Mark Nicholls: Is there an investment case for divesting from fossil fuels?

As NGO campaigns and increasing research question the sustainability and viability of fossil fuel, how should investors consider their exposure?

Climate change is squarely back on the agenda of the investment community. Extreme weather events have conspired with renewed political momentum – in the US, especially – to push the issue to a prominence not seen since the failed Copenhagen climate talks at the end of 2009. Moreover, the investment community finds itself the target of a climate change divestment campaign that is seeking to repeat the success of an earlier campaign, against apartheid in South Africa in the 1980s and 1990s. Led by US activist Bill McKibben’s group, the Go Fossil Free campaign is calling upon college endowments and city and state pension funds to stop investing in fossil fuel companies. So far, the Go Fossil Free’s success has been mostly limited to more mission-driven investors, with six small colleges, 18 cities and foundations, and 12 religious institutions in the US committing to divest. But what about larger asset owners looking beyond the ethical argument? Is there an investment case for divesting? The Go Fossil Free campaign leans on the work of Carbon Tracker, a London-based NGO that warns that markets are overvaluing fossil fuel stocks, given that nearly three-quarters of the sector’s proven reserves can’t be extracted and burnt if we are to hit internationally agreed climate change targets. And as Craig Mackenzie’s article this week in Responsible Investor explained in detail, mainstream equity analysts are providing ammunition. Analysts from HSBC, Citi and Standard & Poor’s have all referenced Carbon Tracker’s work in notes that warn that some fossil fuel companies face steep cuts in the value of their equity or debt. Analysts at GoldmanSachs and Sanford C. Bernstein have warned of a worsening outlook for thermal coal demand, at least partly because of environmental regulations. And some investors are responding. Norwegian financial services group Storebrand has added 19 fossil fuel companies to its list of companies that are excluded from all its investments Link for sustainability reasons. Divestment does, however, bring risk: namely that fossil fuel companies outperform the broader index. The question is, how much risk? A raft of reports – such as from MSCI, Impax Asset Management, and the Aperio Group – have looked at the effects on portfolios of excluding some or all fossil fuel stocks and found limited increases on portfolio risk. Impax found that replacing fossil fuel stocks in the MSCI World Index with a portfolio of environmental technology companies actually delivered 0.5 percentage points of outperformance over the five years to end April 2013. But any increase in risk, no matter how small, opens trustees to challenge, acknowledges Ian Simm, CEO of Impax: “If you take a narrow definition of fiduciary duty – of pursuing the best possible risk-adjusted return – there is limited scope to go significantly off the benchmark,” he says. He argues that there is some “dissonance” between investment mandates that typically run for three to five years, and the time horizon over which climate risk is likely to manifest itself: “It’s not unusual for asset owners to ask managers to take climate change into account, but policy risk plays out over a longer time frame.” His suggestion is that asset owners look to manage climate risk at the portfolio level by making some allocations to ‘climate-
friendly’ assets, such as renewable energy, timberland or a carbon-screened or -tilted equity mandate while leaving the core portfolio unhedged.
“If I were a rational asset owner, there is a clear argument that there will be more [climate] regulation and an substantial carbon price,” says Rory Sullivan, a leading responsible investment consultant: “It seems sensible to build a portfolio that is resilient to plausible carbon regulation.” Such a portfolio might exclude the most “egregious” fossil fuel stocks – such as pure-play coal miners, or tar sands producers – as well as making small allocations to climate-friendly investments. But another element might involve taking a “long-term, strategic view”, setting an overarching emissions target – tonnes of carbon dioxide produced per million dollars of revenue, for example. This might be delivered through a mix of corporate engagement and increasing allocations towards the low-carbon energy sector, for example, and by the gradual decarbonisation of leading equity indexes as companies become more energy efficient. However, even that kind of hedging introduces risks itself, argues Craig Mackenzie, Head of Sustainability at Scottish Widows Investment Partners. “Had you reweighted towards renewables six or seven years ago, you’d have seen 60% wiped off the value of your hedge,” he notes. And he certainly argues strongly against any commitment to divestment that would tie the hands of trustees in ways that would make them highly vulnerable to legal challenge. However, given the dismal outlook for parts of the fossil fuel sector – such as pure-play coal miners, for example – “contingent divestment” could have a similar effect as committing to exclude some of the worst performers, he says.Mackenzie advocates that responsible investors engage with fossil companies on reducing capital expenditure on exploration, and focuses on those parts of their businesses with lower costs of production. This would ensure they perform well in times of low demand, whether caused by economic headwinds or tightening environmental regulation. “There are real concerns about the level of capex in projects where the returns won’t be as healthy as they once were,” says Catherine Howarth, CEO of campaign group ShareAction. “Investors would prefer to see capital returned to shareholders.” On capital expenditure, environmental concerns dovetail with financial concerns, she says. This is an argument that resonates with Mark Campanale, a responsible investment veteran and Carbon Tracker founder. He argues that Storebrand’s move, which he describes as “a bold statement about the market” demonstrates that “big fund managers can sell off”. But he agrees that, as a starting point, asset owners should challenge companies on their investments in exploration, and should consider their valuations under more stringent carbon regulations. “Both of these requests – cancelling capex and reviewing valuations – are examples of asset owners engaging on this issue, without necessarily going for divestment first.” He points to the recent example of Canadian energy firm Suncor, which announced in March that it was cancelling a C$11 billion investment in its planned Voyageur oil sands ‘upgrader’, which processes bitumen into synthetic crude oil. While the company said the reason was based on oil economics rather than environmental worries, it was followed by a 54% increase in its dividend and a C$2 billion share buy-back. “This demonstrates that, to avoid the carbon bubble, companies can smartly
cancel projects that can get stranded and reward investors with share buy-backs or higher dividends,” says Campanale.
Without doubt, investors are mobilising on the issue. As this article went to press, it emerged that investor climate groups are coordinating an engagement campaign aimed at the big oil, gas and mining firms, with capital expenditures a major focus. And, as Mackenzie wrote, SWIP is engaging with companies on their capex programmes. Vicki Bakshi, a Director in the governance and sustainable investment team at F&C said that thefirm is also talking to companies in the extractives sector. “The Carbon Tracker research sets out a feasible low-demand scenario,” she says. “We’re talking to extractives companies about how they make decisions between different potential investment opportunities, and whether the Carbon Tracker analysis is helping them understand the risks involved.” She says it is early days for the engagement: “We’re just opening up a dialogue about a range of risks. But this is the right conversation to be having.”
Mark Nicholls is a freelance journalist and the former editor of Environmental Finance magazine