’ PENSION PLAN The Government of Ontario started providing retirement pensions to its teachers in 1917. To fund the pension, teachers and the province made contributions to a government managed trust, which in turn invested in non-marketable Province of Ontario debentures. More than seven decades later, in 1990, the province separated the investment management function from the government and established OTPP as an independent organization to administer and invest the plan’s $19 billion in assets. At the time, future payments to pensioners were forecast to exceed contributions and existing investments by $7.8 billion. 1 1 OTPP, 2013 Annual Report, p. 106. 45 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. 6. 9B14N020 The province hoped that by replacing the provincial debentures with professional investment management, it could close the funding shortfall without a sharp increase in contributions. Once established, OTPP hired investment professionals and developed capabilities in equities, fixed income, commodities, real estate and absolute return strategies. Investments were diversified across geographies as well as asset classes. By 2013, OTPP had grown to $140.8 billion in net assets. Between its inception and 2013, OTPP generated a compound annual return of 10.2 per cent. This was significantly higher than the returns of its benchmark, at 8.0 per cent, 2 and OTPP moved into a funding surplus of $5.1 billion. 3 Responsible Investing International Agreement Established in 2006, the PRI were embodied in six sustainability principles for investors (see Exhibit 1). The principles were developed on the basis that environmental, social and governance issues were a fundamental part of assessing company risk and performance. Furthermore, they recognized that longterm investment returns are dependent on well-functioning and well-governed social, environmental and economic systems. The principles, developed in collaboration with a core group of institutional investors, offered a menu of actions for incorporating ESG issues into investment practices using different approaches to and across multiple classes of investments. By the end of 2013, 15 per cent of the world’s investible assets were managed by signatories to the PRI; 90 per cent of signatories had collaborated with others on ESG issues, and 71 per cent had asked companies to integrate ESG information into their financial reporting. As an example of the impact the PRI was having, 18 signatories sought dialogues with 24 Fortune 500 companies that generated significant greenhouse gas emissions but lacked a disclosed emission reduction target. Shortly after meeting with the institutional investors, 10 of those companies had set targets while several others demonstrated an understanding of investors’ concerns. 4 Since its inception, OTPP had been dedicated to innovative investment and risk management practices to generate superior returns while reducing its risk of loss. It was one of first pension funds to diversify beyond stocks and bonds and invest in non-traditional assets. Among many Canadian pension fund firsts, OTPP created a long/short portfolio, bought a real estate investment company and invested in assets where the return was protected against inflation. On the management side, it was the first Canadian public-sector pension plan to introduce incentive compensation and the first Canadian pension plan to introduce a risk budgeting system for investments. 5 In 2003, OTPP became a founding member of the Canadian Coalition for Good Governance and played a leading role among institutional investors promoting good governance practices in Canadian public companies. With the belief that good governance practices contributed to a company’s ability to create value, OTPP established a proxy group that voted its shares according to guidelines published on its website. This group further formalized its commitment by signing the PRI in 2011. 2 Ibid., p. 18. Ibid., p. 1. 4 PRI Fact Sheet, www.unpri.org/news/pri-fact-sheet/, accessed March 30, 2014. 5 OTPP, History of Innovation, www.otpp.com/corporate/about-teachers/history-of-innovation, accessed March 30, 2014. 3 46 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Page 2 Page 3 9B14N020 OTPP recognized that environmental and social issues were becoming more and more relevant to publicly traded companies. It conducted a fund-wide review to investigate how climate change and social issues might affect its investments, how the plan was currently managing these risks and what actions needed to be taken. The review concluded that irrespective of whether climate change was real or not, it was clear that increased regulation, societal trends and social licences around ESG would increasingly influence company performance. Based on the results of that review, OTPP formed a Responsible Investing Committee comprised of professionals from each asset class. In addition, OTPP hired Joy Williams, an experienced professional, to help coordinate the organization’s approach and evaluate how ESG issues affected risks and returns in each area. Teachers’ Private Capital (TPC), the group responsible for private equity and other private investments, was one of the first to codify ESG analysis into its investment decision process. ESG issues were systematically identified and evaluated during due diligence to enhance TPC’s risk identification process and better determine whether to invest in a company. Once a company had been acquired, TPC incorporated ESG issues into its oversight, made recommendations to management and monitored risks. By growing businesses in a more sustainable manner, TPC felt that its private equity investments were less likely to incur losses and might receive higher valuations when divested. Kozun recalled: We were evaluating the potential acquisition of a port operation in a developed country. During due diligence, we specifically looked