Divestment and stranded fossil fuel assets: the return characteristics of divested index portfolios Jenny Lieua* Tim Foxonb and Noam Bergmanc *Corresponding author. Tel.: +(44)1273 877599, [email protected] a
b
c
Research fellow, Professor of Energy Transitions, and Research Fellow from SPRU, Science Policy Research Unit, University of Sussex, Falmer, Brighton, BN1 9SL, United Kingdom. Acknowledgement: This paper would not have been possible without the help and support of Ashim Paun, formerly of Newton Investment Management, who collated and analysed the data. September 2nd, 2016 Abstract The fossil fuel divestment movement, motivated by environmental and ethical concerns, was initially driven by grassroots initiatives in 2011 and has since gained international momentum. There has been a growing group of conscious investors that question whether they have a moral responsibility which conflicts with profiting through fossil fuel. There is also a compelling economic case for divestment driven by risks of hydrocarbon assets being economically stranded by regulations, technologies, commodity prices and political risks. These contextual factors mean that economic arguments for divestment could persuade mainstream investors to rethink their investment choices. The shift could reduce investments in fossil fuels and encourage reinvestment in low carbon energy and help push a transition towards a ‘green’ techno-­‐economic paradigm. This paper first presents an overview of the moral motivations of divestment and proceeds to focus on the economic rationale for divestment by evaluating investment portfolios. It considers how market volatility and oil prices could affect risks related to fossil fuel investments. The paper empirically analyses the economic rationale by drawing on market data to create ‘divested’ portfolios that screen out fossil fuels. The performance of the divested portfolios’ are assessed though backtesting. The results show that, depending on timeframe and reinvestment choices, divested portfolios could have out-­‐performed non-­‐divested portfolios and would likely have had less volatility-­‐driven risk. This suggests that divestment could be economically beneficial. Key words: fossil fuel divestment, stranded assets, backtesting, and green techno-­‐economic paradigm 1 Introduction to Divestment In December 2015, over 195 countries signed the Paris Agreement to limit the temperature increase due to climate change to 2°C above pre-­‐industrial levels. This implies a rapid transition from fossil fuels to low carbon energy sources whilst maintaining energy security and economy development. The scale of this transition would require a transformation to a new green techno-­‐economic paradigm, i.e. a new organising principle for industrial and economic development, similar in scale to previous paradigm changes. This approach identifies a reorientation of investment from old technologies and industries that are delivering diminishing returns and towards new technologies and industries that offer higher rates of return as a key aspect of this type of paradigm change. One potential pathway for stimulating change towards a new green paradigm would then be divesting from fossil fuels. Fossil fuels, including coal, oil and gas are essential inputs in the electricity and heat sector as well as the transport sector, and which inputs account for 42% and 22% of the world’s carbon emissions respectively (IEA, 2015). According to the 2016 International Energy Outlook reference case scenario, the total world consumption is expected to increase 48% from 2012 to 2040. Although non-­‐fossil fuel consumption is projected to grow more rapidly than fossil fuels, it will continue to make up around 78% of the energy consumption by 2040 (EIA, 2016). A number of influential studies explore emissions scenarios and propose carbon budgets -­‐ a maximum level of allowable emissions within a timeframe-­‐ to limit the impact of climate change. The Intergovernmental Panel on Climate Change’s (IPCC) most stringent scenario states that limiting climate change to 2°C over this century compared to pre-­‐industrial levels requires maintaining GHG concentrations of 450 ppm on average (IPCC, 2014). The International Energy Agency (IEA) study also supports a 450ppm scenario (IEA, 2013). These are ambitious goals considering that global CO2-­‐
equivalent in December 2015 was approximately 401.62 ppm (NOAA, 2015). Other estimates of emissions reduction have been even more stringent. For instance, studies including Hansen et al. (2007) argued to limit atmospheric CO2at a level of 350ppm while Rockström et al. (2009) proposed planetary boundaries and limits to CO2 to less than 350ppm. Grassroots non-­‐
