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Long-term Matters: Learning from coal

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Last month the chief executive of Norges Bank Investment Management, Yngve Slyngstad, offered an implicit admission of error. According to the Financial Times, the Government Pension Fund Global has been “forced to [….] take a more active ownership role and focus on corporate governance”.

Learning from failure has become commonplace in sectors as diverse as nuclear power, aviation and medicine. It is a systematic process of self-examination aimed at avoiding catastrophic outcomes. But with rare exceptions, it is still alien to the investment world.

Take coal. The Dow Jones US Coal index lost more than 92% of its value between March 2011 and August this year. As the Carbon Tracker Initiative explains, the underlying policy and technology causes were not really new, but rather the speed of disruption. Industry executives were caught off-guard: several US coal companies were expanding capital spending plans and discounted evidence that disruptive forces were about to converge.

Some financial analysts did show foresight. Deutsche Bank published a bearish note on coal in October 2011. But, as we show in a discussion paper, more analysts were bullish about the sector. Behavioural biases and underestimating structural changes seem prevalent. Using a term coined by Mercer, many were “climate unaware risk takers”.

In August 2013, Moody’s, the credit rating agency, changed its outlook from negative to stable. Goldman Sachs declared that US coal had reached “retirement age”, but only in 2015.

Some buyside firms have called the downturn well. Had others done this earlier, they too would have lost less – while a further group even seems to have increased its exposure to coal.

We hope our research, which is based on publicly available reports, prompts academics to do more in-depth studies. There are some big questions to be answered. For example, what are the financial losses experienced by institutional investors from such a preventable surprise? And what have sell-side and credit rating analysts learnt about how to integrate carbon and climate risk into their models?

Similar questions have to be asked of proxy-voting agencies and corporate governance specialists who approved the executive pay plans that motivated this capital spending.

And what have investment consultants understood about their role when there is likely mispricing of risk? And how do these consultants evaluate fund manager stewardship abilities? Linking all of these, what has behavioural finance taught us about biases that could have helped investors anticipate this collapse?

One thing is clear. Whether this learning happens depends on the reactions of asset owners.

There is a lot of investor talk about climate-related engagement at present. Some 120 chief executives of investment firms, accounting for $12trn (€10.9trn) in assets, have lobbied finance ministers of the leading developed nations ahead of this year’s Paris climate negotiations. CDP, the environmental campaigning organisation, boasts the support of institutions with assets totalling $95trn. The Principles for Responsible Investment (PRI), an investor network backed by the United Nations, says it accounts for one-in-two investment dollars globally. 

And still we have the coal crisis, which itself could be a test tube experiment for what might happen, albeit on a much bigger scale, in relation to other fossil fuels. The market did the usual delay and panic: waking up, but only after suffering huge losses, the costs of which were largely shifted to end beneficiaries of asset owners or collective investment vehicles. Court rulings aimed at fiduciary duties to future generations in Europe, the divestment movement, legislation aimed at cutting emissions in many nations, and the potential for technological advances all pose a threat to the economic returns of fossil-fuel producers. Are these risks priced correctly today?

Is it too early to worry about the much bigger “sub-clime” crisis? Former US Treasury secretary Hank Paulson disagrees, likening ignorance to purposely flying straight into a mountain. AXA chief executive Henri de Castries talks about playing Russian roulette with five bullets in the cylinder. The least that prudent investors should do is prepare for a realistically plausible worst-case scenario. Learning from the failure related to coal would be a good first step. 

Raj Thamotheram is CEO of Preventable Surprises and a visiting fellow at the Smith School, Oxford University; Olivier Cassaro is climate programme director at Preventable Surprises; John Rogers is former president and CEO, CFA Institute, and global president and CEO, Invesco Institutional Division

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