Like any issue regarding investment in a particular asset class, divestment of portfolios from fossil fuels is more complex than it first appears. But one thing is worth noting in the first instance; so-called “fossil free” indices do not perform worse than portfolios invested in coal, oil and gas.
If anything, the opposite is true. If you take for example the MSCI ACWI ex Fossil Fuels Index, which includes large and mid-cap stocks across 23 Developed Markets and 24 Emerging Markets countries and acts as a benchmark for investors aiming to eliminate fossil fuel exposure from their investments, it is performing better than both the S&P Global Oil Index and most individual oil majors over the past one, five and 10-year periods.
A study by Newton Investment Management in 2016 also found that, for developed markets, there was no significant impact of fossil fuel screens on portfolio returns; and that, for emerging-market portfolios, there was a significant benefit from a fossil fuel exclusion policy, in part because these companies are often under state control, so not necessarily managed with investors’ concerns in front of mind. Fossil-free stocks both perform better and with less volatility.
So on performance alone, the message is clear; selective divestment is possible without negatively impacting returns. If anything, it enhances returns. The idea, put forward in a recent piece for CapX by Andrew Lilico, that divestment only hurts the divestor is just false.
To understand the realities behind divestment, it is worth taking a step back, and considering how the interest in shedding fossil fuel stocks developed, and why.
There are two arguments that are fundamentally different in nature, though related. One, exemplified by environment group 350.org, seeks to put pressure on fossil fuel companies due to concerns over the impacts of climate change. In this, campaigners are followers in the tradition of previous divestment movements, such as those targeting the apartheid regime in South Africa. There are also parallels with other forms of ethical investing, such as those targeting businesses involved in tobacco, cluster bombs, alcohol, weapons, pornography or gambling.
The second argument – one that will be more persuasive to people who think only about the narrow bottom line – is that holdings in fossil fuel companies are increasingly risky. As governments take action on climate change and associated issues such as air pollution, the prospects that fossil fuel-heavy stocks will take a dive increases. The risk is increased by the advance of disruptive technologies such as renewable energy and electric vehicles. Wind and solar installations are moving so fast that the International Energy Agency has had to throw out its annual projections to make upward revisions a dozen times since 2004. And there is a reputational risk as well, with parts of the buying public becoming considerably more ethically discriminating in their choices of energy, food and travel.
Pension funds holding investments a few years back in US coal companies such as Arch or Peabody have learned the lesson the hard way. Regulated on pollution, out-competed on price by renewables and opposed by the public, both of these previously reliable market performers tanked into bankruptcy. Divestment well before this happened would have been highly pragmatic; and an appropriate name for failing to do so would be what – incompetence-signalling?
Inevitably, unless they modify their business models, the big oil and gas majors will follow the same trajectory. Projecting when this will happen is difficult, and it will certainly not be tomorrow; but if you do not hold stocks, it is not your concern.
Some analysts now argue that examination of climate change or energy transition risks is part of fund managers’ fiduciary duty, especially in the pension sector. That is not universally accepted. But there is no doubt, as analysts Carbon Tracker repeatedly highlight, that only a fraction of the world’s known fossil fuel reserves can be used if governments fulfil their declared pledge to keep climate change within so-called “safe” levels – and that companies whose business models assume greater exploitation are therefore running a risk of stranding investors’ assets. This concern coalesced during the run-up to the 2015 Paris climate summit with establishment of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures, which works with businesses, investors and markets to understand and manage climate-related risks.
To return to where I came in: divesting from fossil fuel stocks does not impair a fund’s performance, and may actually improve it over time. Logic suggests that this picture will become clearer in the coming years, as first coal, then oil, then gas are supplanted by more modern energy provision. Companies in the automotive sector are also prone to disruptive price falls if they fail to anticipate the march of technology, environmental standards and changing public appetites.
Far from being meaningless “virtue signalling”, divestment can lower investment risk without impacting returns. If investing in carbon-heavy stocks is both risky and unnecessary, then… why would you?