governmental organisation, 350.org, has advocated for a 350ppm limit in 20121, launching a fossil fuel divestment campaign calling on institutional investors to stop investing in fossil fuel companies and to divest existing positions within five years (350.org, 2016). The bottom up divestment movement has grown from a student led initiative to a global movement and has largely focused on the moral arguments. The campaign has also gained high-­‐profile global exposure through the momentum created by the Paris Agreement reached at the UNFCCC’s COP 21 in December 2015. 195 countries adopted the historic agreement aimed at limiting climate change to below 2°C. Meeting the climate targets would require identifying possible low carbon pathways that could include a mix of technology choices, financing mechanisms, social initiatives as well as policy options. The divestment campaign represents one potential driver that could divert economic resources away from fossil fuels and reallocate resources to technologies that may lead towards a low carbon pathway. 1
Launching off from previous divestment efforts by college students in the United States 2 Moral arguments based on environmental sustainability may be underlying drivers for divestment but the case for holding fossil fuel assets in investment portfolios is also being challenged by economic concerns. Companies are being questioned on capital deployment decisions as anxieties grow over the potential for stranded assets, whereby reserves lose value and development is no longer economically viable as a result of events or emergent trends (Ansar et al, 2014). Whether fossil fuel producers have a fiduciary duty to shareholders to responsibly use money is another question that has brought more mainstream investors to examine their investments in this sector. Furthermore, companies listed or operating in countries where climate change or fossil fuel divestment have not been broadly debated are exposed to divestment risk, given today’s globalised investor base for public companies. Questioning the investment value of fossil fuels explores the fundamental economic rationale that supports the fossil fuel industry. If the economic basis for investing erodes over time due to global changes, should investors seek better investment alternatives? Additionally are environmental and social sustainability equally important considerations for investment decisions? This paper provides an overview of the main motivations driving divestment movements and focuses on the economic rationale for divestment due to the potential for stranded assets and other risks associated with fossil fuel investments. We evaluate the implications of divestment on economic returns to investment portfolios since 2004 and argue that investors should assess the risks and returns for their investment portfolios. The body of the paper is organised into five sections. Section one introduces the techno-­‐economic paradigm (TEP) as a theoretical framing to discuss fossil fuel divestments as a potential shift towards a ‘green’ TEP. Section two provides a historical overview of the moral motivations for divestment and sets the contextual background for the emerging economic evidence for divestment. The latter half of the paper, section three to five focuses on the economics of divestment. More specifically, section three provides a brief review of complementary studies on the economics of divestment. Section four discusses the contextual factor that could lead to the economic stranding of assets and section five presents empirical findings of ten back tested divested portfolios over a five and ten year period and their respective risk-­‐adjusted performance. 1. Theoretical Framing The rationale for divestment is rooted in sustainable development and driven by actors that have been responding to the risks associated with climate change. Analysing divestments requires a framework that considers the broader global investment markets that could help facilitate a low carbon energy transitions. This section briefly explores techno-­‐economic paradigms (Perez, 1983) and the potential transition to a ‘green’ tech-­‐economic paradigm (Freeman, 1992; Freeman et. al., 2002). The perceived role of the environment in economy and society has changed significantly since industrialisation. Starting with the mechanical industrialisation era (1760s-­‐1820s), the environment was viewed as a free good and pollution was an externality. The economy has since transitioned 3 through various techno-­‐economic paradigms2 (TEP) to the current paradigm dependent on fossil fuels. In the present TEP, there have been significant increases in environmental regulations in comparison to past paradigms and greater emphasis on biodiversity and conservation, increased global collaboration (e.g. Kyoto Protocol) and a rise of green consumerism (Freeman, Perez, Colby qtd. in Hayter & Le Heron, 2002). New technologies have also improved energy efficiency and resource use for industrial and private consumption (Freeman, 1992). A new TEP paradigm arises as a result of a crisis that cannot be addressed by the previous paradigm. Novel industries take over incumbent industries and lead to supporting infrastructure development. Climate change could potentially result in the transition to a new green TEP with policies that focus on ‘dematerialisation of the economy’ and internalising