Hydrocarbon investments in the context of forward risks, pricing of externalities and sustainable returns

Our approach to investing has always been based on the premise that long term returns are driven by fundamental factors, and in thinking about value creation, we maintain focus on trends, risks and opportunities, with the expectation that there are systematic risk factors that are not captured in conventional Profit & Loss and balance sheet-based analyses and this is particularly the case with Environmental, Social and Governance risks.

Accordingly, risks and opportunities are considered on an integrated basis. With governance risks, relating to audit, board structure and function, and the relationship between boards and shareholders and dominant and minority shareholders, we exclude poorly positioned companies from consideration and agitate for change and improvement to reduce risk. Likewise we see many social risk factors relating primarily to mis-costed activities. In contrast, environmental challenges involve both significant risks and clear opportunities.

Specifically on the challenge of climate change, we worry that single issue points of focus can lack robust underpinning and miss aspects of the underlying market failure. To address this risk, we look at hydrocarbon investments in a context and a framework that is focused on forward risks, pricing of externalities and sustainable returns.

As a big picture backcloth, there are profound tensions in areas such as economic imbalances, adverse demographics, degradation of natural capital, labour-capital relations, and apart from the direct or first order challenges, we are focused on possible or likely government and agency intervention involving one or more of regulation, taxation and legislation.

That said, there is the potential for being broadly optimistic as there is scope for innovation and technology to address the environmental challenges, if you can identify sustainable business models and investment opportunities.

In developing any long term focused approach, investors should be acutely aware that long term investing can be lonely and hazardous, and a beady eye should be kept on intermediary risk factors that complement and shape the current investment climate including moderate growth prospects, the uncertain outlook for inflation anddeflation, the legacy of high levels of indebtedness, and the drive for improved living standards the world over.

On the climate challenge specifically, our assessment is that there are considerable uncertainties on both future temperatures and economic impacts but it is clear that there are risks, and those risks aren’t paid for in pricing, or recognized by the market.

In considering the pricing of climate risk, it is worth distinguishing between two fundamentally different types of risk: diversifiable risk and non-diversifiable risk, with non-diversifiable risk deserving a risk premium.

Thus, diversifiable risks should be priced at the level given by the discounted present value of future damages, but non-diversifiable risks deserve a risk premium, with examples of non-diversifiable risks including equity risk and climate risk.

Markets can fail to charge an appropriate risk premium when risk is misunderstood and thought to be diversifiable. Thus mortgage investments were thought to be fully diversifiable, and bundles of mortgages were given high credit ratings. However when the non-diversifiable nature of mortgage risk became apparent and mortgages were re-priced appropriately, there followed the global financial crisis and then an extended and deep recession.

In a similar vein, pricing carbon emissions is a risk management problem involving trade-offs between consumption today and potential bad outcomes in the future, and the trade-off depends crucially on the degree of societal risk aversion, and societal risk aversion can be calibrated in a manner similar to the equity risk premium.

As for the appropriate price for carbon emissions, there is a trade-off between current consumption and future damages, with unknown impacts, the potential for time compression and catastrophic outcomes, and the need to build in margins of safety, and to anticipate risk reduction over time. Thus we expect that as climate change risks become more widely recognised, absent actions to control climate risk, so societal risk aversion will rise. If societal risk aversion rises, this implies an increased risk premium, a lower discount rate for future damages, and a higher price for emissions today.

We also anticipate that delaying the pricing of carbon emissions involves two costs: over-emitting into the atmosphere, pushing increased costs onto future generations, and raising the unknown probability of disaster – and the longer the delay, the higher the likely level of level of risk aversion that will be seen and the higher the expected level and path of emissions prices.

Looking only at the temperature uncertainties, some investors argue that assets are stranded because to burn the world’s carbon reserves will take global temperatures to levels that imply significant and sustained environmental damage.

Adding in the economic issues to an assessment of this world of uncertainty, we can expect taxation and regulation as governmental responses to climate change risk, leading to assets that are stranded economically – where exploitation simply makes no commercial or financial sense.Importantly, we would anticipate that it is not prudent to wait to control risk when emissions pricing is put in place, because stranded assets will re-price to reflect changing expectations of forward prices, rather than changes in actual emissions prices. Accordingly assets like coal will be negatively impacted when expectations change, not when emissions are actually priced. The conclusions are that pure-play thermal coal and tar sands investments will not be viable, and old-style Oil and Gas companies will be challenged by carbon pricing and advances in renewable energy and energy storage.

In the near term, engagement with companies on future policies may yield improved financial and environmental outcomes, and transition to a low carbon economy presents opportunities for long term investors to make exceptional returns. So taking these opportunities is a natural complement to practical concerns on climate change and stranded assets.

James Bevan is Chief Investment Officer at CCLA Investment Management.