Posted on: October 23rd, 2014
Last week marked a key turning point in the ‘Carbon Bubble’ debate when Mark Carney, Governor of the Bank of England added his weight to the view that oil companies will be unable to burn the ‘vast majority’ of their oil reserves if we are to avoid catastrophic temperature rises.
This puts a big question mark over the longer term valuation of oil companies – a risk that should make longer term investors (and their advisers) sit up and listen.
This was discussed at some length during this week’s UKSIF/Good Money Week parliamentary reception where Conservative, Lib Dem, Labour and Green MP’s all remarked on its significance.
The following text and links explain further:
On 13 October 2014 the Guardian Newspaper started its report on Mark Carney’s speech as follows…
The governor of the Bank of England has reiterated his warning that fossil fuel companies cannot burn all of their reserves if the world is to avoid catastrophic climate change, and called for investors to consider the long-term impacts of their decisions.
According to reports, Carney told a World Bank seminar on integrated reporting on Friday that the “vast majority of reserves are unburnable” if global temperature rises are to be limited to below 2C.
Recent investment manager commentary
Clare Brook, FP WHEB Asset Management, August 2014
When the American environmentalist, Bill McKibben, published his article ‘Climate change’s terrifying new math’ in Rolling Stone magazine in 2012 (1), it catalysed a new phase in the movement to combat climate change. As McKibben said in his important article, ‘The anti-climate change movement needs an enemy. And that enemy is the fossil fuel companies.’ By focusing on oil, gas and coal extraction companies, the debate has shifted from being a purely political one to being a discussion around the deployment of capital.
Much of McKibben’s article focuses on work carried out by the UK-based Carbon Tracker Initiative. Carbon Tracker’s argument runs as follows: Consensus scientific reports assert that in order to prevent dangerous climate change, which most scientists agree would be caused by a rise in global temperatures of over 2%, the amount of carbon dioxide in the atmosphere must be kept below 350 parts per million (2). The current price of fossil fuels companies’ shares is based on the assumption that all fossil fuel reserves in the world will be utilised. However, only 565 billion tonnes of CO2 can be burned by 2050 in order have a reasonable chance of staying within the two degree warming limit, versus the 2,795 billion tonnes represented by all oil, gas and coal reserves in the ground.
Therefore, argues Bill McKibben, in order to sustain human life on the planet, up to $20 trillion-worth of fossil fuel reserves will need to remain in the ground. This could render fossil fuel assets ‘stranded’ and potentially worthless, or at least at a substantial discount to valuations placed on major oil companies’ reserves currently. Not only are existing reserves at risk, but these companies are spending an estimated $490 billion a year on capital expenditure attempting to discover new reserves and add to their base (3).
How pressure can be brought to bear for these assets to be left in the ground, and for fossil fuel companies to deploy their capital expenditure more wisely, is now the subject of hotly contested debate (4). Some argue that the best way to apply pressure is for institutional investors to sell their holdings in fossil fuel companies. Already, an impressive number of charities, foundations, churches and universities, have announced their intention to divest from fossil fuels, most notably the Divest-Invest group (5). Municipal and state pension funds are starting to join them. An interesting recent addition to the throng is the British Medical Association (BMA). The logic of these decisions is compelling: for charities whose purpose is, broadly speaking, to protect the environment and human society, to be investing in companies whose purpose is to burn as many fossil fuels as possible is an obvious contradiction. The BMA, for instance, sees climate change as an issue which will have a profound impact on public health (6). Meanwhile, some church groups are emphasising the ethics of climate change and the need to avoid fossil fuel investments as a result.
The argument in favour of divestment is essentially one of spotting an innate contradiction: that if investors are holding shares for the long term – for example, a pension fund investing so that people can ‘enjoy their retirement’, a foundation enabling a charity to carry out vital work, people buying a junior ISA for their children, universities providing students with degrees so they can flourish in the world – then it is contradictory to hold assets in companies whose core businesses threaten the world into which people hope to retire, or grow up, or work in a few decades’ time.
Furthermore, the expectation is that concerted selling of fossil fuel assets by high-profile organisations will bring pressure to bear on the coal, oil and gas companies where hitherto campaigners have failed. Some in the divestment camp argue that those companies will find it increasingly difficult to command a licence to operate, to recruit and retain high quality employees, to raise debt, develop new territories and expand. Even if the upshot is less extreme in the short or medium term, the expectation is that concerted divestment will sharpen the focus on those companies directly responsible for climate change and force them to justify their strategy and impact far more than they have hitherto. Already Shell and Exxon have issued statements explaining why they think their reserves are not ‘stranded’. Now that managements are responding, they will no longer be able to ignore the debate in the future.
