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Fuelling risk

It’s a question that’s increasingly vexing investors: what is to be done about the risk of stranded fossil fuel assets? A growing body of investment research is warning that, if governments move seriously to tackle climate change, demand for fossil fuels could collapse, leaving reserves worthless and wiping billions off company valuations. 

The latest warning shot was fired by Paris-based brokerage Kepler Cheuvreux in a 24 April note, ‘Stranded Assets, Fossilised Revenues’. It calculated that the fossil fuel industry could lose $28trn (€20.5trn) in revenues between now and 2035 were governments to introduce policies to meet the internationally agreed target of limiting global warming to 2°C above pre-industrial levels. 

In absolute terms, the oil industry would be hardest hit, with lower oil prices leading to a $19.2trn drop in revenues, some 22% below those that could be expected under the International Energy Agency’s central New Policies scenario. The coal industry would suffer a 34% slash in revenues to $9.7trn from $14.6trn, in constant 2012 dollars, Kepler Cheuvreux estimates. 

Mark Lewis, an author of the report, acknowledges that this so-called 450 scenario (referring to the parts per million of carbon dioxide in the atmosphere deemed consistent with the 2°C target) is at the extreme end of possible outcomes – given likely political opposition to dramatic action to reign in emissions. “But it’s an attempt to put some numbers into the market to allow investors to work backwards,” he says.  

He adds that, while governments are unlikely to do as much as environmental groups might like, “that’s not to say that climate policy won’t continue to develop”. As the report notes, “whether a global policy framework consistent with a 450 scenario is ultimately put in place or not, there is always the risk of tighter legislation that could lead to stranded assets in certain markets.”

So what is to be done? In a report for the UK’s Environment Agency Pension Fund (EAPF) – arguably one of Europe’s most environmentally progressive asset owners – the research firm Trucost attempted to answer the question. 

As a starting point, Trucost did an analysis of the EAPF’s ‘embedded carbon’. This is the exposure, in absolute terms and relative to their benchmarks, of 16 of its active and passive equity portfolios to fossil fuel reserves held by companies in five oil, gas and coal extraction sectors.

It found, unsurprisingly, that the EAPF’s actively managed portfolios were less exposed to stranded asset risk than their benchmarks. The most exposed fund had an exposure of 13.8% – compared with the 25% exposure of its FTSE 100 benchmark. Its remaining funds were benchmarked against the MSCI All-World, and were between 40% and 100% less exposed. “The performance of the EAPF portfolios demonstrates the active carbon risk mitigation strategies employed by their investment managers,” Trucost noted.

Faith Ward, chief responsible investment and risk officer at the EAPF, says that the Trucost work highlighted that the fund’s active mandates have substantially eliminated climate risk: “The residual risk is in the index-tracker funds.” The fund is collaborating with other pension funds to encourage index providers to introduce lower-carbon products, and Ward says they have already met with FTSE. “As a local government pension fund, we’re trying to balance short-term pressures on cost against long-term risk reduction – we’re trying to find cost-effective solutions.” 

The firm made four recommendations for the EAPF and other funds seeking to manage risks associated with embedded carbon within their portfolios. These centred around requesting greater disclosure of fossil fuel reserves data, engagement, particularly around capital expenditure and low-carbon planning, and awareness raising. It also suggested funds “remain invested in fossil fuel stocks to retain influence and “be part of the conversation”.

However, some sustainable investment practitioners find the recommendations wanting. Seb Beloe, head of sustainability research at Wheb Asset Management takes particular issue with Trucost’s assertion that divestment “is neither an industry-leading or progressive policy”.

“It’s a bold statement, and not one that I agree with,” he says, particularly for a fund such as the EAPF, which has an aspiration towards leadership on environmental issues. He argues that engagement is likely to have limited effects, noting a recent report on climate change by Exxon in response to shareholder pressure. In it, the US oil major argued that demand for energy will trump climate change considerations. “We are confident that none of our hydrocarbon reserves are now or will become ‘stranded’,” it stated.

“As we’ve heard from Exxon, it has no plans to make a shift to low carbon,” Beloe says.

Rather, Beloe and others argue that asset owners can and should construct fossil fuel-free portfolios – he points out that the FP Wheb Sustainability Fund has no exposure to the sector. 

Some argue that exposure to the energy sector can be maintained without investing in oil, gas or coal stocks. Last year, environmental investment boutique Impax Asset Management, modelled the effects of replacing fossil fuel stocks with renewable energy and energy efficiency plays. It found that, over five years, an actively managed fossil fuel-free portfolio would have outperformed the MSCI World by 0.5 percentage points annually, with tracking error of just 1.6%. 

“We showed that you could still get the energy sector beta without the fossil fuel exposure,” says Ominder Dhillon, head of distribution at the London-based asset manager. “There is a strong argument for fiduciaries to look at the…inadvertent bet they are taking on carbon intensity.”

But Lauren Smart, who heads Trucost’s financial institutions business, argues that, for most asset owners, divestment is not an appropriate response. “Most don’t think that the divestment case is strong enough at the moment… the risk of stranding is far too far out to be material.” 

While some foundations or more ethically-orientated funds may have a mandate from their beneficiaries to divest, most bigger funds aren’t in that position, she adds. “They’re more limited in their options,” she adds, noting that engagement might be more appropriate than attempting to “cut out much of the global economy”.

Smart acknowledges that there may be a case for divesting from a relatively small number of stocks most at risk of stranding – such as pure-play coal miners. By constructing a cost-curve of the most high-cost fossil fuel reserves, investors can assess how likely it is that assets will be impaired, she says. 

Such a “mainstream, financial risk-based approach” is one that “any fiduciary investor” could justify, says Craig Mackenzie, investment director at Aberdeen Asset Management. “Asset owners should ensure that their fund managers are looking hard at the downside risk posed by fossil fuel companies.” He also agrees that investors should be paying careful attention to such firms’ capex plans, to ensure they aren’t spending shareholders’ cash looking for reserves that might never be extracted.

Sarika Goel, a London-based senior associate at investment consultancy Mercer, agrees that divestment shouldn’t be at the top of the agenda for pension funds. But she notes that they “don’t have to divest to invest elsewhere”. Mercer suggests that pension funds should consider hedging their climate change exposure by making allocations to “climate-sensitive assets”, such as sustainability-orientated equities, infrastructure, timberland or renewable energy projects. 

“What pension funds should be asking is whether their consideration of climate change risk is consistent with their fiduciary duty,” she says. “We believe it’s very much a systemic risk for investors, and they need to be considering this at the portfolio level.”

As for the Environmental Agency Pension Fund, it has responded to the Trucost report with a strategy paper on how to reduce climate risk. Many of the 10 points in its ‘forward plan’ build on actions it is already taking, such as further embedding climate risk in its investment strategy and asset-liability modelling, widening its carbon footprint reporting, and pressing for greater corporate transparency on the issue.

 The EAPF’s climate strategy may well be among the most extensive of its peers, but Ward stresses that the intent is that it be pragmatic, accessible and helpful to other investors confronting the climate risk issue. “This is not something we’re going to solve overnight, but it’s important to start somewhere. Investors need to look at their portfolios, and decide if they’re comfortable with the climate risk they’re taking.” 

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