at the impact of the port’s operations on the environment and the local community. We also analyzed the sustainability of revenue streams and learned that a large proportion of the port’s revenue came from coal shipments. Because we had a very long time horizon, we had to ask ourselves how sustainable coal was as an energy source and how likely a decrease in coal consumption would affect earnings. Based on that analysis, we were able to get a lot more comfortable with all the risks of investing in that business. Doing so allowed us to proactively address risks before they started to impact the economics of the deal. In contrast to TPC, the Public Equities Group (Public Equities) found more challenges when trying to account for ESG issues. First, available information was typically limited to public documents. Second, if concerns were identified, OTPP had far less influence on the company’s strategy. If important issues were overlooked, sizable losses could result as these investments were typically held for three to four years and involved the investment of several millions of dollars in a single stock. Moreover, efforts to incorporate ESG issues into valuation did not always appear to get the desired result, at least in the short term. Kozun explained: Last year, OTPP participated in an auction to acquire a large block of shares in an oil sands company. While evaluating the company and its operations, OTPP determined that that there was a risk that the tax rate applied to carbon emissions could increase within the investment horizon. As a result, the final bid reflected the value of the future cash flows minus a probability-weighted deduction for an increase in Alberta carbon taxes. OTPP did not win the auction. The winning investor, a Chinese oil company, significantly outbid the competition, perhaps signalling that it had a different view on the risk of carbon taxes. While quantifiable factors, such as forecasts for carbon taxes, could be included with reasonable ease, many other ESG issues were not easily measured, or had only a very small probability of occurring. Because the potential financial consequences were uncertain and the likelihood of occurrence was 47 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Formalizing efforts 9B14N020 difficult to predict, these types of risks were noted qualitatively in the financial analysis, but rarely quantified. Sikora summarized the problem: Many environmental and social risks can be so hard to quantify that you don’t generally apply a risk factor to them. Pricing-in a high impact, low probability event has always been a challenge for investments. It’s one of the things that stays under the radar until it happens. and it’s very hard to quantify those kinds of risks. Which investor could have predicted that BP would have such a catastrophic accident at its Deepwater Horizon oil rig? They had to pay $42 billion in fines and damages. Those sorts of risks aren’t priced into most stocks and that’s why the market reacts so swiftly when there’s an accident, particularly environmental, because it’s not in the market price before the catastrophe. Williams further elaborated about the challenges: Public Equities does not have the same access to information as TPC. We’re restricted to what’s publicly available, and there is also a big difference in control. With TPC, we can go in and make changes as the owner, but in Public Equities the choices are engage, vote or divest. This leads to a different discussion focused on what direction the company’s strategy is headed and how to incorporate the different issues either quantitatively or qualitatively. Still, at the end of the day, it’s a recommendation about when to buy or when to sell — and at what price. Based on the committee’s work, OTPP developed a hierarchy of ESG risks and opportunities (see Exhibit 2). While development continued on a more detailed framework on how to consider ESG issues, the committee provided one perspective to identify ESG issues and links to company performance (see Exhibit 3). THE CANADIAN OIL AND GAS INDUSTRY Production Canada ranked third in the world by oil reserves after Saudi Arabia and Venezuela. Of the country’s reserves of 174 billion barrels, 97 per cent were located in Alberta’s oil sands. Conventional drilling, where the oil was not mixed with sand, traditionally made up a large proportion of production. This situation was rapidly changing; by 2013, 1.8 million barrels of Canada’s 3.2 million barrels of daily production came from oil sands. 6 In Alberta, 20 per cent of the oil sands reserves were accessible through open pit mining. 7 The top layer of earth was removed to reveal “bitumen,” i.e., a mix of heavy oil, sand and clay. Bitumen was transported in large trucks to processing facilities, mixed with water and then processed at an upgrader to separate out the oil using heat and chemicals. From there the “synthetic” crude oil was transported to the refineries in western Canada and the United States. The by-product of upgrading was a mix of sand, clay, water, residual oil and residual separator chemicals, which was sent to an engineered dyke and dam system, termed a tailings pond. Once in the pond, the sand and clay would sink to the bottom, and some of the water was sent back to the processing facility to be re-used in the separation process again. The government mandated that at the end of a mine’s life, the site must be remediated back to its natural state. 6 7 Canadian Association of Petroleum Producers, “Crude Oil Forecast, Markets & Transportation,” June 2013, pp. 2, 15. Ibid., p. 5. 48 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Page 4 9B14N020 The other 80 per cent of Alberta’s oil sands reserves were too deep for open pit mining and were accessed by drilling “in situ.” Wells were drilled in pairs, first vertically and then horizontally, into reservoirs far below the surface. Steam was piped into the reservoirs, which softened the bitumen and enabled it to flow back up to the surface. Steam generation required a great amount of water and natural gas. Fortunately, improvements in technology had greatly reduced fresh water use, and typically 90 to 95 per cent of the water was separated and recycled. 