Faculty of law blogs / UNIVERSITY OF OXFORD

The imperative to mitigate climate change is leading even the largest polluters to start cleaning up their activities and green their strategies. When energy giants Shell, Total, and Eni sold their stake in the Umuechem oil field in Nigeria in 2021, that appeared to be a step consistent with that trend: the energy companies could clean up their operations, come a step closer to meeting their net zero targets, and obtain funds to invest in new, low-emission business lines. Shell, for example, has stated that ‘divestments are a key part of our efforts to refresh and upgrade our portfolio as we drive towards our target to become a net-zero emissions energy business by 2050’ (see here at 84). Unfortunately, one company’s step away from high-emitting activity can be another’s opportunity to double down. Immediately after its sale to a private-equity backed firm, Trans-Niger Oil & Gas, levels of flaring (the high-emission burning of excess gas released when pumping up oil) at the Umuechem oil field quadrupled and the acquirer announced its intention to rapidly triple oil production.

Far from being an outlier, this problematic fact pattern has become the norm as high-profile listed companies with business lines that emit high quantities of carbon are forced to respond to growing pressures to decarbonise. Even the carbon majors traditionally most bullish on oil have been forced by investors, particularly institutional investors who themselves feel the heat from asset owners like pension funds and sovereign wealth funds, to change their boards and amend their strategies in attempts to get them to reduce their carbon footprint. One of the most straightforward and quickest ways for firms to shrink corporate emissions and hit their climate-related targets is to divest high-emission assets, either by spinning them out into a new entity or by selling them. However, while this reduces the divesting firm’s emissions, it does not reduce overall emissions, as the dirty assets are just shifted from one firm to another. In fact, this may increase overall emissions if the newly-created entities or buyers—frequently operating in less intensely regulated and more opaque private markets—are less inclined to be concerned about climate change and do not experience the same pressures to decarbonise.

1. High-emission assets in the age of net zero

For large, publicly traded companies with high-emission businesses, society’s move towards net zero emissions to mitigate climate change creates a dilemma: they can double down on their current business strategy or evolve their business model away from high-emission activity towards lower-emission strategies. How that dilemma is resolved depends largely on the preferences of their shareholders. Traditional firm-value maximising shareholders who are otherwise indifferent about climate change may, given their exposure to the physical and transition risks (in particular, transition risk because of asset stranding) associated with a high-emission strategy, still support a firm’s decarbonisation agenda. But the push championed by these climate-indifferent shareholders may amount to too-little, too-late for those shareholders who are more climate-conscious—because they maximise portfolio value and thus internalise more of the costs of climate change, weigh climate risks and opportunities more highly than their peers, or have strong green preferences (so that their investment mandate may not even allow for investment in high-emission activities). Climate-conscious investors tend to prefer a more ambitious transition and to attach higher value to firms that act accordingly. They can express this preference, respectively, through voting and trading.

Accordingly, ESG activist investor pressure group Climate Action 100+ has singled out the highest-emitting public companies for special shareholder activism intended to bring about change in their business models to lower emissions. That view may have been strengthened by an International Energy Agency (IEA) 2021 report calling for an end to all new oil and gas exploration and investment if the world is to reach net zero emissions by 2050, which reinforced the perceived risk of stranded fossil fuel assets. Where shareholder engagement produces insufficiently ambitious results, climate-conscious shareholders and activists have resorted to legal action. In 2021, Shell was forced by a Dutch ruling to cut its absolute emissions far more rapidly than the company had planned. Believing that Shell has not done enough to prepare for the energy transition, environmental group ClientEarth is now also taking the first steps in legal action against Shell’s board members.

Even against the backdrop of such heterogeneous shareholder preferences around how to respond to climate change, managers are still made responsive to the wishes of investors through compensation and voting. Regulation, especially the increasingly stringent climate-related disclosure requirements applying to public companies (in the EU: the Non-Financial Reporting Directive) and their investors (in the EU: the Sustainable Finance Disclosure Regulation), has strengthened those mechanisms in the context of climate change by increasing transparency. When climate-conscious investors gain the upper hand, we can therefore expect managers to act accordingly. This may involve declaring a ‘net zero’ target for the company, and perhaps even making a credible commitment to living up to that ambition. The UN-backed ‘Race to Zero’ campaign estimates that non-state net zero targets, including those by companies, now cover nearly 25% of emissions and over 50% of global GDP.

A quick way to make progress towards net zero targets is to dispose of a business’ highest-emission assets (‘dirty assets’) such as polluting wells, coal-burning plants, and coal mines. Corporate law facilitates such disposals: asset partitioning allows for the segregation of clean and dirty assets by allocating them to separate entities. Such ‘climate-driven asset partitioning’ can be achieved by hiving down the ‘dirty’ assets into one or more separate entities, which can either be spun off into a new organisation or sold to a third party. The value thesis here is the same as behind conglomerate demergers. The newly clean company (call it Green) will attract higher valuations from climate-conscious investors. By the same token, those climate-conscious investors would discount the value of the dirty-asset entity (call it Dirty) resulting from the spin-off. But climate-indifferent investors, who regard Green as over-valued relative to fundamentals—because of the premium accorded by climate-conscious investors—now see Dirty as cheap relative to fundamentals. So here, asset partitioning performs the function of allowing different classes of investors to specialize in their investment assets, and thereby increase aggregate valuations. Since both Green and Dirty now have more homogenous shareholder bases, they are also able to pursue climate strategies that are better aligned with their shareholders’ preferences and unlock more value.

