Carbon investment: worth the risk?
Gyorgy Dallos argues that the financial risks associated with investing in fossil-fuel companies will increase as they extract in more hazardous places and stricter carbon constraints are enforced. Meanwhile, their huge capex bills are already hurting capital returns and dividends
Pension funds, like most asset owners, underestimate the significance of their exposure to high-carbon (including coal and oil/gas) investments. Even European funds – despite often ranking higher in terms of their volume of climate-friendly investments – have significant fossil fuel assets on their books.
Dutch agriculture industry fund Bedrijfspensioenfonds voor de Landbouw (BPL), which is a leading investor in ‘green’ companies, remains exposed to tar sands and coal investments. The government of Norway Pension Fund Global has had three to four oil majors among its top 10 equity holdings for decades, including Shell, BP and Exxon in the first quarter of 2013. Total and Chevron are also close to the top 10. Moreover, the fund has equity exposure to coal mining companies from the US, China and Australia, as well as significant direct fixed income exposure to the carbon sector.
Index-linked tracker funds further add to carbon exposure. For example, 20-30% of the FTSE 100 – a key indicative index for most UK pension funds – consists of oil, gas and coal companies. Carbon exposure can also be increased by holding the sovereign debt of countries with strong coal, oil and gas interests.
Carbon intensive assets are not only dangerous in environmental terms, but also threaten shareholder value. The frequency of bad news for coal, oil and gas investors has increased greatly over the past few years. Coal is also performing poorly in the context of pension fund investments. Bloomberg Industries showed in July that the median earnings per share (EPS) of the top 40-50 global coal-mining companies had halved since the second quarter of 2012. Major Indian firms such as Adani and Essar – which are increasingly linked to coal and oil – are struggling to generate enough cash to service their huge debt.
The share price of coal-mining companies Arch Coal or Peabody fell by 34% and 27% respectively, while the S&P 500 was up 22% during the 12 months to mid-July 2013. Coal India is down 18%, while the Sensex index is up 17% and China Shenhua is down 19%, and the HIS index is up 9%. Looking at the oil majors, Chevron is trailing the S&P 500 by eight percentage points, Exxon Mobil by 13, Total by 15, BP by 17 and Shell by 31.
Can the typical 3-4% dividend yields of the oil majors and the even lower yields of the coal-extraction industry balance this very unimpressive share price performance? Is the low (sometimes even negative) spread that oil and coal bondholders receive over similar maturity sovereign bonds proportionate to the increasing risks of these companies?
The economics of coal mining are collapsing across the globe due to low coal prices; the shale gas boom and regulatory changes in the US; emission policies and expanding renewables in Europe; and growing air pollution and water concerns in China. The impact is significantly lower demand than expected. Some of the integrated mining giants, such as BHP Billiton and Rio Tinto, are trying hard (and failing) to sell off some of their coal assets.
Oil majors are also taking on more risk. As they face waning demand growth and struggle at the same time to maintain their reserves replacement ratios, they are pushing into the deepest oceans, the Arctic and the tar sands. Shell has already spent $5bn (€3.8bn) for its excursion into the Arctic. But as these companies take on greater risks, the probability of major accidents also increases. Many UK and US funds are still suffering from reduced dividend payments following BP’s Deepwater Horizon catastrophe.
Further, oil, gas and coal assets would likely plunge in value if the world adopts regulatory constraints on carbon emissions. According to HSBC, such constraints could reduce coal asset values by nearly 50% – a risk addressed in an article by Mark Campanale of the Carbon Tracker Initiative in the February 2013 issue of IPE. President Obama’s recent climate action speech and the Export-Import Bank of the United States’ ensuing decision not to fund a major Asian coal project, as well as the World Bank and the European Investment Bank’s shift towards a virtual no-coal policy, are strong market signals that high-carbon assets are increasingly risky propositions.
So what can pension funds do to protect themselves against the risks associated with high-carbon assets? First, pension funds must assess the full extent of their carbon exposure. How much and what kinds of carbon assets are the funds exposed to directly and indirectly? Funds should require fossil fuel companies in their portfolios to disclose relevant information in more detail.
Many fund managers underestimate their exposure to carbon: for example, while fossil fuel extraction has a share of about 9% of the global economy, it has a 16% share of the capital raised by listed companies and a 22% share of the capital invested in listed companies.
Second, funds should also consider re-allocating some of their fossil fuel equity. Recent analysis from Impax Asset Management suggested that removing all fossil fuel extractors from the MSCI World index, and adding selected renewable and energy-efficiency investments, would have generated better returns during the past seven years than the underlying index. MSCI’s own research has also shown no weaker performance during the last five years if all 247 fossil fuel reserve companies were removed from the full MSCI ACWI index.
Finally, funds should ask for a return of cash. Although oil and gas majors still generate vast amounts of profit, they maintain a poor 20-30% dividend payout ratio. This is because while attempting to build reserves – a significant portion of which would be ‘unburnable’ in a carbon-constrained world – oil and gas companies have doubled their capital expenditure over the past decade, reaching $1trn in 2012. In 2013, global oil and gas capex is estimated to be around $1.2trn – this is nearly as much as the combined GDP of the Netherlands and Belgium. Coal dividend yields are for the most part even worse, thanks to massive investment in mines, ports and other infrastructure in the US, China, Australia and elsewhere.
Is it now the time for pension funds to demand from oil/gas and coal companies better dividends, share buybacks or other rewards for being so patient with disappointing recent returns and with significantly greater operational and regulatory risks still to come?
Gyorgy Dallos is senior adviser to the Global Climate & Energy Programme at Greenpeace International