Our views on stranded asset risk
Our View on Divestiture and Fossil Fuels:
Divestiture Gaining Ground. A total of 436 institutions plus hundreds of family offices, together representing $2.6 trillion in assets have committed to divest themselves from fossil fuel companies as of September 2015. One year ago, those numbers were 181 institutions and $50 billion. Given this level of growth, the divestment movement can no longer be referred to as a fringe movement.
Nonetheless, both sides of the divestiture argument are deploying blunt nosed instruments to address what really is a far more nuanced question of risk and return.
Eighteen months ago, we sat down with two of the largest pension systems in the U.S. and walked them through our thoughts based upon the research we did in writing Fossils on the Beach. Although both were interested in our findings, they asked "can we show this to our conventional energy funds to get their opinions?" Not surprisingly, the conventional energy funds replied that there was nothing to be concerned about.
In the last 12 months, those two pension funds lost $5 billion dollars in their coal, oil and gas portfolios.
Kevin Bourne, a managing director of London-based stock market indices provider FTSE, has called divestment “one of the fastest-moving debates I think I’ve seen in my 30 years in markets.” So far, the movement has attracted more action with respect to coal than oil or gas; perhaps because coal seems to be the dirtiest fuel, perhaps because coal represents a smaller share of most portfolios, or perhaps because coal indices have already fallen quite far. In any event, investors seem to treat each fuel type as a single asset class to be dealt with in a uniform way.
The industry lobbying groups of each of the coal, oil and gas industries too are asking us to treat their particular fuel as a separate and uniformly important asset category we cannot possibly abandon. Gas is playing the “we are cleaner than coal” card. Oil is taking the “we dare you to stop using oil even if it kills you” approach. And coal appeals to “motherhood and apple pie – we brought you the lifestyle you now so enjoy,” job preservation and all. Admittedly, these are giant asset classes – oil & gas companies make up 11% of the S&P 500 and 20% of the London FTSE 100.
Commodity Risk Profile Already Changing. The reality is that the risk profile of carbon assets has already changed and the pace of further change is likely to accelerate. In the case of coal, particularly in the U.S., much of the damage has already been done. Effectively, U.S. investors in coal stocks and indices lost 75% or more of their value before any of them reacted to the “divestiture call.” Those who did divest could be accused of using the movement as a cover for losses they should have avoided by acting sooner.
Falling oil prices over the last 12 months have had a similar and unexpected impact on portfolios heavy in oil stocks.
But none of coal, oil or gas is an asset of uniform value or risk characteristics. The commodities are different from each other and from the companies exploiting them. U.S. coal faces a different prospect than coal in parts of Asia or Africa. U.S. natural gas from fracking is in a different position than more expensive pipeline gas from Russia. Whether your oil holdings are tied to the Saudis, BP/Shell/Exxon, smaller U.S. shale developers or Canadian tar sands makes a bigger difference today than it did just a year ago. From an investment perspective, the important question is “just how differently will my overall portfolio behave in the near and longer term future than it has behaved in the past?”
Divest and Invest. The folks behind the diversiture movement are increasingly calling for a "divest and reinvest" approach focused on putting the money pulled out of fossils into new forms of cleaner energy. But many of those calls are couched in activist and "impact investing" or "ESG" terms, not based on sheer financial returns. In our view, any call for divestment that fails to provide a finally as or more rewarding reinvestment approach is difficult to support on fiduciary grounds and likely to fail. However, blindly sticking with an asset class whose risk/reward profile has already dramatically changed is equally likely to lead to fiduciary liability.
We do pay significant attention to the recent announcements by Apple and Google that they will source 100% of their energy needs from solar and wind sources. What discussion is likely to take place in Fortune 500 Board rooms as they realize that those were financial, not social, moves by two of the biggest corporations in the world?
Similarl;y, we believe investors should pay attention to the Apple and Google announcements about buildings electric and autonomous driving cars. In addition to the leadership that Tesla has already shown, most of the major European auto manufacturers have now made clear that they plan to roll out mainstream EV vehicles in the 2017 or 2018 model year. How will that affect your holdings in Ford, GM, the European or the Asian carmakers and their long-term plans for oil and fuel consumption generally?
Solar first grows on sun-drenched residential rooftops and subsidized regions, then as remote power in developing countries and onward to utility scale globally. Energy storage starts maturing in consumer electronics then jumps to cars and grows orders of magnitude in scale, setting it up to profit in the even larger grid connected load shifting market and onward. These new technologies each move to ever larger scales, begetting ever lower cost structures and causing sudden, nonlinear disruptions to fine-tuned but and vulnerable business models in the fossil fuel energy and transportation stack.
In our view these all represent areas ripe for reinvesting dollars once held in fossil stocks and areas that should, over the foreseeable future, represent better risk adjusted returns than broadly maintaining all fossil holdings.
Different than Prior Political Divestiture Movements. A number of consultants have compared the call for fossil divestitures to previous divestiture efforts around alcohol, gambling or tobacco. But those analyses seem to ignore the fact that while we might have wanted to slow or stop drinking, gambling or smoking, no one is trying to stop energy usage. The real question in energy is once the shift from fossils to renewables starts accelerating can anything slow it down? Why would we ever go back if the price of the new technology keeps falling? There are certainly those who are buying up fossils in the belief that they are being oversold; particularly in view of recent declines in oil prices. But the smart money knows that those shifting to solar and electric vehicles aren’t going back; if anything they are increasing their commitment to the new.
