The latest warning from the worlds scientists is unambiguous: Climate change, if left unchecked, will increase the likelihood of severe, pervasive and irreversible impacts for people and ecosystems. This was among the conclusions of a report from the Intergovernmental Panel on Climate Change, released in November, which distills the current state of climate science and which represents the consensus view of the 195 governments that make up the IPCCs membership, established by the United Nations Environmental Programme (UNEP) and the World Meteorological Organization (WMO) in 1988.
The new IPCC report is just the most recent addition to the growing assessment of scientific evidence about the causes of the worlds changing climate. This research is helping to build social and political momentum for action to reduce emissions, including an increasingly vocal campaign calling for divestment from fossil fuel stocks. Meanwhile, the technological advances that make a transition away from fossil fuels possible are ever more cost-effective.
As a consequence, a growing number of financial analysts are warning that energy portfolios face a risk that tighter regulations of emissions of carbon dioxide, as well as falling costs and improved performance of low-carbon technologies such as renewable power plants and electric vehicles, could lower demand for fossil fuels. The decrease in demand would make fossil fuel assets, and the companies that own them, substantially less valuable.
These twin pressures add up to exactly the sort of systemic risk to which investors should be paying more attention. But to a large degree, these risks are unpriced or at least underpriced by the markets.
The warnings from mainstream financial analysts are adding fuel to the fire that the divestment campaign is lighting under college endowments and municipal and state pension funds. Divestment campaigners argue that it is morally wrong for these funds to profit from investing in companies contributing to climate change.
What should investors do? On one hand, investment research has revealed unpriced risks that are accumulating in the fossil fuel sector. On the other hand, many investors are concerned that divestment from fossil fuel stocks would introduce other types of risk into their portfolios. Their biggest worry is that excluding energy, a large component of most global indexes, will increase the volatility of investment returns and potentially lead to underperformance against market benchmarks.
At Impax Asset Management, we looked at the implications of excluding the fossil fuel sector from a conventional equity investment portfolio reflecting the components in the MSCI World index. Using returns over six years through April 2014, we found that a portfolio that simply dropped the fossil energy sector would have outperformed the MSCI benchmark by 40 basis points a year, returning an annualized 4.5 percent, with a marginal increase in volatility: 19.3 percent, compared to 19.2 percent for the index.
Nonetheless, such a portfolio would underperform during periods of strong returns for the conventional energy sector. So we also looked at two portfolios in which we substituted fossil fuel stocks with energy efficiency and renewable energy stocks, thus maintaining exposure to the energy sector.
First, we modeled the performance of the MSCI World index, except we replaced the fossil energy sector with FTSEs Environmental Opportunities (EO) energy index series, which comprises about 250 clean energy companies. Over the same six years, that portfolio would have outperformed the MSCI World by 20 basis points a year, with a tracking error of 1.7 percent.
We also looked at a portfolio that used an actively selected and managed subset of stocks from the FTSE EO Energy index series, a strategy Impax has been running since 2008 and that was managed defensively during the 200809 financial crisis. That portfolio would have outperformed the MSCI World by 40 basis points a year, with a tracking error of 1.9 percent.
Of course, these encouraging results are necessarily backward-looking. But there is mounting evidence that the alternative energy sector offers the prospect of stronger returns without the downside risks of owning fossil fuel assets. The recent IPCC report suggests that, by the end of the century, greenhouse gas emissions will have to be reduced to zero. Substantial reductions will have to be made in the coming decades. This suggests an enormous need for capital and investment opportunities within the clean energy sector.
As fiduciaries, investors should do more to understand these trends and their impact on portfolios. They should explore the options that exist to invest in clean energy. And they should engage with the policymakers who are likely to dictate the timing, speed and economic efficiency of the low-carbon energy transition.
Whereas divestment is a major decision and not one that most investors can or should make in haste there is a compelling argument to be made for the investment case for divestment. What our research shows, however, is that for investors seeking alternatives to investing in the fossil fuel energy sector, reducing the climate risk in a portfolio doesnt necessarily mean adding volatility and underperformance risk.
David Richardson is a managing director and head of institutional business development and client service for North America at Impax Asset Management in New York.
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