Fossil fuels – divestment or dialogue?
We respond to investors' increased thought into how to respond to the commitments global leaders made to limit the rise in long-run temperature to two degrees.
Investors and asset managers have put increasing thought into how to respond to climate change within investment portfolios. As stewards of long-term assets, how can we ensure that the funds we manage align with the commitments global leaders made to limit the rise in long-run temperature to two degrees?
Climate change is a long term and escalating challenge for society. It will affect the way we live and products we buy. Experts at Schroders estimate that we are currently heading for a temperature rise of over four degrees (see Schroders Climate Progress Dashboard), so meeting the ‘two degrees’ commitments will require significant change with profound implications for how we all live.
At the forefront of the climate change debate are fossil fuel companies and the role that long-term investors can play in encouraging the transition to a low carbon world. Should we be making a moral judgement about fossil fuel producers and selling our shares or using our rights as shareholders to push for change?
A growing number of investors are responding to climate concerns by selling shares in fossil fuel producers. At $5.4 trillion1, the value of investment portfolios that exclude fossil fuels has doubled in the last two years and some voices in the EU Parliament are recommending divestment. This is because most of the blame for climate change lies with man-made greenhouse gas emissions, around 80% of which are from fossil fuels2. Limiting temperature rises to acceptable levels means cutting those emissions by two-thirds over the next three decades, which is a clear challenge to producers. It implies that the world will need to cut fossil fuel production by 1% annually up to 20503, a sharp reversal from the 2% annual growth of the last thirty years.
A number of foundations, university endowments and charity investors are part of this divestment ‘movement’, choosing to sell their fossil fuel holdings for a variety of reasons. Some may want to show their moral disapproval, judging that fossil fuel companies contradict their mission. Some divest for financial reasons, believing that the intrinsic value of fossil fuel assets are much lower than current market valuations - so called 'stranded assets'. For others, the act of divestment itself is an attempt to influence public policy or reduce their own indirect carbon emissions. Many universities are also feeling pressure from student groups, where stakeholder influence can be a powerful force for change.
Whatever the catalyst, asset owners need to consider the potential challenges and practicalities of full divestment.
The impact of divestment on asset allocation and returns
Fossil fuel producers make up around 6% of the global stock market and over 12% of the UK market4 . Excluding an entire sector impacts asset allocation, resulting in increased benchmark risk (relative to the market) and potentially higher volatility.
Schroders research shows that over the long-term the impact of exclusions on investment returns is minimal. However, it can increase volatility in the short term. In the charts below we compare the returns of the global equity market to a screened index.
Past performance is no guarantee of future results. Investors cannot invest directly in any index.
Source: Schroders; Datastream 30 June 2017. † Exclusions for fossil fuels and all sin stocks are based on 10% revenue cut off, as defined by MSCI. Exclusions for weapons, fur and nuclear are based on business involvement, as defined by MSCI. *Sin stocks include tobacco, alcohol, gambling and pornography.
The exclusion of fossil fuels has had a significant impact on relative returns in the short term, but the effect of these exclusions over the longer term is less distinct.
For income investors, the exclusion of fossil fuel companies can also have a meaningful impact, as dividends from this sectors makes up around 6% of income from the UK market (FTSE All Share 28.02.18). Schroders research shows that the tracking error of an income strategy increases by over 1% when excluding fossil fuels based on a 10% of revenue tolerance.
Practicalities of divestment
In order to divest, investors must first determine which companies should be included in the definition of fossil fuel. Most choose to do this with help from a data provider, who can produce a list of companies with involvement in fossil fuels. However, different providers have differing definitions; Provider A captured 104 companies as having involvement in fossil fuels, whilst provider B captured 357. The difference in number can mostly be explained by the wider coverage of provider B. However, the overlap between the two was much lower than one might expect for similarly defined exclusions.
Source: Schroders 2017; Anonymous data providers (2017). All data as at 1 May 2017. *Exclusions for fossil fuels based on 10% revenue cut off.
As our ‘Demystifying negative screens’ paper highlights, screening is not as simple as it might seem. Investors need to determine exact criteria and ensure it matches their individual policy. For fossil fuel screens, investors will need to consider whether to exclude only extractors and producers, or service providers also, and whether to apply a revenue tolerance and at what level? These factors will in turn have different implications on the investable universe.
Coal generates twice as much carbon as gas to produce the same amount of energy
Additionally, not all fossil fuel producers are the same. Coal generates twice as much carbon as gas to produce the same amount of energy , while oil is somewhere in between. The Church of England Ethical Investment Advisory Group have determined that tar sands or thermal coal, being the most carbon intensive, are the biggest concern and opted for divestment from these companies at a 10% of revenue tolerance level. This enables inclusion of companies such as Royal Dutch Shell and BP, which significantly lowers the impact on the investable universe.
Dialogue and engagement
However, perhaps divestment is too simple an answer. It is clear that oil, gas and coal producers will face challenges as demand for their products fade, but the impact on individual companies will depend on how their businesses adjust to the new world.
Coal producers will initially bear the brunt of the impact and these, along with companies exposed to tar sands, are the focus for many divestment strategies. In contrast, gas producers will benefit from the lower carbon content of their fuel relative to other options. Equally companies with lower cost operations will be better able to withstand falling consumption. Low cost producers biased towards gas production sit towards the more attractive end of the fossil fuel investment spectrum, whereas high cost coal producers are more exposed.
Investors seeking financial return will need to be able to sort the best protected from the most exposed, but individual company responses to the challenge make shareholder engagement potentially influential. Many investors, including ourselves, have been vocal in calling for more robust planning and greater transparency. Schroders began engaging with companies on their climate change policies in 2002 and has made great progress through both individual engagements, collaboration with other asset owners and participation in industry initiatives. Maintaining our investments preserves our seat at the table and enables us to influence change. There are signs that this pressure is paying off. In the last few months, for example, Exxon has announced that it will publish analysis of the impacts of climate change and Shell has set a goal to halve the carbon intensity of the energy it produces.
We have highlighted the range of different options available to investors when deciding how to respond to climate change within their portfolios below.
Although there may be good reasons for individual charity investors to divest from fossil fuels, particularly the most carbon-intensive companies, evidence suggests that long-term investors can influence corporate practice through dialogue, helping to steer us towards a lower carbon future.
1 https://gofossilfree.org/commitments 28.02.18
2 https://www.eia.gov/energyexplained/index.cfm?page=environment_where_ghg_ come_from
3 Based on IEA scenario analysis, combining different fuels on a contained energy basis.
4 Source: Bloomberg 28th February 2018. Global index represented by MSCI AC World and UK market represented by the FTSE All-Share.
The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and a trading name of Schroder & Co. Registered Office at 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored.