Pressure is building on institutional investors to assess their exposure to companies that extract fossil fuels. As concerns rise about the likely effects on the climate from greenhouse gas emissions, grassroots campaigns calling for fossil fuel divestment are growing. In parallel, financial analysts are increasingly warning investors of the risks that tighter regulations on carbon dioxide emissions and falling demand for fossil fuels could make fossil fuel reserves substantially less valuable, or even ‘stranded’ and ultimately rendered worthless.
While trustees may be sympathetic to these concerns, and investment officers sceptical of the outcome of looming greenhouse gas regulation, there are legitimate questions about the effects on portfolio risk and returns from the partial or complete divestment of fossil fuel stocks.
So the question becomes: how should a fiduciary compare the risks to portfolios presented by stricter carbon regulations to the risks associated with reducing exposure to fossil fuel stocks?
Analysis of historical data shows that over the past seven years eliminating the fossil fuel sector from a global benchmark index would have actually had a small positive return effect. Furthermore, much of the economic effect of excluding fossil fuel stocks could have been replicated with ‘fossil
free’ energy portfolios consisting of energy efficiency and renewable energy stocks, with limited additional tracking error and improved returns.
Impax believes that investors should consider reorienting their portfolios towards low carbon energy by replacing fossil fuel stocks with energy efficiency and renewable energy investments, thereby retaining exposure to the energy sector while reducing the risks posed by the fossil fuel sector.