By increasing the combined valuation of the stock of both Green and Dirty, climate-driven asset partitioning thus appears to unlock gains from trade that appeal to corporate managers (who are motivated by stock price compensation) as well as climate-conscious investors and climate-indifferent investors (both benefiting from a higher valuation). It looks like a win-win-win, and therefore seemingly a no-brainer for the decision-makers involved. It should thus be unsurprising that, concomitant with a rising influence of climate-conscious investors in public companies, we have seen a rapid rise in climate-driven asset partitioning. ExxonMobil and Chevron in the US and BP, Shell, Total, and Eni in Europe have reportedly sold off $28.1bn in assets since 2018 alone, with the total value of oil and gas assets up for sale across the industry standing at more than $140bn.

2. Dark and dirty assets

The win-win-win character of such transactions should be viewed with scepticism by the green investor base, however. Investors motivated by green preferences, in particular, should pause and reflect on the distinction between greening a firm or even a portfolio on the one hand and greening the planet on the other. Not only does shifting high-emitting assets to a different entity by itself achieve no climate mitigation benefit whatsoever, but it may make matters worse from a planetary perspective if there are no safeguards in place on how these dirty assets will be used going forward.

High-emitting public companies (particularly oil, gas, and mining companies), which are comparatively easy to scrutinise because of the more stringent regulatory and disclosure obligations that apply to them, are facing the brunt of the investor and activist pressure to decarbonise. But ultimately, these companies only make up a relatively small subset of the overall energy system. The IEA estimates that oil majors, for example, only account for 12% of oil and gas reserves, 15% of production, and 10% of estimated emissions from industry operations. That leaves the vast majority of the energy system dominated by state-owned enterprises and privately held companies. By and large, these are the types of entities that buy the dirty assets.

Depending on the jurisdiction, buyers might be privately held firms backed by private equity groups (as was the case when Austria’s OMW sold its assets in 2016 to Siccar Point, backed by private equity groups Blackstone and Bluewater), local energy groups (Shell sold a stake in an offshore gas field in the Philippines to a subsidiary of domestic conglomerate Udenna Group), or state-owned enterprises (BP sold its 20% stake in an Oman gas block to Thailand’s PTT).

These buyers appear to be less concerned about climate change than the sellers and have weaker incentives to reduce emissions. A report by the Environmental Defense Fund concluded that assets tend to move ‘from industry leaders on the energy transition to industry laggards’. The report highlighted that buyers are less likely to have any emissions targets (and those that do tend to be less ambitious) and tend to be strategically committed to ramping up fossil fuel production for as long as possible. Because these buyers are not active in public markets, they are not subject to the same stringent disclosure requirements as the sellers of the dirty assets. Moreover, the logic of the investment thesis dictates that Dirty firms’ investors will be climate-indifferent, meaning that these firms’ activities move beyond the reach of climate-conscious investors to push for lower ongoing emissions.  These dirty assets, in other words, move to the dark corners of the market, shielding the polluting entities from scrutiny and providing a more ‘comfortable’ environment for climate-indifferent investors to pursue their preferred strategy.

Perhaps unsurprisingly, following an asset disposal, emissions associated with the dirty assets do indeed frequently rise. Thungela, the South African coal business spun off by Anglo American with a view to eventual closure of the mines, has instead rapidly increased its output since it began trading as a stand-alone business. Acquisitions of dirty assets follow the same pattern. Hilcorp, a privately held company backed by private equity giant Carlyle, has become the largest known methane emitter in the US after it bought ageing assets from ConocoPhillips and BP. Its methane emissions intensity was almost six times higher than the average of the top 30 producers in the US. After the oil and gas driller Apache sold about 2,100 oil wells in the Permian Basin to a little-known operating company, Slant Energy, the plug rate of the inactive wells (the rate at which inactive, leaking wells are plugged to prevent methane emissions) dropped dramatically. Under Apache, it would have taken nine years to finish plugging the backlog of inactive wells; at Slant Energy's pace, it will take 120 years.

(Even) more cynical examples involve transferring the ‘dirty’ assets to an underfunded entity which is spun off, squeezed for its remaining profits, and then allowed to go bankrupt without sufficient assets to cover environmental liabilities. This practice, documented by Joshua Macey and Jackson Salovaara in the US context, is particularly common with oil and gas wells and other assets nearing the end of their lifetime, which are then bought by operators without the intent or resources to invest in clean-up work. Creative use of accounting methods, designed to push clean-up costs far into the future by claiming the wells remain productive for decades to come, help enable this practice: Diversified, a London-based operator that has bought up ageing wells to become the largest owner of oil and gas wells in the US, allegedly operates on this basis. 