8 This was important because in certain regions the Alberta government had capped the amount of fresh water that could be taken from lakes and rivers. Transportation Unlike many oil-producing locations, Alberta did not have access to a nearby port for shipping to international markets. To get to the coast, oil had to be transported significant distances, either over the Rocky Mountains (roughly 1,200 kilometres) or to either the St. Lawrence River or the Gulf Coast (roughly 3,500 kilometres each). The transportation challenge was further compounded by the fact that bitumen in its raw form was heavy and viscous. Producers added a diluent so that it could flow through pipelines, but this added an incremental cost to production that was not always fully recovered. Thus, oil extracted in Alberta was largely landlocked within North America, beholden to one main buyer (the United States) and unable to access the premium pricing afforded by international markets. Four major pipelines moved crude out of the Western Canadian Sedimentary Basin (WCSB). Canada was the largest oil exporter to the United States, with daily exports of approximately 2.4 million barrels per day. Canada’s oil exports to the United States were predominantly shipped to refineries in the U.S. midcontinent (see Exhibit 4). Growth in transportation capacity had lagged growth in production, and this, combined with the recent increase in U.S. oil production from fracking technologies, created a glut of supply to refineries in the midcontinent. Without the ability to transport the oil to world markets, or even the U.S. Gulf Coast, the oversupply of West Canadian Select (WCS) caused the price to be bid down. Sikora felt that the quality and transportation costs (the “differential”) was just $15 to $20 relative to the West Texas Intermediate [WTI] benchmark on a long-run normalized basis, but recently the spread had been as wide as $36 (see Exhibit 5). To make up for the shortage in pipeline capacity, rail had become a flexible, albeit more expensive, substitute for transportation. To meet demand, leasing companies and refiners invested in terminals and rail cars, and at the end of 2012, daily exports to the United States by rail reached 120,000 barrels per day. However, this was not without huge risks. In 2013, a train carrying crude oil to east coast refineries derailed in the Quebec town of Lac-Mégantic, and the resulting horrific explosion killed 47 people. As might be expected, the resulting intense public and political scrutiny resulted in increased regulation. Four major pipeline projects were in the approval process to relieve the bottleneck out of Alberta. Keystone XL was one of the largest, with the earliest projected in-service date. If completed, it would open up a new market by adding 830,000 barrels per day of capacity to transport crude oil from Alberta to refineries on the U.S. Gulf Coast. Keystone XL was also the most politicized of the four. The nature of the project required presidential approval, and a large number of groups were strongly opposed. They protested the potential environmental damage of pipeline leaks and accelerated climate change based on the expectation that added transportation capacity would accelerate the development of the oil sands. And the linkage to climate change stemmed from the greenhouse gas intensity of extraction and upgrading, which were estimated to be 3.2 to 4.5 times more intensive per barrel than conventional crude. 9 The 8 9 Canadian Association of Petroleum Producers, “Water Use in Canada’s Oil Sands,” June 2012, p. 1. Pembina Institute, www.pembina.org/oil-sands/os101/climate, accessed March 27, 2013. 49 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Page 5 9B14N020 approval of Keystone XL had been pushed back several times, and U.S. President Barack Obama had expressed his opinion on it several months earlier: Allowing the Keystone pipeline to be built requires a finding that doing so would be in our nation’s interest. And our national interest will be served only if this project does not significantly exacerbate the problem of carbon pollution. The net effects of the pipeline’s impact on our climate will be absolutely critical to determining whether this project is allowed to go forward. 10 This proposed pipeline was just one of several, and exemplified issues that cut across the entire oil sands industry. Without new pipelines, production could soon exceed transportation capacity (see Exhibit 6). INVESTMENT ALTERNATIVES The first equity investment was Enbridge Inc. (Enbridge), a pipeline company that transported oil and gas across North America. Enbridge offered an attractive dividend yield with a large portfolio of capital expansion projects that were positioned to take advantage of excess demand for pipelines. One of its major projects, the Northern Gateway pipeline, faced stiff opposition that derived, in part, from weaknesses in Enbridge’s environmental performance. The second equity investment was Canadian Natural Resources Ltd. (CNRL), a western Canadian oil exploration and production company. Despite quality assets and growth, its shares were trading at a discount relative to competitors, largely due to its ongoing exposure to volatile WCS pricing. Another contributing factor appeared to be recent significant one-time expenses related to major environmental and social problems. ENBRIDGE INC. Enbridge (TSX: ENB, market capitalization $39 billion) was a diversified energy infrastructure company focused on oil and gas transportation in Canada and the United States. Enbridge owned the world’s longest crude oil