There is an increasing likelihood that governments of major economies will act within the next decade to reduce greenhouse gas emissions, probably by intervening in fossil fuel markets. Smart investors therefore recognise that the risks related to fossil fuel prices and ownership have changed. Neither “full divestment” of all fossil fuels stocks (and potentially other companies) nor “do nothing” are rational. Is there a way of using well established investment management tools to establish a logical approach that not only reflects today’s risks, but is flexible enough to evolve as climate change investment risk changes?
Investors approaching this issue to date have generally used “carbon foot-printing”. In addition to the by now well accepted problems of measurement, foot-printing fails to take account of a company’s pricing power, and is therefore a poor and potentially misleading proxy for financial risk.
Instead, we have developed an approach based on the potential impact of government intervention on the expected (future) cash-flows of affected companies. By estimating how much of today’s asset values is “at risk”, it’s possible to model an optimal level of reallocation from the most exposed companies, while also demonstrating that reallocation to companies active in energy efficiency markets limits the introduction of new risks. Investors adopting such as “Smart Carbon” approach will gain not just a portfolio that is designed to reflect climate change risk as measured today, but, more importantly, a framework for managing this issue in the future.
Regulatory risk not climate risk
Today, the risk for investors of government intervention to reduce future emissions is much more significant than the underlying risk of climate change itself. Companies are able to buy insurance against most forms of extreme weather, while diversification allows portfolio managers to spread climate risks. Although climate change may be accelerating, it appears unlikely that either of these tools will be redundant for many years.
Government intervention to reduce pollution is typically based on taxation, “cap and trade” schemes or standards. In the context of policy to mitigate climate change, we’ve focussed on “Carbon Pricing” as a proxy for these policy instruments.
Our approach has concentrated on listed companies engaged in the exploration and production of fossil fuel assets. As suppliers of globally traded commodities, these companies are unlikely to be able to pass on the full effect of Carbon Pricing to their customers or to adjust their revenue or asset base quickly enough to avoid this exposure. In contrast, companies further down the energy value chain, for example gasoline refiners, utilities, or airlines, typically face much more complex market structures – many can pass a portion or even all of their cost increases onto their customers in the form of higher prices.
A simple model of each fossil fuel sector shows that the introduction of Carbon Pricing will raise retail prices, depress wholesale prices and reduce supply/consumption, leaving some assets stranded and impacting cash-flows for those who remain in the market.There are strong indications that today’s prices of energy stocks do not account for the risk of government intervention. Although not linked to climate change policy, the recent catastrophic collapse of the prices of coal stocks appears to illustrate poor investor understanding of the rapid build-up of the supply of shale gas, which undermined coal prices significantly.
Partial divestment and reallocation
Using a scenario approach to Carbon Pricing, we have has calculated an expected “value at risk” for those companies in the MSCI World Energy Index that are potentially affected. We recommend that divested amounts are reinvested in a basket of stocks of companies providing goods/services that enhance energy efficiency. These stock prices are typically correlated more closely with the retail price of energy (which is expected to rise with Carbon Prices) than with the wholesale price of energy (which is expected to fall). We’ve then used a portfolio optimisation model to determine the optimal level of reallocation.
The FTSE Environmental Opportunities Energy Efficiency Index represents an attractive basket of stocks for reallocation. With around US$1 trillion of aggregate market capitalisation, there is plenty of scope for small and medium sized investors to adjust their portfolios.
We have not included companies active in renewable energy markets as the corresponding stock universe is dominated by a small number of large cap names. We believe that investing in this limited group would introduce material, additional risks, particularly stock-specific risk and the risk of regulatory change.
Our portfolio optimisation model currently recommends a reallocation of 30% of the holdings of a typical portfolio in oil and coal producers.
A Dynamic Plan for the Future
To implement this strategy, we recommend that investors replace their traditional basket of energy stocks with a new basket/index for the Smart Carbon portfolio. We also recommend that investors:
- seek additional information from fossil fuel asset owners (in order to improve their risk analysis),
- engage with regulators to mandate further disclosure of this information, and
- continuously refine their assumptions and modelling of this issue in order to adjust their positioning as to the quantum, timing and likelihood of Carbon Pricing.
Crucially, the Smart Carbon portfolio represents only a partial sell-down of many fossil fuel stocks, so those investors wanting to engage with companies and seek to persuade them to change strategy will still have a seat at the table.
In time, it is likely that the market values of all stocks will incorporate climate change risk. However, investors who position themselves ahead of this change should out-perform.
Ian Simm is Chief Executive of Impax Asset Management.
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