Divesting from fossil fuels is a compelling win-win for investors and claims of underperformance are wrong, writes Ominder Dhillon of Impax Asset Management.
Pressure is building on institutional asset owners to assess their exposure to companies that extract fossil fuels. The alarm was first raised in the US, but the arguments have rapidly broadened and gathered momentum, and investors are now facing concerns from several stakeholders to assess the risks of their exposure to companies that extract fossil fuels.
In parallel, financial analysts are increasingly warning investors of the risks from tighter regulations on carbon dioxide emissions and falling demand for fossil fuels that could make reserves substantially less valuable, or even ‘stranded’ and ultimately rendered worthless.
Many investors are however still sceptical of the outcome of looming greenhouse gas regulation and are asking legitimate questions about the effects on portfolio risk and returns from the partial or complete divestment of fossil fuel stocks. So, what are the risks associated with reducing exposure to fossil fuel stocks?
Analysis of the data
Many investors are concerned that divestment from fossil fuel stocks will increase volatility and tracking error – and potentially lead to underperformance. Impax analysed the historical data over the last seven years to look at the impact of eliminating the fossil fuel sector from a global benchmark index – and it would actually have had a small positive effect on returns.
Excluding the fossil energy stocks from the MSCI World Index over the last seven years would have had a small positive impact on returns (0.5% annually) and only a modest increase in tracking error (a measure of how closely a portfolio follows the index to which it is benchmarked) of 1.6% a year.
For the five years to the end of April 2013, which excludes the dramatic run up in energy prices ahead of the 2008 financial crash, eliminating the fossil energy sector would have improved returns by almost 0.5 percentage points annually, to 2.3% a year from 1.8%.
Investors may be understandably concerned that excluding an entire industry sector such as fossil energy and reallocating this portion across the other sectors may introduce tracking error into portfolio returns, and raises the possibility that an investor may miss out on the sector’s future outperformance.
So, as a replacement for MSCI Energy, Impax modelled the performance of the MSCI World index with the fossil energy sector replaced with FTSE’s Environmental Opportunities Energy universe, which currently comprises 243 energy efficiency and renewable energy stocks. The key outcome is that, over seven years, there would have been no impact on performance.
As might be expected, the substitution of MSCI Energy with FTSE EO Energy does introduce some tracking error – but just 1.6% per year. Impax also modelled portfolios using an active fossil free allocation rather than passive, and a fourth model replacing the fossil fuel constituents with an actively managed allocation of stocks selected from a wider range of resource optimisation and environmental investment opportunities. Both of these portfolios would have delivered slightly better performance than the MSCI World with similar levels of volatility.
So what can investors do and how can they do it?
Impax believes that investors should consider reorienting their portfolios towards low-carbon energy by replacing fossil fuel stocks with energy efficiency and renewable energy investments, thereby retaining exposure to the energy sector while reducing the risks posed by the fossil fuel sector.
Given the growing consensus around climate change science, it is rational for investors to expect much tighter carbon regulation – with profound economic effects. Many investors may be confident that they can anticipate such regulation and will be able to exit high-carbon investments before their value is significantly eroded, but there is considerable uncertainty around the timing and nature of future carbon regulation.
Recent history of financial markets suggests that few investors will be successful in anticipating any sudden re-pricing and/or stranding of fossil fuel assets that result. Additional considerations should include the falling demand for fossil fuels from the substitution of competing low-carbon energy generation such as wind and solar, and from energy efficiency and other technologies, particularly in the industrial, commercial and transportation sectors.
For many investors, a gradual or intermediate option to full fossil fuel divestment maybe a more manageable approach. Investors could pursue a ‘carbon-tilting’ strategy, where they retain their exposure to the energy sector but overweight less carbon-intensive companies and underweight those with the greatest carbon exposure, for example those with the highest levels of reserves relative to market capitalisation.
Alternatively, or in combination, they could pursue thematic strategies to supplement broader market investments and offer a hedge to fossil fuel exposure – for example, by investing in portfolios of ‘climate solutions’ providers, or in forestry assets in regions that are not exposed to significant climate change risk. These could be developed progressively, building a low-carbon portfolio funded by incremental allocations from their fossil fuel holdings.
While forward-looking analysis is speculative by its nature, an analysis of the historical data shows that the financial risks involved in fossil fuel divestment are minimal, and can be largely offset by substituting oil, gas and coal stocks with less carbon intensive alternatives.
If these can also mitigate the large and growing financial risks of fossil fuel energy, it would be the compelling win-win most investors seek in discharging their fiduciary duties.
Ominder Dhillon is head of distribution at Impax Asset Management. The full white paper, Beyond Fossil Fuels: The Investment Case for Fossil Fuel Divestment, can be downloaded for free here.