transportation system running from Alberta to the Gulf Coast in Texas. The company also owned Canada’s largest natural gas distribution company, as well as interests in close to 1,300 megawatts of renewable and alternative energy assets in wind, solar and geothermal energy. Transportation rates for pipelines were set or tightly monitored by regulatory bodies. Once built, pipelines typically required limited maintenance capital expenditures, and the cash flows were very predictable. Enbridge traditionally returned 60 per cent to 70 per cent of its earnings to shareholders in dividends. With demand for pipeline transportation expected to exceed capacity in western Canada, Enbridge had positioned itself with Cdn$36 billion in expansion projects planned for the next four years. Funding had already been secured for a majority of the projects, with approximately 30 per cent coming from shareholder equity. However, obtaining the necessary approvals was a process fraught with unpredictability, and delays could easily stretch the timeline by one to two years, or more. With expected return on equity (ROE) ranging from 10 per cent to 15 per cent, delays in capital projects could have a material impact on forecast earnings per share (EPS). 10 President Barack Obama, June 25, 2013, www.whitehouse.gov/the-press-office/2013/06/25/remarks-president-climatechange, accessed August 12, 2014. 50 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Page 6 9B14N020 The proposed Northern Gateway pipeline was the most controversial of Enbridge’s capital expansion projects. Following a very different route than TransCanada’s Keystone XL project, the 36-inch diameter pipe would link central Alberta, near the oil sands, to the west coast of Canada, at Kitimat, British Columbia. Doing so created access for tanker ships to transport WCS to refineries around the world. The Northern Gateway would add approximately 525,000 barrels per day of highly desired capacity for producers at a cost of $6.5 billion. The pipeline crossed environmentally sensitive areas and was strongly opposed by many groups, who pointed to Enbridge’s history of inland oil spills. In 2013, the B.C. provincial government formally rejected the proposal, stating that Enbridge had not yet shown its ability to provide world-class spill response capability. A parallel review by a Joint Review Panel, established by the Canadian National Energy Board and the federal Ministry of the Environment, recommended the federal government approve the project subject to 209 required conditions ranging from the thickness of the pipe to investments in oil spill research in local universities. The panel did not address issues related to First Nations groups, many of whom opposed the pipeline. If it were eventually approved, some research analysts felt that the pipeline would begin full operations in 2020. Environmental Issues In July 2010, Enbridge’s 6B pipeline in Michigan ruptured. Due to poor detection capabilities, the control room in Edmonton pumped oil through the pipe for 17 hours before finally shutting it down. Approximately 20,000 barrels of oil were spilled, making it the largest on-shore spill in U.S. history. Some of the oil ended up in waterways, requiring large sections of rivers to be cleaned or dredged entirely. Total cleanup costs have exceeded $1 billion so far, with some river cleanup work still ongoing. 11 Because the specific pipeline was only partially owned through Enbridge’s interest in Enbridge Energy Partners (NYSE: EEP), Enbridge’s earnings were not significantly impacted. Enbridge has been responsible for eight major oil spills, each over 1,000 barrels, from 2010 to 2013 and had 80 spills in 2010 alone. 12 In some instances, Enbridge’s aging network had been deemed to be a contributing factor. Some reports indicated that Enbridge knew the integrity of the pipeline was compromised but failed to act. As a result, some sections of pipelines were running at reduced pressure. The financial and reputation consequences of its spill history led Enbridge to launch its Operational Risk Management Plan in 2011, which increased spending on system integrity and environmental and safety programs. It also replaced large sections of its older pipelines. With improvements ongoing, the company was confident that these efforts would translate into improved operational performance. Investment Thesis Enbridge traded at a premium multiple to its peers but offered both a good dividend yield with very little risk of fluctuations and an attractive EPS growth profile supported by a strong pipeline of development projects. 11 12 Sustainalytics, “Enbridge Inc. ESG Report,” September 29, 2013, p. 14. Enbridge Inc., “Enbridge 2012 Corporate Social Responsibility Report,” p. 69. 51 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Page 7 Page 8 9B14N020 Because of their highly predictable cash flows, pipeline companies were frequently traded on the basis of their dividend yield. Using a 3 per cent target yield and the expected 2014 dividend of $1.40, Cheng estimated the value of Enbridge’s stock to be in the range of $47. Currently, it was trading at $46, but with so many capital projects expected to come online in the future, the dividend was likely to grow. Based on existing assets and development projects, and a 70 per cent dividend payout ratio Cheng came up with the projections and valuation shown in Exhibit 7. Cheng noted that the earnings estimates included most announced new projects. While near-term projects were probably already under construction, longer term projects were still seeking approval. Using the expected ROE and 831 million shares outstanding, Cheng could adjust his expectations for future earnings and dividends as he got more clarity on the timing and scale of those new projects. He also noted that while Northern Gateway was not included in his valuation since there were still great uncertainties