Many investors will have been waiting for the expert panel review of the Norwegian Government Pension Fund Global (GPFG) to be released as they consider how their own investment institution deals with the issues of unburnable carbon and stranded assets. The thoughtful piece by the experts exploring the issues indicates where they see the stranded assets thesis being applied, and what reasons there are to sell certain assets. However it does not constitute a rejection of stranded assets, and proposes that the fund may need a mechanism to exclude the most extreme high carbon companies. Carbon Tracker identifies the following key points from the analysis:
1. Investors have to act on this issue
The fact that one of the largest institutional investors in the world saw fit to commission a panel to produce 71 pages of analysis sends a strong message that ignoring this issue is not an option. One of the striking aspects of the divestment campaign has been that the responses show few institutions are able to articulate how they are managing this type of risk. Each week sees more announcements of new strategies, products and research to try and address this issue, which is by no means a simple challenge.
2. GPFG has already recognised the financial case
GPFG has sold out of 11 coal companies based on the likelihood that their business model was no longer sustainable. This suggests that there are already financial arguments for avoiding companies that have exposure to potential stranded assets. In this context, as Carbon Tracker has defined it, a stranded asset means a part of a company that will lose or destroy shareholder value, in response to changing market conditions. The recent announcement from E.ON that it would split its business into separate renewables and fossil fuel power divisions is a wake-up call that the old energy sector business models need to be challenged.
3. GPFG can’t currently recognise the ethical case, but should in their exclusions policy
The exclusions policy of GPFG was set up to address corporates which caused extreme localised environmental damage. Given the historical relationship between corporations and carbon dioxide emissions established by work such as the Carbon Majors analysis, there is a clear causal relationship that can be used if the policy is updated to recognise impact at a global scale. The panel has rightly recommended that GPFG updates its exclusions policy to allow the most extreme companies be excluded on a case-by-case basis.
4. Stranded assets are financially material but not the basis for portfolio management
The expert panel does not ‘reject’ stranded assets – explicitly stating it does not consider the issue of stranded assets is immaterial to investors or that one should be indifferent to the issue. The panel does say that it does not believe it is appropriate to translate this concept into portfolio composition. Essentially this is rejecting blanket divestment of fossil fuels as a way of dealing with the problem. This reflects the problem that many funds – in tracking the indices – cannot readily exclude the oil sector. It also reflects Carbon Tracker’s more detailed analysis looking at high cost projects on cost curves, which was produced to inform investor engagement with the companies they continue to hold.5. GPFG may be too reliant upon the efficient markets hypothesis
It is slightly troubling that as such a large investor, GPFG has to rely on the markets to price climate risk. The financial crisis should still serve as a reminder that markets cannot be relied upon to price everything correctly. Bank of England Governor Mark Carney recently identified how the ‘tragedy of the horizons’ means that capital markets currently struggle to reflect longer-term climate risks. Ironically, GPFG also identifies the mispricing that occurs in the market as creating an opportunity for its fund managers at Norges Bank Investment Management (NBIM). This therefore transfers the risk alongside the opportunity to the active managers. For example, did these fund managers spot the decline of the US coal mining sector and avoid following the market down?
6. Active management in the form of engagement can deal with the issue
For many investors, some form of engagement will be central to how they choose to deal with avoiding stranded assets. Carbon Tracker supports the need for engagement as one the main tools open to investors, but only if the practice carries sufficient teeth to drive fundamental changes in where capital is spent and the emissions that will ultimately result. This is going to have to go beyond the incremental green initiatives that have been the core of many engagement programmes. The shareholder resolution being proposed at Exxon this year by As You Sow and Arjuna Capital gets to the heart of capital deployment. It is not sustainable for the oil majors to continue borrowing to maintain expenditure and dividend levels. Shareholders who want to prioritise income and get the cash returned, rather than let Exxon spend it on high cost projects, should support this resolution.
7. Engaging with regulators and ratings agencies needed as well
Recognising the GPFG’s exposure to the efficiency of markets, it is prudent that the expert panel also recommended that the fund needs to engage with the players who set the market frameworks and rules of the game. For example, this could be getting financial regulators to compel better or more timely disclosure from companies when their business case is falling apart as demand and prices fall; or requiring ratings agencies to consider alternative future scenarios or go beyond the typical 3 year ratings horizon to reflect bond maturity length.
The outcome of an engagement?
For the GPFG, there is a critical step of defining what its engagement process and objectives will be. NBIM has its own “expectations” for companies on climate change management, last updated in 2012. At present these expectations do little to reassure Norwegians that the fundamentals of a company’s business reliant on fossil fuels will form part of the engagement. Perhaps this does not reflect what is being discussed currently given some coal companies have been jettisoned, and Statoil is trying to step away from oil sands – either way the expectations need updating for 2015 and beyond.
Carbon Tracker believes a new level of active engagement is needed that can demonstrate the following:
• A clear focus on capital discipline in the form of challenges to high cost, high carbon capital expenditure inconsistent with future low demand / low price / low carbon scenarios;
• A review of the business models of fossil fuel-based corporations to assess financial resilience to low demand / low price / low carbon scenarios;
• A commitment to creating a portfolio that drives decarbonisation rather than follows it once the market eventually responds;
• Actions to change the financial frameworks of financial regulators and ratings agencies to redirect capital away from activities based on excess carbon emissions; and
• Effective sanction mechanisms for companies which fail to respond within a reasonable timeframe, including ultimately selling out of companies that fail to take concrete steps.This belief stems from an observation that many large investors have been engaging on climate change for years already, yet are far from aligned with the need for a contraction of the fossil fuel sector to avoid dangerous levels of climate change. NBIM first identified climate change as a focus for ownership activities in 2006. Its approach must now undergo a step change that goes beyond incremental improvements in operational emissions and gets to the heart of the business models and capital expenditure plans of these companies.
Entering into an engagement implies a certain commitment from both sides. A long engagement starts to bring this into question – 8 years and counting for GPFG on climate change already. If the oil and coal companies are not willing to commit to the future that funds and their beneficiaries expect, then investors need to call the whole thing off, or they will end up wedded to stranded assets.
James Leaton is Research Director of the Carbon Tracker Initiative.