The “stranded assets” debate

Written By: Henry Boucher Partner, Deputy Chief Investment Officer Sarasin & Partners

Should investment portfolios exclude fossil fuels as part of a wider debate on stranded assets and carbon emissions? Henry Boucher of Sarasin & Partners examines the issues

If we are to minimise the risk of leaving a ruined and chaotic planet for future generations, the need to tackle climate change is now urgent. 2014 was the warmest year across the world since records began in the 19th century. The 10 warmest years in the instrumental record, with the exception of 1998, have now occurred since 2000. On a “business-as-usual” pathway, global mean temperatures will increase by 3-5°C over pre-industrial levels by the end of the 21st century, according to the Intergovernmental Panel on Climate Change (IPCC).

This United Nations panel of the world’s top climate scientists believes that keeping the temperature rise to below 2°C is possible, but is becoming increasingly difficult. It will require significant change to our consumption of fossil fuels in the next few years.

Stranded assets
As political leaders begin to take greater action to cut back on carbon emissions, some of the vast fossil fuel reserves of the large energy companies may never be used. Indeed, according to the International Energy Agency (IEA), approximately two-thirds of existing fossil fuel reserves (coal, oil and gas) must remain in the ground if we are to meet the global goal of limiting climate change to 2°C.

In short, a very large proportion of the world’s fossil fuel reserves are likely to be “un-burnable” and “stranded” underground. Such uncertainties over the future production profile of the energy companies (and therefore their profits) pose risks which may be misunderstood and poorly priced by the market.

Exclusion of fossil fuel companies
Given the need to take greater action on climate change and the potential risks to the share prices of coal, oil and gas companies from stranded assets, a cogent case has been made for the exclusion of such companies from investment portfolios. Proponents of divestment argue on both investment and moral grounds: the investment case is that markets have not fully discounted the risk that a proportion of the reserves of fossil fuel producers may be unusable. The leading proponent of the investment argument has been the Carbon Tracker Initiative, a not-for-profit think-tank that provided guidance on the likely extent of “stranding” by listing the largest 100 coal companies and 100 oil and gas companies, ranked by estimated carbon reserves.

From a moral standpoint it is argued that it is unethical to channel more capital to fossil fuel companies whose only function is to dig up the very product that threatens the world. The picture is far from clear. Does the fault lie with those producing the fossil fuels, those that enable greenhouse gas emissions (like car manufacturers), or those that actually emit greenhouse gases, e.g. airlines, manufacturers, supermarkets and indeed all of us as consumers?

University endowments, religious institutions and a number of high-profile charities are some of the investment institutions that have come under pressure to divest. Some influential investors have announced the exclusion of some fossil fuel companies from their investments, such as Oxford University and the Church of England in the UK, and Stanford University and the Rockefeller Foundation in the US (which was originally funded by Standard Oil). By contrast, the Norwegian Government Pension Fund Global (GPFG), which is one of the world’s largest investment funds and well known for its long-term, responsible investment approach, employed an expert panel to explore the issue and concluded that this should not exclude fossil fuel companies.

Investment risks are multi-dimensional
Clearly, uncertainties exist over the regulations and technologies that will be introduced to reduce carbon emissions and it is impossible to know ahead of time exactly what shape they will take. Nearly all those who emit CO2 as part of their activities do not bear the full costs of their actions. Looking beyond the production of fossil fuels, business models that rely on generating a lot of CO2 are particularly vulnerable to changes in societal norms and increased regulation to reduce their emissions. It is becoming increasingly likely that greater sanctions will be imposed on carbon “freeriders” of all types.

Investment choices
Investors can respond to the climate change threat in a number of ways. The first way is to build these risks fully into their investment strategy. This means ensuring that fund managers are adjusting portfolios to take account of the negative risks of change and considering any positive investment potential from the reduction in carbon intensity, for instance in energy efficiency.

Secondly, investors also have a role to play by participating in the debate with policy makers, for instance by making representations to the participants of the United Nations December 2015 Climate Change Conference in Paris, which aims to achieve a binding and universal agreement on climate change. Engagement with companies is also important to encourage reductions in carbon intensity and to provide greater disclosure of information about CO2 emissions and their individual climate change strategies.

Thirdly, investors that wish to consider divestment or exclusion of fossil fuel producers can follow Oxford et al and apply an ethical overlay to their portfolios. Of course, this provides greater certainty that no capital will be invested in the identified companies, but it is not a simple decision to choose those companies to be avoided. Excluding only the companies that produce coal and oil from tar sands does not make the portfolio “fossil free”.

Judging the extent to which the stock market has already taken account of the stranded assets risk is difficult. Many see this risk judgement as being the key to exclusion – whether it should be mandated or left at the discretion of the fund manager. It is notable that the Norwegian GPFG expert panel concluded that it does not believe it appropriate to translate the concept of stranded assets into portfolio composition.

When considering whether to implement a formal exclusion policy for fossil fuel producers – whether for investment or moral reasons, each investor will need to engage with the issues and consider their strategy in the light of their own beliefs and investment goals. But for all long-term investors, the wider issue of climate change is growing in significance. The exclusion campaign provides tangible evidence of concern and adds to pressure on policymakers to take bold action at the intergovernmental climate talks in December. A concerted global policy response in Paris has been made more likely by the outlines of a deal agreed by presidents Obama and Xi last November (the US and China account for 44% of CO2 emissions between them). A robust move on CO2 regulation will then have a material bearing on the outlook for a wide range of companies in the world equity index.