around it, it could potentially be worth as much as $4.00 per share, if approved. Cheng felt that there was a 50 per cent chance that the project would be approved in its current form. An improved spill record on Enbridge’s other pipelines, or additional investments in safety of the proposed pipeline, could increase the probability of approval to 70 per cent. CANADIAN NATIONAL RESOURCES CNRL (TSX: CNQ, Market Capitalization C$39B) was a Canadian energy company focused on oil and gas exploration, development, production and marketing primarily in western Canada. It was the largest heavy oil producer in Canada and owner of the Horizon Oil Sands Project (Horizon). In addition to Horizon, it owned several large in-situ and natural gas projects in western Canada and several international production sites. The company’s operations generated more than 100 kilotons of CO 2 annually and were subject to Alberta’s greenhouse gas reduction regulations. Horizon, situated in northern Alberta, was a large mine that accessed 3.35 billion barrels of potential resources. It produced up to 112,000 barrels per day with Phase 2 and 3 expansions expected to increase capacity up to 250,000 barrels per day. Future expansions could further increase production to 500,000 barrels per day by the end of the decade.13 North American non-oil sands mining projects included both conventional projects as well as in-situ projects in Alberta and British Columbia. These operations produced approximately 366,000 barrels per day and production was expected to increase to about 487,000 barrels per day by 2020. Health and Safety Issues In 2007, two workers were killed in a construction accident. Police laid 29 charges against CNRL, but the charges were eventually stayed. The contractor pleaded guilty to three charges and was fined US$1.5 million, the largest workplace safety penalty in Alberta history. In the winter of 2011, a fire broke out at Horizon’s primary upgrader when hot bitumen in the midst of upgrading spilled out and ignited. Massive damage to the building and equipment resulted, and five workers were injured. Production was shut down for seven months. Severe cold weather made it difficult 13 Canadian Natural Resources, “2012 Annual Report,” p. 6. 52 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Valuation 9B14N020 to even access the damaged areas initially. In total, repairs to the building and equipment cost $726 million, and capacity utilization rates remained far below 90 per cent for several years. 14 CNRL Stewardship Report highlights are in Exhibit 8. Environmental Issues In 2009, four sites at the company’s Primrose in-situ property started leaking bitumen into nearby forests and ponds. (Primrose production accounted for approximately 16 per cent of the company’s total production.) The injection of high-pressure steam had driven bitumen to the surface following a path outside the intended well. Operations in the area were immediately shut down for six months, after which diagnostic steaming was finally approved by regulators. The company’s incident report stated that the oil likely reached the surface though old wells that had not been closed properly. However, regulators found CNRL’s report inconclusive and noted that the protective cap rock that prevented the oil from rising to the surface might have been fractured. By November 2013, a total of 7,300 barrels of bitumen had seeped to the surface, leaving 27 birds, 23 small mammals and 71 frogs dead. The cleanup to date had cost the company Cdn$40 million. 15 Recently, production had returned to approximately 110,000 barrels per day. Regulators still closely controlled steam levels, and the area continued to be closely monitored for new leaks. Investment Thesis CNRL traded at a relative discount to North American oil and gas competitors on a price-multiple basis. Sikora felt that the earnings potential of CNRL’s assets did not warrant such a steep discount. He concluded that CNRL would be a good investment for OTPP on the expectation that the share price would increase as pipeline and other transportation constraints eased, reducing bottlenecks and tightening differentials. Specifically, CNRL offered OTPP significant upside through its leverage to rising and more stable WCS pricing. Either increased global oil prices, or a smaller differential, would greatly increase CNRL’s earnings. Valuation Sikora favoured the discounted cash flow approach to valuing oil exploration and production companies like CNRL. This approach required him to first develop his own projections of the company’s financials and then present value using a discount rate and perpetual growth rate. Sikora started by forecasting the company’s oil and gas production and then multiplied this figure by his expected realized price, which was based on the major Alberta oil benchmark, WCS, and adjusted for differences in quality. He was conscious that the price of WCS was influenced significantly by world prices as well as a quality and transportation differential, so he modelled WCS as a spread below WTI. In addition, Sikora made some company-specific adjustments from WCS to reflect CNRL’s specific crude quality. (Refineries typically paid a higher or lower price depending on the sulfur content, viscosity [API] and several other factors.) Once he had calculated total revenue, he deducted royalties, operational costs 14 Sustainalytics, “Canadian Natural Resources ESG Report,” January 28, 2014. “Media-shy Canadian Natural Resources Speaks Up After Bitumen Seepage near Cold Lake,” Alberta Oil Magazine, November 6, 2013. 