What if the entire world turns to Uber and its imitators for a much more efficient transport profile? What if the lowest cost of production national oil companies believe the world will do something serious about Climate Change and carbon before 2020 and they would rather sell 100% of their reserves at $50/barrel while more expensive producers are left standing by until their holdings truly are stranded? Those are not questions best addressed by divesting or not divesting the oil, coal or gas asset class. Those are questions that require a vigorous reassessment of one’s entire portfolio, one holding at a time, to see just how much more risk is suddenly inherent in any number of investments reflecting a very different risk profile only a short while ago.
The answers to those questions are likely to lead some larger investors to take a much more active role with their portfolio holdings and portfolio managers – passing the tough questions on to them and hoping they have good answers. If you get a far better answer from Chevron than from Exxon, or from Ford than from GM, maybe you should drop one and buy the other, rather than dropping oil or autos.
Transitional Precedents. The Internet age brings us a fairly recent precedent for how such a transition might work. At some point around year 2000, most of us had come to a view that much if not most of media and its associated advertising revenue was moving from paper to electronics and that the book publishing industry, the newspaper and magazine industry, and ultimately all of advertising would follow. Unlike some of the advertising we are now seeing from the fossil industry; the wood and paper industry didn’t try to tell us that our information world would end because we no longer had access to their form of reading pleasure. But, as is the case here, the ramifications were far broader than that we used less paper and more electrons. Most of the media companies who had learned how to exploit paper, now had to learn an entirely new industry. In doing so, they faced newcomers from the Internet world, like Google and Facebook, Amazon and eBay, and thousands of nimble startups that sought to eat the paper incumbent’s lunches while stealing more and more of their advertising revenue.
Early on, the pace of change seemed glacial and few of the old world incumbents seemed all that threatened. But the leading newcomers kept growing, rapidly getting to a scale that made some of them much bigger than the old-liners they were threatening. As a result, more and more of those old-liners found they had to change to survive. A few did so quite effectively, others quietly faded away. But 15 years later, we have an entirely different media and advertising business with a very different group of global leaders. In many ways it was a bloodless coup, but investors who didn’t pay attention and held on too long or failed to capitalize on investing in the new winners either took on significant losses or left on the table giant gains they could have had. There was no “divest paper, invest Internet solution.” Instead there was a much more nuanced shift across an entire range of industries that was affected by the shift from paper to electrons and their associated advertising revenues.
So it is likely to be with the shift from coal, oil and gas to wind, solar, batteries and other cleaner forms of producing electricity and fueling transport. Companies that today produce returns from giant reserve holdings of fossil fuels, or from owning 100 year legacy power production assets will lose ground to more nimble producers of clean electrons and alternative fuels, many of them as a result of individual and corporate buying decisions (not mass utility purchases). Returns on energy assets will be converted to returns on energy services. Energy will move from a giant B-to-B business to a B-to-C business that resembles the change from the old AT&T to today’s world of global data communications players.
Overweight, Underweight, Divest and Invest Carefully. So the real question is not should I divest from coal, oil or gas. It is: how do I reallocate my portfolio from those stuck in the old way of doing things to those who will profit from the new way and how much time do I have to make that transition? How do I best overweight, underweight, and divest accordingly. Should I consider the global economic effects and resultant shifts in trade flows? Which economies will suffer over the long term? What long-term assets does the portfolio hold that are tied to those economies?
The more obvious portfolio management choices boil down to:
Monitor your exposure to fossil assets and fuels. This alternative includes a “do nothing” outcome, but at least advises that you think about the full range of sectors from mining to shipping to chemicals and steel and that you think not only of carbon but of pollution and environmental impacts (such as flooding or drought) more generally.
Engage with the management of exposed firms – often better results can be obtained by getting a portfolio company to change its behavior and risk profile than by divesting from it. Also consider engaging with peers and with the press and develop and articulate a coherent strategy. If you are divesting for impact then do so by raising public awareness, target bad actors and influencing government action.
Over and Under-weight based upon responsiveness based upon the extent to which companies are demonstrating progress in reducing their exposure to carbon stranded assets and/or shrinking the size of their overall carbon footprints.
Selectively divest either those companies whose carbon profiles are the most extreme or whose recovery costs suggest they are greatest risk of being stranded.
Hedge your risk through a variety of financial instruments. But remember that when investors faced the sub-prime crisis in real estate, hedging turned out to be far more difficult and the impacts far broader than anyone imagined.
Invest in the Areas Gaining Ground. We would suggest a different course. Although energy efficiency can certainly affect our need and desire for fossil fuels and environmental reasons can influence our motivation to be more efficient, our view is that global energy use will either stay relatively constant or rise – due largely to global population and GDP growth.
Therefore the real business question to be addressed is which energy assets and correlated secondary assets are at greatest risk of being dropped in favor of newer, cheaper and cleaner energy, transport and correlated assets? Where should your capital migrate to in anticipation of a new equilibrium based not just on a desire to drop dirty energy but on the ability to choose a better alternative?
Today, that transition seems as improbable as jumping from a listing cruise ship to a small lifeboat in unfriendly seas. But the sooner that we realize that our burning of coal, oil and gas must come to an end (there are, after all, quite valuable uses of these carbons that do not involve burning them), that there is no substitute cruise ship at our ready, the sooner we will become smarter about at least booking a reservation on that lifeboat.
If one maps the projections made by the U.S. and Internation Energy Agencies for growth in wind and solar over the last decade against the actual gains made by wind and solar power, it is clear that governmental agencies have continuously and significantly underestimated the rates of change and seemingly continue to do so today. Early observations regarding energy storage and electric vehicle penetration suggest that overly conservative pattern will hold in those sectors as well.
That difference between reality and expectation is where investment returns lie.