Those who are against divestment point out that divestment in isolation may not have the effect that it had with, for example, the Anti-Apartheid Movement. Then it was relatively easy to isolate a few companies who were invested in South Africa, such as Barclays, to close one’s bank account in protest, or avoid buying South African wine or fruit. Fossil fuel usage is more invidious. Let he who never drives a petrol-powered car or uses plastic or turns on a light cast the first stone. Without concerted political action that forces fossil fuel companies to pay for the external and future costs associated with burning their product, divestment by some asset owners may stir up debate, but not on its own bring about the quantum change in business models necessary to keep global temperatures within a two degree rise.
To date, much of the commentary around divestment has focused on the negatives: ‘what is the impact on the performance of a portfolio if one strips out oil, gas and coal companies?’ (Answer: historically negligible.) ‘What is the impact on the yield of a portfolio?’ (Answer: a little more meaningful). Again, opinion and statistics differ. For example, Cambridge Associates, in its report ‘Fossil Fuel Divestment’ states, ‘Global energy stocks, which are largely fossil fuel companies, account for 10% of global equity market capitalization today. Historical analysis shows that their performance is cyclical and has been additive to the global equity index over the long term, both in absolute and risk-adjusted terms (7).’ By contrast, Impax Asset Management in its white paper ‘Beyond Fossil Fuels: The Investment Case for Fossil Fuel Divestment’ shows that over a five year period to 30 April 2013 the MSCI World Index with the fossil fuel sector stripped out would have out-performed the MSCI World Index with it left in. Furthermore, if one substitutes energy efficiency and alternative energy companies for the fossil fuel sector removed, performance is further enhanced (8).
Aside from Impax, it seems, there has been little focus on the corollary of divestment, which must be investment, or what to put in the place of fossil fuel assets in a balanced portfolio. If investment in fossil fuels is both contradictory for any asset owners who are positioning their investments for the long-term future, and potentially high risk if those assets are structurally over-valued and potentially ‘stranded’ assets, then what should replace those investments in a long-term portfolio?
At WHEB, we contest that sectors involved in reducing global CO2 emissions and providing solutions to climate change, and other sustainability challenges, are likely to have a concomitantly higher growth trajectory, and thus valuation, than is currently being assumed by the market. Companies involved in clean energy and resource efficiency are among the alternatives for a long-term investor who not only wants to ensure that their portfolio is ‘fossil fuel free’, but that it is instead invested in the solutions, in those companies whose growth will make a positive contribution to society.
As the Cambridge Associates’ report puts it, ‘the consideration of divestment requests can be a catalyst for investors to begin a careful evaluation of the growing opportunity set of more environmentally sustainable investment strategies.’
It is important to distinguish genuinely fossil fuel free funds from the broader range of socially responsible and ethical funds. Some SRI and ethical funds include natural gas, or even oil and gas and mining companies, in their portfolios. At WHEB we take a firmer line: To be absolutely clear, the FP WHEB Sustainability Fund has no investment in companies whose core business is the extraction or combustion of fossil fuels. If such a label were available, we could receive the FFFF (fossil fuel free fund) seal of approval. Instead of exposure to coal, oil or gas, the WHEB fund is exposed to the themes in the graphic below.
While past performance is no guide to future performance, the outlook for fossil fuel companies would appear to be subject to risk, which we feel is not yet priced by the stock market. Meanwhile, we believe the outlook for energy efficiency, clean energy, sustainable transport and alternative energy has never looked more attractive. Until now, the performance impact of holding fossil fuel companies in an index-tracking portfolio has been relatively insignificant. As and when concerted action around climate change gets underway, then the impact of owning companies with ‘stranded’ assets could become much more significant. For trustees of long-term investment vehicles, the imperative is to question the need to hold fossil fuels as an investment has never been so pressing.
FP WHEB Sustainability Fund Investment Themes:
Sources and References:
2 Carbon Tracker Initiative 2011 report
3’Shell, Exxon and carbon – The elephant in the atmosphere’, Economist, July 19th 2014
4 See, for example, Raj Thamotheran writing in Responsible Investor, 23 April 2014
5 See: http://divestinvest.org/
8 Impax Asset Management, ‘Beyond Fossil Fuels: The Investment Case for Fossil Fuel Divestment’