15 53 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Page 9 9B14N020 including transportation, management expenses, cash taxes and anticipated capital expenditures to arrive at free cash flow. Some key assumptions to his projections were: • • • • Production at Primrose would average 110,000 barrels per day. Although past production had been as high as 120,000, Sikora felt that production issues required some downward adjustment. Production at Horizon beyond 2018 could be 90 per cent of the nameplate capacity of 250,000 barrels per day. However, historical levels following accidents suggested that 80 per cent was more likely. Alberta carbon taxes would remain at $15 per ton. (Europe was at $100 per ton.) Average greenhouse gas intensity was about 0.078 tonnes of CO 2 per barrel of oil-equivalent (BOE). The risk-weighted differential between WTI and WCS would be 20 per cent, but with expanded pipeline capacity could be as low as 17 per cent. Without added capacity, it could widen to 30 per cent. To calculate the value per share, Sikora took the present value of the free cash flows from 2014 to 2020 using a discount rate of 10 per cent. To calculate the terminal value, he multiplied the last year’s cash flow by a perpetual growth rate of 2 per cent and then divided that amount by the difference between the discount rate and the perpetual growth rate. This valued CNRL at $52 per share when the stock was trading publicly at $36 per share. Highlights to the projections and valuation are presented in Exhibit 9. EXTERNAL RATINGS OTPP subscribed to an external data and rating company that provided ESG rankings and scores for large publicly traded companies. Data was collected primarily through public sources and direct inquiries. CNRL was ranked 31 among 78 oil and gas producing companies. Enbridge was ranked six among 20 refining and pipeline companies (see Exhibit 10). Sikora was unsure how to best incorporate this information into the valuation for either company. OTHER CONSIDERATIONS Kozun wondered how he would best explain such investments to the teachers’ unions should questions arise during the next annual general meeting. After all, it was their money that he was stewarding. He explained the complexity of the challenges: There are some who feel that our job is to generate the highest return possible and then let the teachers do whatever they want with their pension. This can be problematic if, for example, we invested in a weapons company and there was a terrible event like a shooting. The fact that OTPP owns a large stake could create huge problems for our reputation. As a separate example, there may be pensioners who feel an old pulp and paper mill should be shut down based on the amount of air pollution it creates. They may feel that their retirement savings should not be used to perpetuate environmental damage. But then what about the teachers in those small towns that depend on the mills? Their students are likely the kids of parents employed at the mills. Their view of responsible investing and sustainability would be very different than someone from a major city. 54 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Page 10 Page 11 9B14N020 As Kozun discussed the analysis with Sikora and Cheng, he recognized that there weren’t obvious answers to his many questions. Each alternative had attractive risk-reward profiles before adjustments for ESG issues. OTPP had to be comfortable with the risks inherent to each company, but the lost auction opportunity from last year still lingered in his mind, and he wondered what magnitude of adjustments were appropriate. 55 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. MOVING FORWARD Page 12 9B14N020 Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes. • Address ESG issues in investment policy statements • Support development of ESG-related tools, metrics, and analyses • Assess the capabilities of internal investment managers to incorporate ESG issues • Assess the capabilities of external investment managers to incorporate ESG issues • Ask investment service providers (such as financial analysts, consultants, brokers, research firms, or rating companies) to integrate ESG factors into evolving research and analysis • Encourage academic and other research on this theme • Advocate ESG training for investment professionals Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices. • Develop and disclose an active ownership policy consistent with the Principles • Exercise voting rights or monitor compliance with voting policy (if outsourced) • Develop an engagement capability (either directly or through outsourcing) • Participate in the development of policy, regulation, and standard setting (such as promoting and protecting shareholder rights) • File shareholder resolutions consistent with long-term ESG considerations • Engage with companies on ESG issues • Participate in collaborative engagement initiatives • Ask investment managers to undertake and report on ESG-related engagement Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.• Ask for standardized reporting on ESG issues (using tools such as the Global Reporting Initiative) • Ask for ESG issues to be integrated within annual financial reports • Ask for information from companies regarding adoption of/adherence to relevant norms, standards, codes of conduct or international initiatives (such as the UN Global Compact) • Support shareholder initiatives and resolutions promoting ESG disclosure Principle 4: We will promote acceptance and implementation of the Principles within the investment industry. • Include Principles-related requirements in requests for proposals (RFPs) • Align investment mandates, monitoring procedures, performance indicators and incentive structures accordingly (for example, ensure investment management processes reflect long-term time horizons when appropriate) • Communicate ESG expectations to investment service providers • Revisit relationships with service providers that fail to meet ESG expectations • Support the development of tools for benchmarking ESG integration • Support regulatory or policy developments that enable implementation of the Principles Principle 5: We will work together to enhance our effectiveness in implementing the Principles.