environmental value in businesses and ensuring environmental issues are at the forefront of R&D (Freeman, 1996; Hayter & Le Heron, 2002; Hayter, 2008; Perez, 2013; Mathews, 2015). One of the key changes required to shift to a green TEP is a transformation of the energy sector. Industrial ecologists England and Cope (1997) state that changes in energy uses are the foundation to the green paradigm as every sector consumes energy and consequently, energy has become a significant contributor to environmental issues. Some technologies which can dramatically alter the energy system and its environmental impacts are technically feasible, but remain constricted by cost and lock-­‐in to current technological trajectories through existing infrastructure, investments, as well as vested interests and social norms. A technological transition therefore requires a shift in valuing fossil fuel resources (e.g. pricing externalities), in addition to low carbon technologies being applied within mainstream society. For the transition to be ‘green’, accompanying changes in norms, practices, institutions and regulations would also be necessary. Shifts in TEPs can be explored through studying changes in technology systems or clusters of innovation where there is mixture of interrelated products and process, innovations that embody leaps in productivity and in nearly all aspects of the economy and the “opening up a unusually wider range of investment and profits opportunities” (Freeman and Perez, 2008: p. 48). There are three key factors that create greater investment opportunities. These factors can be applied to renewable energy technologies, including: low and rapidly decreasing technological costs (falling costs for solar PV); nearly unlimited availability of supply over prolonged periods (abundance of solar resources); and clear potential use through the economic system (from decentralised solar rooftops to large scale solar farms). These factors create investment opportunities and potentially large increases in productivity and investments. In addition to technological changes, a transition may experience a period of depression due to “deep structural change in the economy” and a “profound transformation of the institutional and social framework” (p. 66-­‐67). The recession signifies a disconnect between the emerging techno-­‐economic system and the expiring socio-­‐institutional framework. Aligning these requires a comprehensive reassessment of social behaviour and institutions norms. Freeman and Perez identify nine key characteristics of a new TEP (see Freeman and Perez, 2008: p.65). We draw on four characteristics that emerge (in)directly as a result of the fossil fuel 2
TEP since industrialisation: mechanical (1760s-­‐1830s) stem (1820s-­‐1970s), electrical (1870s-­‐1920s), Fordism (automotive 1920s-­‐1970s), Information and Communications Technologies (ICT) (1970s-­‐2020s) and eventually the green techno-­‐
economic paradigm (TEP) (Freeman, 1992; 2008). 4 divestment movement and/or are traits that encourage reinvestment in low carbon technologies. These characteristics involve: 1. “New pattern in the location of investment both nationally and internationally as the change in the relative cost structure transforms comparative advantages. 2. A particular wave of infrastructural investment designed to provide appropriate externalities throughout the system and facilitate the use of the product and processes everywhere. […] 3. A tendency for large firms to concentrate, whether by growth or diversification, in those branches of the economy where the key factor is produced and most intensively used […]. 4. A new pattern of consumption of goods and services and new types of distribution and consumer behaviour” (2008: p.65). Fossil fuel divestment supports characteristic of a potential pathway to a green paradigm by discouraging investments in carbon intensive technology systems (e.g. fossil fuels). Diverting funds away from carbon intensive industries and reinvesting in low carbon industries and infrastructure represent characteristics 2 to 4 in a new TEP. Although the divestment movement could, in this way, contribute to the formation of a new TEP, it is still a niche movement that needs to be scaled up to the mainstream market in order to contribute more significantly towards a green paradigm. The next section provides an overview on the development of the divestment movement and explores how the fossil fuel divestment campaign is contributing towards creating a new pattern of investment by challenging the investment norms in the fossil fuel industry. 