By Ian Simm
There is an increasing likelihood that governments of major economies will act within the next decade to reduce greenhouse gas emissions, probably by intervening in fossil fuel markets. Smart investors therefore recognise that the risks related to fossil fuel prices and ownership have changed.
However, neither “full divestment” of all fossil fuels stocks (and potentially other companies) nor “do nothing” are rational. Is there a way of using well-established investment management tools to establish a logical approach that not only reflects today’s risks, but is flexible enough to evolve as climate change investment risk changes?
Investors approaching this issue to date have generally used “carbon foot-printing”. In addition to the by now well accepted problems of measurement, foot-printing fails to take account of a company’s pricing power, and is therefore a poor and potentially misleading proxy for financial risk.
An alternative approach is required. We have estimated how much of today’s asset values are “at risk” and modelled an optimal level of reallocation from the most exposed companies, while also demonstrating that reallocation to companies active in energy efficiency markets limits the introduction of new risks. This approach reflects climate change risk as measured today and provides a framework for managing this issue in the future.
Regulatory risk not climate risk
Today, the risk for investors of government intervention to reduce future emissions is much more significant than the underlying risk of climate change itself. Government intervention to reduce pollution is typically based on taxation, “cap and trade” schemes or standards. In the context of policy to mitigate climate change, investors should focus on “Carbon Pricing” as a proxy for these policy instruments.
Investors should concentrate on listed companies engaged in the exploration and production of fossil fuel assets. These companies are unlikely to be able to pass on the full effect of Carbon Pricing to their customers or to adjust their revenue or asset base quickly enough to avoid this exposure. In contrast, companies further down the energy value chain, for example gasoline refiners, utilities, or airlines, typically face much more complex market structures – many can pass a portion or even all of their cost increases onto their customers in the form of higher prices.
A simple model of each fossil fuel sector shows that the introduction of Carbon Pricing will raise retail prices, depress wholesale prices and reduce supply/consumption, leaving some assets stranded and impacting cash-flows for those who remain in the market. There are strong indications that today’s prices of energy stocks do not account for the risk of government intervention.
Partial divestment and reallocation
Using a scenario approach to Carbon Pricing, the “value at risk” for companies in the MSCI World Energy Index that are potentially affected can be calculated and sold. The divested sum can then be reallocated to a basket of energy efficiency stocks. These stock prices are typically correlated more closely with the retail price of energy (which is expected to rise with Carbon Prices) than with the wholesale price of energy (which is expected to fall).
The FTSE Environmental Opportunities Energy Efficiency Index represents an attractive basket of stocks for reallocation. With around US$1trn of aggregate market capitalisation, there is plenty of scope for small and medium sized investors to adjust their portfolios.
Reallocating to renewable energy companies may appear to be an alternative approach. However the sector is dominated by a small number of large cap names and investing in this limited group could introduce additional risks, particularly stock-specific risk and the risk of regulatory change.
A Dynamic Plan for the Future
This model must evolve if it is to keep pace with changing risk. To implement this strategy effectively investors should seek additional information from fossil fuel asset owners in order to improve their risk analysis. They should also engage with regulators to mandate further disclosure of this information, and continuously refine their assumptions and modelling in order to adjust their positioning as to the quantum, timing and likelihood of carbon pricing.
Crucially, such a “smart carbon” portfolio represents only a partial sell-down of many fossil fuel stocks, so those investors wanting to engage with companies and persuade them to change strategy will still have a seat at the table.
In time, it is likely that the market values of all stocks will incorporate climate change risk. However, investors who position themselves ahead of this change should out-perform.
Ian Simm iw chief executive of Impax Asset Management.