• Support/participate in networks and information platforms to share tools, pool resources, and make use of investor reporting as a source of learning • Collectively address relevant emerging issues • Develop or support appropriate collaborative initiatives Principle 6: We will each report on our activities and progress towards implementing the Principles.• Disclose how ESG issues are integrated within investment practices • Disclose active ownership activities (voting, engagement, and/or policy dialogue) • Disclose what is required from service providers in relation to the Principles • Communicate with beneficiaries about ESG issues and the Principles • Report on progress and/or achievements relating to the Principles using a ‘Comply or Explain’1 approach • Seek to determine the impact of the Principles • Make use of reporting to raise awareness among a broader group of stakeholders Source: United Nations Principals for Responsible Investing, www.unpri.org/about-pri/the-six-principles/, accessed August 12, 2014. 56 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. EXHIBIT 1: THE PRINCIPLES FOR RESPONSIBLE INVESTMENT AND POSSIBLE ACTIONS EXHIBIT 2: OVERARCHING PRINCIPLES AND GUIDELINES: ENVIRONMENT, SOCIAL AND GOVERNANCE (ESG) ISSUES AND BUSINESS Source: Ontario Teachers’ Pension Plan 2014. 57 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Page 13 9B14N020 9B14N020 EXHIBIT 3: FRAMEWORK FOR THE BUSINESS CASE: ENVIRONMENT, SOCIAL AND GOVERNANCE (ESG) ISSUES Community Products Social Employees Environmental Activity Governance Illustrative Financial Impact Creation and treatment of waste products and pollutants Avoid or minimize environmental liabilities Climate change Lower costs/increase profitability through efficiencies, particularly energy Environmental disclosure Evidence of well-governed company, attentive to regulatory and reputational risks Diversity Innovation through openness to new and wider ranging ideas Health and safety Improved productivity and morale, lower downtime Labour-management relations Reduce turnover and absenteeism Human rights Reduce potential for litigation and reputational risks Safety Reduce potential for litigation and reputational risks Quality Creates brand loyalty Community relationships Protect license to operate Responsible lending Improve brand loyalty Practices and performance Aligns interests of shareholders and management Reporting and disclosure Reduces reputational risks Source: Adapted From PAX World as cited in Lisa A. Cohen, “Responsible Investing, Redux,” Registered Rep 34.1, 2010, pp. 65–66. 58 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Page 14 9B14N020 EXHIBIT 4: CANADA AND U.S. CRUDE OIL DEMAND BY MARKET REGION (THOUSANDS OF BARRELS PER DAY) Source: Canadian Association of Petroleum Producers, June 2013.Used with permission. EXHIBIT 5: CRUDE OIL PRICE DIFFERENTIAL – WEST TEXAS INTERMEDIATE VERSUS CANADIAN WESTERN SELECT Western Texas Intermediate Vs. Western Canadian Select 120.00 60% 100.00 50% 80.00 40% 60.00 30% 40.00 20% 20.00 10% 12/31/2008 12/31/2009 % Difference (RHS) 12/31/2010 12/31/2011 WCS Last Price (LHS) Source: Data from Bloomberg. 59 12/31/2012 0% 12/31/2013 WTI Last Price (LHS) For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Page 15 9B14N020 EXHIBIT 6: WESTERN CANADIAN SELECT BASIN TAKEAWAY CAPACITY VERSUS SUPPLY FORECAST Source: Canadian Association of Petroleum Producers, June 2013. Used with permission. EXHIBIT 7: DIVIDEND YIELD BASED VALUATION Dividend Yield Based Valuation Projected Earnings Per Share Dividend Payout Ratio Expected Dividend per Share Dividend Yield Expected Value Per Share 2014E 2015E 2016E 2017E 2018E $ 1.94 $ 2.23 $ 2.48 $ 2.75 $ 3.05 72% 70% 70% 70% 70% $ 1.40 $ 1.56 $ 1.73 $ 1.92 $ 2.13 3.0% 3.0% 3.0% 3.0% 3.0% $ 46.67 $ 52.03 $ 57.76 $ 64.11 $ 71.16 Note: 2014 based on management guidance Source: Created by case writer. 60 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Page 16 Page 17 9B14N020 Health and Safety Recordable injury frequency (per 200,000 hours) Fatalities (employees + contractors) 2009 1.00 0 Environment Water withdrawal (meters cubed) Total North American exploration and production 15,499,725 Total Horizon oil sands 13,190,289 Spills Total number of reportable spills 288 Total volume spilled (meters cubed) 5,791 Number of spills and leaks / production (per million BOE) North America exploration and production 1.6 Horizon oil sands mining 1.1 Volume of spills and leaks / production (meters cubed per million BOE) North America exploration and production 23 Horizon oil sands mining 110 Number of leaks per 1000 km pipeline Air and GHG emissions Direct GHG emissions (million tonnes) North America exploration and production Horizon oil sands mining International exploration and production Direct GHG emissions intensity (Tonnes CO2e/BOE) North America exploration and production Horizon oil sands mining International exploration and production Source: Adapted from CNRL Stewardship Report. 61 2010 0.92 1 2011 0.82 0 2012 0.78 1 15,895,385 20,962,823 16,378,970 10,624,961 17,899,600 24,056,019 299 3,500 364 4,339 446 23,327 1.6 0.5 1.9 1.0 1.9 2.6 14 33 21 33 24 592 1.8 1.7 2.0 2.0 11.05 2.59 1.79 11.31 2.99 2.16 11.16 1.65 2.03 12.93 3.64 1.75 0.0674 0.141 0.0466 0.0652 0.0901 0.0631 0.061 0.112 0.068 0.0671 0.115 0.0914 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. EXHIBIT 8: CANADIAN NATIONAL RESOURCES: STEWARDSHIP REPORT HIGHLIGHTS 9B14N020 EXHIBIT 9: CANADIAN NATURAL RESOURCES LTD. – SIKORA’S PROJECTIONS, FINANCIAL FORECAST AND VALUATION Production Forecast Horizon (000's barrels /day) Thermal Bitumen (000's barrels /day) Other Canadian (000's barrels /day) International (000's barrels /day) 2011A 40 98 197 53 2012A 86 100 227 38 2013E 100 99 251 34 2014E 105 128 269 36 2015E 114 155 273 45 2016E 143 161 281 50 2017E 173 177 286 53 2018E 225 192 284 50 2019E 225 196 279 45 2020E 