2. Divestment movements: challenging market norms One of the characteristics of a new TEP (characteristic 4) involves a new pattern of consumption and changes in consumer behaviour. A divestment movement challenges the existing consumption norms by explicitly highlighting moral and social issues and criticises its impact on society and the environment. Through social pressure, such movements can indirectly contribute to creating new pathways for a green TEP. Divestment from fossil fuels is rooted in social responsible investments, a practice that emerged in the Europe and the United States as early as the 1900s where religious institutions played a role in creating ethical funds and invested based on moral criteria. In the mid 1900s, Churches set up a fund that avoided investments in arms, alcohol, gambling, tobacco and later, the apartheid regime in South Africa (see Kreander, Molyneaux, & McPhail, 2003; Ansar et al, 2013). Social concerns in the 80s and 90s evolved to consider broader environmental issues, which became especially evident with the release of the Brundtland Commission report “Our Common Future” in 1987. This opened up a wider public conversation on sustainable development and the heightened environment awareness was reflected in the development of ethical environmental funds (Bengtsson, 2008; Sparkes, 2002). These contextual developments set the backstage for the fossil fuel divestment movement that would emerge decades later. The Divest-­‐Invest Global campaign, supported by the United Nations, started as a grassroots movement with an overarching objective “to mobilize private and public capital to speed the global energy transition away from carbon intensive fossil fuels and into clean and sustainable forms of 5 energy” (UN Climate Summit 2014, 2014). The motive to divest, based on moral and ‘sound financial management’, has led to a robust public debate and more detailed financial analysis within the industry (see Morgan Stanley, 2015; Impax Asset Management; 2013; Bullard, 2014; Mercer, 2013). The fossil divestment was initiated in 2011 by university student activists at Swarthmore College in Pennsylvania, U.S. concerned about mountaintop removal in coal mining. The movement later evolved to address fossil fuel divestment and spread to other American campuses. Eventually a ‘Divest Coal Coalition’ was formed with NGOs (Grady-­‐Benson, 2014). The campaign received greater recognition when Bill McKibben, an environmentalist published the article “‘Global Warming’s Terrifying New Math’ in Rolling Stone magazine3. The article opened up a wider public discussion that would be instrumental in pushing forward the divestment agenda (McKibben, 2012; Ansar et. al, 2013). The divestment movement has increased seven fold in less than two years, scaling up from seventy-­‐
four institutions in January 2014 to over five hundred entities in mid-­‐2016 (Arabella Advisors, 2014; gofossilfree.org, 2016; Goldenberg, 2014; Carrington, 2015) (see Table 1). Table 1: Breakdown of organisation divested by country Educational( Faith3based( For(Profit(
Healthcare(
Pension( Philanthropic( Sub3
Country(
Institution( Organization( Corporation( Government( Institution( NGO( Other( Fund(
Foundation( total(
Australia)
5)
13)
5)
20)
1)
2)
1)
57)
8)
112(
Australia,)New)
Zealand)
1)
1(
)
)
)
)
)
)
)
)
Canada)
1)
12)
1)
2)
3)
19(
)
)
)
)
Denmark)
3)
2)
2)
7(
)
)
)
)
)
)
France)
1)
1)
2)
4(
)
)
)
)
)
)
Germany)
1)
2)
2)
1)
3)
9(
)
)
)
)
Hong)Kong)
1)
1(
)
)
)
)
)
)
)
)
Netherlands)
2)
1)
2)
5(
)
)
)
)
)
)
New)Zealand)
2)
6)
2)
10(
)
)
)
)
)
)
New)Zealand)&)
Polynesia)
1)
1(
)
)
)
)
)
)
)
)
Norway)
2)
1)
2)
5(
Republic)of)the)
)
)
)
)
)
)
Marshall)Islands)
1)
1(
)
)
)
)
)
)
)
)
Senegal)
1)
1(
)
)
)
)
)
)
)
)
South)Africa)
1)
1(
)
)
)
)
)
)
)
)
Sweden)
3)
1)
5)
1)
1)
11(
)
)
)
)
Switzerland)
2)
2(
)
)
)
)
)
)
)
)
UK)
24)
11)
1)
4)
1)
2)
3)
22)
68(
)
USA)
31)
90)
2)
36)
3)
25)
2)
82)
271(
)
Sub3total(
67(
138(
16(
74(
6(
33(
1(
68(
126(
529(
Total(%(of(org3
anisation(type(
13%(
26%(
3%(
14%(
1%(
6%(
0%(
13%(
24%(
100%(
)
Source: Compiled from data provided by 350.org, 2016 3
The article emphasised that the total carbon in fossil fuel reserves was five times greater than the ‘allowable’ carbon burned. The general public responded with over 14,000 comments, creating broader social awareness on the connection between burning fossil fuels and climate change. 6 The majority of the organisations divesting are based in the United States, Australia, the UK, Canada and Europe while a few organisations are beginning to follow in Africa and Asia. Over 84% of the organisations divested consisted of religious groups, philanthropic foundations, education institutions, government organisations, and governments. A small but growing percentage (around 16%) of the organisations comprise of pension funds and for-­‐profit organisations, indicating that the divestment campaign is moving to the wider market (350.org, 2015). Since 2011, an increasing number of influential foundations and financial organisations have been divesting from fossil fuels. These organisations include the Rockefeller Brother Fund worth USD860 million4 and financial institutions. For instance, Norges Bank Investment Management divested from coal and oil sand firms in 2014 and reinvested an additional 33-­‐66% (30-­‐50 billion kroner or USD 4.33-­‐7.21 billion) in environmental technologies (Norges Bank, 2015). Norges Bank, the fund manager for Norway’s Government Pension Fund Global (NGPF) (valued at USD 850 billion) also