As we learned from the recent financial crisis, systemic issues can wreck portfolios and undermine investor confidence for years. For many, climate change is emerging as a major systemic issue facing investors: economic damage from extreme weather and shifting climatic belts is likely to get worse, and governments are unlikely to sit on the sidelines. Investors need to act now, developing a coherent, flexible strategy to manage the risk of intervention.
The “unburnable carbon” issue has become polarised. Those advocating full divestment are seen by many as extreme, particularly as divestment entails the wilful avoidance of dividend streams and a risk of underperformance if energy prices rise. However, recent statements from fossil fuel E&P companies to challenge the analysis behind stranded asset risk and/or downplay its significance have been less than persuasive.
Asset owners are increasingly frustrated, particularly if faced with rising stakeholder pressure to reduce exposure to fossil fuels. Although there have been a few high profile announcements of wholesale divestment, for the vast majority, the default response is to do nothing and wait for further developments.
Polarised responses are irrational for two reasons. First, recent developments in science and policy have had a major impact on the climate change issue, recasting it as a risk rather than an uncertainty, thereby facilitating the use of traditional investment management tools, particularly asset allocation. And second, developments in energy efficiency markets have created options for investors to mitigate some of the risks implied by divestment.
Assessing the risk
Investors struggle to deal with uncertainty, where the magnitude and timing of a potential impact cannot be readily estimated, but are typically comfortable with incorporating risk information into their decisions, particularly the level of allocation to different types of asset.
For many years, the mainstream investor reaction to climate change has been that the science and likely policy response have been too uncertain to justify action. However, the UN Intergovernmental Panel on Climate Change report of September 2013 reported a strong scientific consensus over the causes of climate change and the likely consequences for the planet of the current trajectory of greenhouse gas emissions. Subsequent announcements from both the United States and China of specific plans to limit emissions of carbon dioxide have materially raised the chances of policy intervention. Investors can now legitimately consider scenarios in which major economic blocs pass legislation to restrict CO2 emissions within the next decade, for example through a significant “Carbon Price” which will affect the economics of both energy producers and consumers.
Towards an investment response
Investors generally have three types of response to higher levels of risk: lower exposure to the assets concerned, reduce the risk and/or hedge it.
Faced with a material probability of a Carbon Price within a decade, a timescale that matters for decisions taken today, it is rational for investors to lower their exposure to assets that could be affected. On the one hand, it is likely that the effect on today’s valuations of these lower wholesale prices is “drowned out” by myriad other drivers of prices, for example political risk. On the other hand, as shown in Figure 1, a Carbon Price may render those assets with a higher marginal cost of production “stranded,” or potentially worthless. It is these assets that should be targeted for selective divestment.
To mitigate risk, investors should challenge the companies whose fortunes could be improved by a change of strategy, for example oil majors that could cut back on capital expenditure into high marginal cost assets, possibly with a commensurate increase in dividend levels.
Although the wholesale energy price is depressed by a Carbon Price, the retail energy price can be expected to rise (Figure 2). By reinvesting the proceeds of selective divestment of fossil fuel assets into energy efficiency related business opportunities, investors not only hedge the risk that they miss out on future energy price rises, but also create exposure to energy prices that should increase in line with government intervention to limit greenhouse gas emissions.
Divestment in practice
Taking a risk-analysis approach to the impact of future climate change policy, investors may rationally decide to reduce their exposure to fossil fuel assets rather than full divestment. We recommend that a plan of action includes four components. First, examine individual assets to determine their marginal cost of production (and thereby their potential exposure to Carbon Pricing); this is likely to be difficult except for discrete assets or for companies with high levels of disclosure. Second, develop scenarios for the level of Carbon Prices and the probability and timing of their introduction; we recommend a simple model to start with which can be developed further as circumstances change. Third, divest in line with the probability-weighted loss per asset, i.e. multiply the loss per asset in the scenario by the probability of the scenario occurring; this will be far from an exact science, so it makes sense to start with conservative assumptions, i.e. a relatively low level of divestment. Fourth, consider reinvesting the divestment proceeds into the energy efficiency sector; this may introduce additional risks, for example exposure to the industrial capital expenditure cycle.
At the heart of this issue is the scarcity of useful data, particularly around marginal production costs. Alongside their divestment plans, investors should request additional information from the companies they hold and consider supporting wider initiatives to persuade stock exchanges and financial market regulators to oblige companies to provide further public disclosure.
Positioning for outperformance
Policy to reduce greenhouse gas emissions isn’t developed in a vacuum. We won’t wake up one morning and discover a material Carbon Price has been imposed overnight. Nevertheless, governments have a nasty habit of ratcheting up their intervention to solve important policy problems, so investors who can anticipate government action and take pre-emptive measures to protect themselves are likely to outperform.
Founder and Chief Executive, Impax Asset Management