225 213 274 41 Total Oil Production (000's barrels /day) 389 452 484 538 587 635 690 751 745 753 1,257 1,220 1,157 1,152 1,090 1,106 1,083 1,095 1,107 1,120 Total Natural Gas Production (mmcf/day) Commodity Assumptions West Texas Intermediate (US$/barrel) Less: Differential % CAD/US Exchange Rate Western Canadian Select (C$/barrel) Less: CNRL Quality Adjustment % Average Realized Oil Price (C$/barrel) $ $ $ Average Realized Natural Gas Price (C$/barrel) 2011A 95.12 $ -18% 1.01 77.23 $ -17% 64.15 $ 2012A 94.18 $ -24% 0.98 73.06 $ -4% 70.49 $ 2013E 98.37 $ -25% 0.94 78.29 $ -7% 72.46 $ 2014E 95.38 $ -20% 0.90 84.78 $ -6% 79.70 $ 2015E 95.00 $ -20% 0.90 84.44 $ -6% 79.38 $ 2016E 93.50 $ -20% 0.90 83.11 $ -6% 78.12 $ 2017E 94.50 $ -20% 0.90 84.00 $ -6% 78.96 $ 2018E 95.50 $ -20% 0.90 84.89 $ -6% 79.80 $ 2019E 97.00 $ -20% 0.90 86.22 $ -6% 81.05 $ 2020E 99.00 -20% 0.90 88.00 -6% 82.72 3.73 2.43 3.19 3.78 4.43 4.16 4.64 4.86 5.07 5.07 2011E 9,103 4,689 2012E 11,624 2,965 2013E 12,793 3,691 2014E 15,641 4,355 2015E 17,010 4,829 2016E 18,107 4,601 2017E 19,883 5,025 2018E 21,882 5,322 2019E 22,039 5,612 2020E 22,726 5,678 13,792 14,589 16,484 19,996 (2,000) (6,199) (500) (800) 21,839 (2,184) (6,770) (546) (874) 22,708 (2,271) (7,040) (568) (908) 24,908 (2,491) (7,722) (623) (996) 27,204 (2,720) (8,433) (680) (1,088) 27,652 (2,765) (8,572) (691) (1,106) 28,405 (2,840) (8,805) (710) (1,136) 10,498 (7,900) 11,465 (8,600) 11,922 (8,700) 13,077 (8,600) 14,282 (7,000) 14,517 (7,000) 14,912 (8,200) 2,598 2,865 3,222 4,477 7,282 7,517 6,712 Operating Cash Flow Forecast ($millions) Total Oil Revenue Total Natural Gas Revenue Total Revenue Royalties Operating Costs Management & Administration Expenses Cash Taxes 10.0% 31.0% 2.5% 4.0% Cash Netbacks Capital Expenditures Free Cash Flow Discounted Free Cash Flow Valuation Weighted Average Cost of Capital Present Value of Free Cash Flows Terminal Value (2% terminal growth rate) 10.0% 22,417 43,917 Total Enterprise Value Net Debt 66,335 (10,000) Total Value of Equity # Shares Outstanding (millions) 56,335 1,086 Value per Share $ Source: Case writer estimates. 62 51.87 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Page 18 9B14N020 EXHIBIT 10: HIGHLIGHTS FROM EXTERNAL RATINGS OF ENVIRONMENT, SOCIAL AND GOVERNANCE Enbridge Canadian Natural Resources Raw Score (/100) Comments Area & Rank Item Environment Environmental Policy (Leader) Environmental Management System 100 Oil Spill Disclosure & Performance (Leader) 100 Operations Incidents (Laggard) 20 (Ranked 18/20) Social (Ranked 6/20) Governance Ranked 2/20 LITR Trend (Leader) Social & Community Incidents 100 100 50 Company has a strong and detailed environmental policy The company has a strong and detailed EMS Area & Rank Item Environment Environmental Policy (Ranked 20/78) The Company reports on the total volume of oil spills and shows that this volume has been reduced by more than 5% over the last 5 years Enbridge faced numerous substantial environmental issues, primarily pipeline spills. Most notably, the company was responsible for the largest onshore oil spill in US history. In addition the company has a large number of other pipeline spills with seven spills greater than 1,000 barrels since 2010 The company's lost-time incident rate has declined Community relations are viewed as negative, evidenced by the British Columbia's government's early public opposition to the Northern Gateway Pipeline. The company has also been the target of many protests from First Nations, environmental groups and local communities. These protests have impacted the company's regulatory approval process. Bribery & Corruption Policy (Leader) 75 The company has an adequate policy on bribery and corruption ESG Governance 100 Business Ethics Incidents (Leader) 99 A board member or a board committee is responsible for overseeing ESG issues No evidence of relevant controversies Social (Ranked 33/78) Governance Ranked 60/78 Environmental Management System Air Emissions Programs (Laggard) GHG Reduction Programs 63 25 80 25 25 Environmental Reporting 50 Oil Spill Disclosure & Performance (Leader) 100 Carbon Intensity 0 Human Rights Policy (Laggard) 20 Community Involvement Programs (Leader) Indigenous Rights Policy LITR Trend Employee Fatalities Society and Community Incidents 75 Bribery & Corruption Policy ESG Governance Business Ethics Incidents (Leader) Source: Data from Sustainalytics 2013. Raw Score (/100) Comments 0 Company has an environmental Policy but it is not very detailed The company has a relatively strong EMS that covers more than 10 core elements The company has a program to reduce air emissions but it applies to less than 50% of its operations The company has implemented a program to reduce GHG emissions but no evidence was found of quantitative targets or deadlines The company discloses some data but disclosure on some key environmental performance indicators is missing The Company reports on the total volume of oil spills and shows that this volume has been reduced by more than 5% over the last 5 years The Company's carbon emissions intensity is well above the industry average (over 2x) there is no evidence of a formal policy but the company has a general statement addressing this issue. The company has a program for community engagement The company does not have a policy 100 100 100 The company's lost-time incident rate has declined No fatalities have occurred in the last three years No evidence of relevant controversies 50 The company has a weak policy on bribery and corruption A board member or a board committee is responsible for overseeing ESG issues No evidence of relevant controversies 100 100 For use only in the course Finance, Ethics & Social Responsibility at University of Ottawa taught by Pouya Safi from September 01, 2020 to December 31, 2020. Use outside these parameters is a copyright violation. Page 19 
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