divested from companies with poor environmental records (Norges Bank Investment Management, 2014). The partial/full divestments from long-­‐standing organisations that have profited from fossil fuels indicate that they are recognising the economic risks and are responding by changing their investment strategies. Axa group a French insurance company (valued at USD 61.9 billon) is another large organisation that has invested €500 million (USD 566 million) in 2016 and plans to triple its green investments to over €3 billion (USD 339 billion) by 2020 (Axa Group, 2016). These examples of reinvestments in low carbon innovations exhibit the development of characteristic 3 of a new TEP where large organisations tend to concentrate in areas of the economy supporting the innovation. The divestment movement has been further strengthened by commitment by the Guardian Media Group, with an endowment fund worth £800 million (USD 1.19 billion) (Carrington, 2015). Additionally, municipalities have joined the divestment campaign. For instance, in 2015, Oslo became the first capital city to divest from fossil fuels and was followed by Copenhagen, Stockholm and Berlin (350.org, 2016). Individuals have also been consolidating to increase societal pressure to divest, illustrating characteristic 4 of a new TEP where new patterns of consumption of goods and services are developed. The “Move your bank” campaign5, supports the divestment campaign and has spread to countries including the UK (Passman, 2011; moveyourmoney.org, 2014). In total, individuals have pledged to divest USD 5.1 billion, a commitment that has quickly increased by nearly two folds from USD 2.7 billion in 2015 (Divest-­‐Invest, 2016; 350.org, 2016). The value divested in the fossil fuel campaign has contributed to the largest potential financial outflows compared to other campaigns in the past, as seen Table 2. A total of USD 50 billion has been divested in 2014 from fossil fuels may represent a small percentage of the USD 4.9 trillion in 1,500 listed oil and gas firms and an additional USD 230 billion in 275 coal firms (Bullard, 2014); but compared to past movements, fossil fuel divestment is the largest in scale. 4
The decision for the Rockefeller family to divest is symbolically significant as John D. Rockefeller, a co-­‐founder of the Standard Oil Company in 1870, was instrumental in developing the oil sector in the United States (Tarbell, 2009). 5
The campaign originally stemmed from the Occupy Wall Street Movement in 2011 in the U.S. 7 Table 2: Divestment Campaigns Area%divested%
Issue%
Oil%exploration%
divestment%in%
Darfur,%Sudan%
Tobacco%
South%African%
apartheid%
Government)
funding)militia)to)
kill)Darfur)citizens)
Health))
Violence)and)racial)
segregation)
Fossil%fuel%(oil%&%
gas)%
Climate)Change)
Divestment%
Campaign%
timeframe%
Early)2000s:2011)
Total%market%
cap%of%target%
firms%
USD)300)billion)
Cumulative%
campaign%%outflows%
1970s:)~2004)
1978:1990)
USD125)billion)
:)
2011:)2016)
USD4000)billion)
USD5)billion)
2.3)billion)
rand)between)
1985)and)1989)
Total)USD50)billion)in)
Total)2014)USD)3.4)
trillion)pledged)in)2016))
Fossil%fuel%(coal)%
US)$60)billion)
USD)3.5)billion)divested)
or)frozen)
)
Source: Ansar et. al.,2013; Bullard, 2014; 350.org, 2016 Decreased investments in the fossil fuels along with the divested funds can provide opportunities to invest in clean energy6, a global sector with a value of USD 310 billion that has seen an increase of 14% from 2013 to 2014 (Bloomberg New Energy Finance, 2015). The clean energy sector is expected to grow to USD 5.5 trillion between 2014 and 2030. The influx of investments in low carbon innovations is an example of characteristic 2 of a new TEP where waves of infrastructural investments occur. By contrast, low oil prices in 2014 and the first quarter of 2015 resulted in a capex budget decrease of USD 32.7 billion for major oil and gas companies (Fulton, 2015). The depression in oil prices can lead to “deep structural changes” (Freeman and Perez, 2008) and highlights the gap between the growing investment potential in low carbon energy sector and the continued but possibly risky investments in stranded assets. Risk in fossil fuels investments is an important element that influences decision-­‐making in the mainstream market, as many investor decisions are not necessarily motivated by moral arguments. The next section discusses how the economic stranding of assets might support a shift towards a green paradigm. The economic case provides evidence of characteristic 1 of a new TEP by creating a new pattern of investment in the global market. 3. Complimentary studies for the economics of divestment There is limited literature on the economics of fossil fuel divestment to date. While studies from investment banks, research providers to financial service companies and asset managers have outlined the broad parameters of divestment as a response to stranded assets risks, they do not quantitatively demonstrate how divestment affects returns. This section of the paper begins to address this gap by showing how backtested portfolios have performed under certain restrictions and also provides a framework to analyse portfolio impacts and risks of divestment. Willis & Spence (2014) created backtested portfolios over one-­‐, three-­‐ and five-­‐year periods, all ending in December 2013. Divested portfolios removed several sub-­‐sectors from the S&P 500 Index. A core exclusion included oil and gas and related sectors, and metals and mining, accounting for 6
