IPE’s Martin Steward wonders whether a habit of thought is developing that fails to recognise ‘stranded’ portfolio carbon assets as a risk and starts to regard them as a certainty
There was a lot of talk about ‘de-carbonising’ investment portfolios through programmes of divestment, off the back of the recent UN Climate Summit.
Sweden’s AP4 announced that it was leading the Portfolio Decarbonisation Coalition (PDC), with the aim of shrinking the carbon footprint of $100bn (€78bn) of institutional investment worldwide. PFZW committed to reducing the carbon footprint of its entire portfolio by 50%, based on data from Sustainalytics, MSCI, South Pole and Trucost. A growing number of investors, including CalPERS, the London Pensions Fund Authority (LPFA), VicSuper and ERAFP are taking steps to measure the carbon footprint of their investments. MSCI recently added Global Fossil Fuels Exclusion indices to its existing roster of low-carbon benchmarks.
Are they doing this because it is the right thing to do? No: they are doing it, the argument goes, because it represents the prudent risk management that any financial fiduciary should practice.
The logic tends to be expressed as follows. Carbon emissions, largely as a result of the use of fossil fuels, are behind the dangerous rising temperatures in the global climate. It is simply not possible for carbon to be emitted at the current rate and for life to persist as it is. Notwithstanding current debates, that means there is no option but to cut carbon emissions – either via regulation and legislation to make emissions prohibitively expensive, or simply by a free market re-pricing to reflect the true cost of those emissions. It is imperative investors start to think about the risk of that re-pricing to the inherent value of the companies whose stock they hold in their portfolios.
I think this logic is unimpeachable. But I worry that a habit of thought is developing that fails to recognise this as a risk and starts to regard it as a certainty. Listen to the debate, and it often seems there are certain sectors, businesses and manufacturing processes for which emitting a lot of carbon is essential.
But that simply isn’t the case. Certain enterprises require a lot of energy, and, given our current energy mix, that does mean a lot of emissions and a big carbon footprint. But change the energy mix, and those businesses can continue, as they were, unabated. Losing exposure to them represents a potentially huge downside risk should their energy mix change.
That’s the point, argues the fossil fuel-divestment lobby. Vote with your investment euros today, and you incentivise that change in energy mix tomorrow, and contribute to making the companies in question more sustainable.
But that doesn’t make any sense in risk-management terms. Removing your money protects you from the risk that the company doesn’t change and goes out of business. But it leaves you exposed to the risk that the company does change – because when that change happens, it will be priced-in by the discounting mechanism that is the market, and you will be left on the outside looking in. You’ve just replaced one risk with another, so you need to have a clear idea of which risk you believe is the greater, in terms of both probability and impact on your portfolio.
But even then we would be assuming the energy mix has to change. This is the thinking behind the idea that fossil-fuel extraction companies are massive owners of ‘stranded assets’ – oil and coal deposits that will stay underground because it is simply not feasible to burn them for energy above ground. But there are potentially lots of ways material can be utilised above ground without burning it and emitting carbon.
Even before we start to speculate about technologies that could enable us to generate energy from fossil fuel without emitting carbon into the atmosphere, there are a whole range of industrial uses – in chemicals, plastics and fertilisers – that do not emit carbon. The term ‘fossil fuels’ obscures this non-energy and power aspect of what oil and gas companies pull out of the earth.
Admittedly, the market does not currently appear to be pricing these eventualities into oil and gas stocks. Today’s prices have more to do with damaging subsidies we could all do without. But the risk-management question is, ‘How will I know when present values have stopped pricing-in these unsustainable cash flows and started pricing-in sustainable cash flows?’ Until you know the answer, you cannot manage the ‘stranded asset’ risk – a risk, not a certainty – by divesting.
I’m no expert in any of this. You’d need, say, a professor of energy engineering for that. Enter Paul Younger, who occupies the Rankine chair of engineering at Glasgow University. He recently made it known that he was “utterly dismayed by, and vehemently opposed to, the decision of our University Court to divest from fossil fuels”, which he called “collective intellectual dishonesty” because it ignored the submission of the School of Engineering (adopted as the position of the entire College of Science and Engineering) on this investment question.
The School of Engineering observed that there are no viable alternatives to fossil fuels yet available at scale, and that divestment would make it difficult for the academic sector to engage with the industry to achieve that objective. Such engagement is essential, it said, because the skills and facilities of the fossil fuels industry are indispensable to the development of carbon capture and storage, which the IPCC has cited as a necessity for the attainment of decarbonisation targets. And in any case, it added, fossil fuels are essential in food production, pharmaceuticals, chemicals and plastics that do not emit carbon.
For good measure, Younger decried the “dishonesty” and “gesture politics” that saw the university divest from fossil fuel companies at the same time as it is planning a new gas-fired combined heat and power system.
Many pension funds do recognise these risks behind the ‘de-carbonising’ rhetoric. APG, for example, has chosen to double its investments in sustainable energy over the next three years rather than divest from fossil fuel industries. A spokesperson starkly dismissed the ‘stranded assets’ argument with the simple observation that “oil and coal will still be needed for a long time”.
But this approach makes sense in a lot of other ways, too. While the clean-energy play might expose APG to the risk of fossil fuel energy production becoming much cleaner, the fund mitigates that risk by staying exposed to fossil fuel companies while also investing in technology that would be valuable in its own right, and not just as an alternative to fossil fuels.
The last time I checked, this sort of thing – ‘diversification’ – was the essence of portfolio risk management. The avoidance of hypocrisy is merely an added bonus.