The upshot of this is that while climate-driven asset partitioning works to lower firm-level emissions in the company that disposes of assets and to increase firm-level valuations in that company and the asset acquiror, it simultaneously serves to increase global emissions.

3. Fixing climate-driven asset partitioning

The unintended consequences of climate-driven asset partitioning point to a crucial flaw in the strategies adopted by climate-conscious investors and regulators. Their focus, in evaluating the desirability or climate-friendliness of climate-driven asset partitioning, is too often narrowly on firm-level or portfolio-level emissions rather than on reducing emissions as such.

Unhelpfully, regulation strengthens this tendency and helps make it systemic. The EU’s Sustainable Finance Taxonomy Regulation (the ‘Taxonomy’), for example, requires issuers to specify what share of their economic activities can be considered ‘sustainable’. Spinning off dirty assets to a separate legal entity would, under this regulation, be a workable approach to improve a firm’s green credentials.

Similarly, investors who are looking to obtain an EU ‘green label’ under the Sustainable Finance Disclosure Regulation (SFDR) (designated as an ‘Article 8’ or ‘Article 9’ fund) would likely see their claims to qualify as ‘green’ strengthened rather than weakened by such spin-offs by portfolio companies. Under the final regulatory technical standards, for example, the ‘adverse sustainability indicators’ that fund managers should control for include metrics like carbon emissions, carbon footprint, share of investments in companies active in the fossil fuel sector, and other indicators that come to be reduced through dirty asset partitioning. All of these indicators are defined in terms of the activities of the portfolio companies. None of them therefore captures the adverse consequences that dirty asset partitioning triggers. Similarly, funds that have emissions reductions in their objective are required to have an objective of ‘low carbon emission exposure’ under Art 9(3), which focuses on emissions associated with portfolio companies.

Moreover, it is doubtful how far the EU’s non-financial reporting framework covers potential buyers of dirty assets in climate-driven asset partitioning transactions. The current Non-Financial Reporting Directive applies only to ‘large public-interest undertakings’. ‘Large’ undertakings for these purposes have 500 employees or more and a balance sheet total exceeding €20m or turnover exceeding €40m. ‘Public interest’ undertakings are listed companies, financial institutions, or otherwise designated as public-interest entities. The proposed Corporate Sustainability Reporting Directive will extend the scope to include all large undertakings and all small and medium-sized public interest undertakings. But this will still exclude many private companies; moreover the costs associated with reporting emissions from dirty assets may themselves spur further climate-driven asset partitioning: dirty assets remaining ‘dark’ without the sunlight of disclosure.

To fix climate-driven asset partitioning, climate-conscious investors and regulators need to widen their lens to consider the real impacts on climate mitigation associated with the asset partitioning. For investors, this means thinking about the aggregate emissions consequences of spin-outs or sales by portfolio companies, as well as the emissions of those companies themselves. This should then inform conditionality in these investors’ approval of such transactions. In the UK, the Class 1 transactions rules require a shareholder vote for significant transactions by firms with a premium listing. In the US, under standard background rules of corporate law, a sale of only a fraction of corporate assets will rarely trigger a shareholder vote, so climate-conscious investors will need to push for a charter amendment to trigger a vote if assets involving significant emissions are to be transferred. 

What of the conditions themselves? A sensible baseline would be to impose restrictions on the use of dirty assets in the hands of a buyer that match the ambition of the seller’s transition commitments. This removes any opportunities for climate commitment arbitrage through asset transfers. Where the buyer is an existing company, these restrictions could be made binding through a ‘green pill’ covenant given to the seller. For spin-outs to new companies, there are further options: a dual-class ownership structure whereby cashflow rights are granted to outside investors but voting control is retained by the public company, or vesting voting control in the hands of a non-profit with a focus on climate change mitigation.

There are also several implications for policymakers. First, the requirements for certification of ‘green’ investment funds—such as in the EU, Arts 8 and 9 of the SFDR—should be modified to make clear that consideration of the risks of climate-related asset partitioning should be taken into consideration, and not just the emissions from remaining portfolio firms. Second, further thought should be given to the scope of climate disclosure regulation. To be sure, mandatory disclosure regimes generally exempt smaller firms because the costs (benefits) are generally relatively high (low) for such firms. However, as we have suggested, this does give rise to arbitrage opportunities vis-à-vis taking dirty assets dark. It would be worthwhile to consider a lower threshold for firms in high-emissions industries (by analogy with the proposed Corporate Sustainability and Due Diligence Directive).  Third, jurisdictions may consider clean-up liabilities associated with dirty assets being retained by firms that transfer these assets to under-capitalised acquirors.


John Armour is Professor of Law and Finance at the University of Oxford and ECGI Fellow. 

Luca Enriques is Professor of Corporate Law at the University of Oxford and ECGI Fellow. 

Thom Wetzer is Associate Professor of Law and Finance at the University of Oxford and Director of the Oxford Sustainable Law Programme.


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