Although this may not always be the case due to competition with other investment sectors such as information technologies 8 11.1% of the index. An extended approach also included airlines, chemicals, utilities, road and rail transport, in total 17.9% of the index. The paper found outperformance over all three time-­‐periods and a marginally better Sharpe ratio for each screened approach, broadly in line with the results of this study. Andersson, Bolton & Samama (2014) developed a simple investment strategy for passive investment designed to hedge climate risk without sacrificing returns. The aim was to extend beyond a divested portfolio by creating an actively selected portfolio without relative market risk, the aim being that if tracking error could be removed, then this would represent an investment in the market with ‘a free option on carbon’, meaning exposure to upside if climate change is more heavily regulated or otherwise mitigated. This approach of mimicking index returns without holding certain securities or sectors is a growing investment style referred to as 'smart beta'. Some investment managers are offering smart beta products to clients that exclude sectors based on environmental principles. 4. Economic stranding of assets: an argument supporting a shift towards a green TEP A new pattern of investment can be created for low carbon innovations as a potential pathway towards a green TEP by challenging the economic rationale that supports the fossil fuel dependent paradigm. We identify a several key contextual developments that could support a green TEP including: increasing economic risks from stranded assets linked to falling commodity prices, CO2 pricing, technological innovations, policy developments and regulatory risks. In recent years, fossil fuel production has failed to generate a good relative rate of return, even with oil prices of over USD 100. With oil prices declining sharply, this concern becomes more acute. A number of economic reasons are driving portfolio re-­‐examination. First, companies have allocated higher capital expenditure to developing frontier reserves (CTI, 2014), difficult and expensive to produce, and higher on-­‐going operational expenditure for their production. Second, there is a strong possibility that cost for carbon for fossil fuel producers will increase. Third, there is a risk of falling prices for fossil fuels, as seen in sharp energy price declines over the past years. For instance, , in particular oil benchmarks which lost roughly half their value in the space of a few months before recovering some of their losses, since the third quarter of 2014. Fourth, climate policy developments can strand assets. Fifth, the cost of installing renewable energy technologies has fallen dramatically to the point where it is reaching competitiveness with the more expensive types of fossil fuel production. The rapidly falling costs are a key factor for increasing productivity and profits in low carbon technologies, which could lead to developing a pathway towards a green paradigm (Freeman and Perez, 2008). Capital expenditure The Carbon Tracker Initiative (CTI), a non-­‐profit organisation which seeks to align capital market risk and pricing with climate-­‐change policy, found that USD 21 trillion of capital expenditure (capex) will be invested by listed companies developing high risk projects that fail to break even in a world of higher oil prices, either due to lower demand or climate change regulation. Figure 2 shows how Brent Crude and West Texas Intermediate oil prices have fallen dramatically (December 2013 to November 2015) to c.USD 67 and c.USD 76, respectively, at the time of the analysis. Companies have followed this downward trajectory, though less dramatically. 9 Figure 1, containing CTI data, shows large projects that would not be viable where the oil price was below USD 95 per barrel. The table shows that the assets most at risk of stranding are oil sands, arctic and deepwater / ultra-­‐deepwater. Investments in companies with most exposure to these assets are at the most risk. These assets are not only expensive to produce but they also have a high, embedded climate cost7. Figure 1: Top 20 largest undeveloped oil projects requiring USD 95 per barrel market oil prices Source: Carbon Tracker, 2014 Carbon price Increased global pressures to address climate change, i.e. the Paris Agreement, may result in more stringent regional or national policies that set a higher price for emitting CO2. A higher price applied to all fossil fuels production rather than to energy end-­‐users, as in the