Investments in coal, oil, and gas increase financial risk without increasing returns, according to this report, which includes the first simulation comparing performance of an Australian fossil fuel free investment portfolio with an indexed ASX portfolio.
Debates about climate change have recently been reframed in terms of financial risks. Current global fossil fuel reserves, if extracted and burnt, would release far more greenhouse gas emissions than is compatible with meeting the internationally agreed limit of no more than two degrees of global warming.
Consequently, fossil fuel business valuations involve a fundamental intellectual ‘fallacy of composition’ – analogous to the traditional speculative bubble. Investors’ expectations cannot be met as they have become divorced from the physical reality and committed policy response. Currently, in aggregate, fossil fuel companies are estimating they will freely be able to extract (for subsequent sale and combustion) over three times more carbon than is compatible with the agreed two degree limit.
‘Unburnable carbon risk’ is the risk to investors who hold shares in companies owning reserves that those reserves will become ‘stranded’, that is, they will lose economic value prior to the end of their useful life.
Valuations of fossil fuel reserves are based on discounted cash flow analysis. Anticipated future changes in the use of fossil fuel reserves, even though they may have little impact on price and production trajectories for, say, a decade, can still have a significant impact on current values. So the investment risk to shareholders in fossil fuel companies is significant.
This paper deals with these investment risks particularly as they face decision makers at religious funds, universities, public authorities and private foundations. This group of investors often have pertinent ethical and/or responsible investment obligations or policies.
All prudent investors should assess their attitudes and exposure to unburnable carbon risk. There are then three options that should be assessed in relation to each asset class –
1. Do nothing but plan for regular risk assessment,
2. ‘Walk’ or
In relation to Australian equities there is a wide range of company-specific exposures to unburnable carbon risk – from pure play coalminers through to oil and gas majors, power generators, diversified miners with some fossil fuel operations, to companies providing services to fossil fuel producers. We grouped these companies and US based analysts Aperio Group simulated historical performance of a screened portfolio that eliminated from the ASX 200 index companies with business models dominated by fossil fuel production or use. Consistent with well-established theoretical and empirical results about screening, this portfolio exhibited similar risk return characteristics as the index.
Many religious groups and foundations and some universities and public authorities will have legal constituting documents that impose an ethical, environmental objective. A screen eliminating companies whose business model is dominated by fossil fuels can readily be conducted, reducing unburnable carbon risk without compromising returns and, if necessary, without compromising tracking error.
Many institutions will have governing documents that express no ethical objective but impose a trustee or trustee-like duty. If trustees take the view that a fossil fuel screen like the one described above, for example, may well improve and be unlikely to compromise risk-adjusted returns (if policy action is delayed) by reducing unburnable carbon risk, then they are free to adopt it.