More and more, analysts fear that investment in parts of the fossil fuel industry is becoming an increasingly risky bet. Talk of stranded assets and even a carbon bubble in fossil fuel stocks is spreading from environmental groups to the very heart of the investment mainstream. These concerns should prompt a fresh look at exposures to the hydrocarbon segment and a consideration of other energy industry sectors.
Investors tend to view climate change and efforts to reduce greenhouse gas emissions as long-term issues. The thinking has been such that if climate change or greenhouse gas emissions were to have any noticeable impact on the markets, it would play out over decades. But in recent months a number of leading equity analysts have begun to warn about the near-term investment risks to a particular part of the fossil fuel sector: thermal coal extraction.
Goldman Sachs, Citibank and Deutsche Bank have all produced research reports cautioning that the outlook for the thermal coal market is dismal, with environmental regulations a factor in reduced demand.
That segment of the energy sector is perhaps the canary in the coal mine (pun intended) of a trend set to play out more widely over the years to come. As governments step up policies to reduce carbon emissions and other forms of pollution and as the costs of low-carbon technologies fall, whole swaths of the fossil fuel industry could face a slump in demand that would push down prices, making extraction uneconomic and energy reserves on balance sheets overvalued.
Along these lines, oil and gas specialists at HSBC earlier this year warned that 40 percent to 60 percent of the market capitalization of some firms in the sector could be at risk if oil prices were to drop back to $50 per barrel. Standard & Poor’s has identified high-cost Canadian oil sands developers as the first that would feel such a slide in prices.
Such scenarios may appear improbable. But a combination of environmental policy and technological advances can change markets rapidly. Improved fuel efficiency standards for U.S. cars, finalized last year, have helped put the brakes on U.S. oil demand. The falling cost of renewable energy is putting the squeeze on utilities’ profit margins in the U.S. and Europe. A breakthrough in energy storage technology or a rapid drop in the cost of batteries would rapidly accelerate the penetration of renewables or electric vehicles, respectively.
In terms of how investors with fossil fuel exposure should take action, there is an argument for outright divestment, whether for ethical reasons as espoused by grassroots campaigns on U.S. college campuses or for reasons of risk mitigation, given that any repricing of fossil fuel stocks is likely to be rapid and hard to anticipate. The counterargument is that selling out of fossil fuel stocks would introduce a sector bias to a portfolio, adding a risk of underperformance if low-carbon policies are slower to bite or technology advances do not materialize.
Our research and analysis suggest that these concerns are overblown, however. We have modeled the effects of removing fossil fuel energy stocks from the MSCI world index and replacing them with baskets of alternative energy or a wider array of environmental technology stocks. The results, possibly surprising to some, show a favorable outlook for diversifying away from fossil energy. During a seven-year period ended March 2013, a fossil-free MSCI index outperformed the standard MSCI by 0.5 percent on an annualized basis, with a tracking error of just 1.6 percent. Adding an actively managed alternative energy portfolio to retain energy sector exposure also outperformed the MSCI world index by an annualized rate of 0.4 percent, with a similarly modest tracking error of 2 percent.
But there are intermediate responses between inaction and complete divestment. Investors may want to consider tilting their core equity portfolios using one of several measures of carbon intensity, and underweighting poor performers while overweighting those stocks with less carbon risk. Such an approach has the advantage of retaining sector weights while starting to reduce carbon exposure.
Another approach would be to start building new, noncore portfolios as a natural hedge against climate change–related risk. Impax Asset Management and index provider FTSE have identified more than 1,000 listed companies globally for which a majority of their business is derived from markets linked to climate change and related resource efficiency themes. These companies represent a growing set of opportunities that are likely to come to fruition as climate risk bites into the performance of the fossil fuel sector.
Climate-related risks are not hypothetical, speculative or long term. They are playing themselves out at this very moment. Investors who are not assessing their exposures and taking action are failing to mitigate the largest future risk to their portfolio: climate change.
David Richardson is a managing director and the head of business development and client service for North America at Impax Asset Management, a global equity manager that focuses on green investment opportunities through both listed and private equity strategies.