current paradigm, would add to the cost of oil, gas and coal. CTI has calculated the ‘remaining carbon budget’, defined as the amount of carbon which can be emitted by 2050 whilst meeting the 2°C target, as being 900 gigatonnes. Of these 900 gigatonnes, 360 can be emitted by the oil and gas sector, given current shares of global carbon emissions. Less than 100 gigatonnes remains for oil and gas public companies indicating that, if Paris Agreement targets are to be achieved, and then more expensive assets are unlikely to be developed. CTI calculates that assets costing more than USD 60 per barrel to produce will need to remain in the ground. Falling energy commodity prices There are a variety of external contextual factors such as hurricanes, global financial crisis, wars, OPEC conferences, and the spread of information on the Internet, that affect energy commodity prices (Guo & Ji, 2015). Most of these factors are outside the direct control of oil and gas companies. Yet the strategies of many public oil companies rely on historically high, or rising, oil prices to justify 7
Investors wanting some exposure to these unconventional oil sources but without risk of total losses may do better to invest in companies with diversified oil and gas reserves rather than pure play tar sands, arctic or deepwater companies. 10 capital expenditure plans. However, prices fluctuate and may not stay high. Figures 2 demonstrate a high level of volatility in the oil price, reflecting the fluctuations in contextual factors. Figure 2: Brent Crude, West Texas Intermediate and MSCI World Oil Gas & Consumable Fuels Index, 2014 performance normalised to 2nd December Source: Bloomberg, 2014 A number of contextual factors could catalyse a falling oil price. Energy supply may be increased as countries resume or increase production. In relation to oil, this has been observed in areas with conflict such as Iraq and Libya. Meanwhile, countries including Brazil, Kazakhstan and Canada could increase their production. Supply agreed by the Organisation of Petroleum Exporting Countries (OPEC) can be set at levels high enough to lower prices. Demand can also decrease very quickly. A sharp contraction in the global economy would hit energy demand globally, i.e. financial crisis of 2008. Similarly slowing rate of economic growth in one major economy, such as China, could significantly reduce global oil demand, leading to oil price reductions. Policy risks In addition to the economic catalysts for stranded assets, assets can also be stranded through policies. Policies are the embedded rules and changes to these rules may result in risks and/or opportunities for market players. Climate change related policies can be viewed as an opportunity to shift towards a green paradigm and concurrently as a risk to carbon intensive technologies, often adding to the cost of fossil fuel derived energy. The cost of emitting carbon for companies could rise dramatically to levels closer to those policy makers intended when originally designing regulations. This would increase the cost of oil production relative to lower carbon energies but can also make it less viable in the long-­‐term and ultimately bring the price down. An energy system revolution could come with affordable carbon-­‐capture-­‐and-­‐storage technology, usable in a range of energy and industry situations, which would allow for the fossil fuels intensive paradigm to persist while mitigating climate change impacts. The Paris Agreement has been an important policy and political driver for pushing the divestment movement towards the mainstream market. A stronger climate policy framework that drives deeper and quicker emissions cuts can catalyse further fossil fuel divestment. A new divestment record was 11 set during the COP 21 negotiation period, with over 500 institutions pledging to partially or fully divest 3.4USD trillion (350.org, 2015). These commitments have not yet been tracked but the scale of the divestment movement sends a strong message to the market that long-­‐term policy favours low-­‐
carbon innovations. The agreement has also called for the development of carbon finance to help reach the minimum 2°C target but there are still uncertainties as to how this will be established. Whether these financial mechanisms may include carbon taxes, voluntary financial incentives, or as Stua (2016) proposes, establishing a ground breaking global carbon market, these policy actions would limited market opportunities for fossil fuel players. Other national energy regulations can affect the viability of fossil fuel reserves. Fossil fuel extraction companies’ value in the markets assumes that they will be able to extract and burn all their reserves. Their reserves to production ratio affects their value shares, and maintaining this ratio requires finding new reserves, and/or converting unproven reserves to proven reserves annually. An example affecting the tar sands industry is the Obama administration’s rejection to build the Keystone XL pipeline extension after a lengthy seven-­‐year review (Davenport, 2015). This was considered on economic and environmental grounds, and also to protect national interests. With the boom in shale gas and oil production there is speculation that the U.S. may achieve an energy surplus and there may be a strong economic case to export domestic oil. A further U.S. regulatory risk therefore lies in removing the current legislative ban on exporting oil (other than to Canada). Changing political agenda and regulatory event risks may also occur as countries decide for or against low carbon energy, or environmental restrictions on coal-­‐fired power stations are enacted or when OPEC sets oil production quota. 5. Testing the economic rational: evaluating stranded assets in 10 backtested portfolios through divestment One important factor in the investment market is the treatment of risk, which can potentially challenge the perceived comparative advantages of the fossil fuel industry and favour low carbon industries, as indicated in characteristic 1 of new a TEP. Investors may weigh the opportunities and risks in their portfolio selection when including or omitting fossil fuels from their investment portfolios. There are risks to returns from a policy of divestment. There have been periods when extractive sectors have been relatively strong components of broader index performance. Considering the risk rationale presented above, we evaluated the performance of divested portfolios by constructing three sets of portfolios based on historical data from the MSCI All World Index (AWI). The first set of portfolios consists of three different portfolios (Portfolio 1, 2, and 3) with various degrees of divestments and funds reinvested in a broader screened index8. The second set of portfolio is comprised of another three portfolios (Portfolio 4, 5, and 6) also with differing degrees of divestments but with funds reinvested in the FTSE ET509. The third set of portfolios (Portfolio 7, 8, 9 and 10) is ‘tilted’ to exclude either oil/gas and coal with reinvestments in the screened index and in the FTSE ET50. We then studied the total returns (i.e. appreciation in stock price plus dividends 8
The broader screened index refers to the residual stocks left in the benchmark index -­‐ the MSCI AWI -­‐ once the divested sectors have been screened out. For example the broader screened index is the MSCI AWI minus oil & gas, and then minus mining companies etc. 9
The FTSE ET50 Index is comprised of equity securities from the fifty largest companies in the world with a their primary business in environmental technologies 12 received) over a five-­‐year (30th September 2004 to 30th September 2014) and a ten-­‐year period (30th September 2009 to 30th September 2014). The portfolios excluded different sectors, namely Oil & Gas, Energy Equipment & Services and Metals & Mining from the MSCI All World Index (AWI). These were the sectors mainly responsible for the production of fossil fuels, with the last category containing many companies involved in coal production. Investors may wish to take a more selective approach to screening out companies from the Metals & Mining sector, or to focus on coal companies rather than those primarily involved in production of other commodities. Exclusions were made at the time of portfolio inception, with funds released reinvested at that point in time and at the appropriate weighting at that point in time (i.e. portfolios were not actively rebalanced over the period). This approach was taken as it was assumed that exclusion was a decision which would be taken by investors at a certain point in time and that funds would then be reinvested, whether passively following a screened index or through active stock selection, from that point on. Figure 3, shows Portfolio 1, 2 and 3 with progressively greater exclusions, with funds both reinvested in the screened index. The data showed that backtested fossil fuel free portfolios under performed over a ten-­‐year timeframe with the best outcomes resulting from the 9.24% annualised return achieved by the un-­‐divested MSCI All World index. Figure 3: First set of divested portfolios and their returns !!
MSCI%All%World%TRI!
Portfolio!1:%MSCI%AC%World%TRI%
ex%Oil,%Gas%&%Fuels%
Portfolio!2:%MSCI%AC%World%TRI%
ex%Oil,%Gas%&Fuels%%
ex%Energy%Equipment%&%Services%
Portfolio!3:%MSCI%AC%World%TRI%
ex%Oil,%Gas%&%Fuels%
ex%Energy,%Equipment%and%
Services%
ex%Metals%&%Mining%
10y!to!
30/09/2014!
(annualised)!
9.24%%
8.86%%
%
8.77%%
8.59%%
5y!to!30/09/2014!
(annualised)!
Percentage!of!
index!excluded!!
Sharpe!
Sharpe!
ratio!10y! ratio!5y!
11.77%%
12.05%%
%
12.03%%
0%!
8.28%%
0.452!
0.421%
0.819!
0.855%
9.43%%
0.416%
0.859%
12.47%%
10.97%%
%
0.594%
0.918%
%
Portfolio 3 had the lowest return with a total of 8.59% achieved by the ten-­‐year portfolio with the greatest degree of exclusions, effectively covering all fossil fuels production. This is driven by high commodity prices in the years before the financial crisis of 2008, as rapid economic growth drove companies and countries to demand more raw materials to fuel growth. Therefore, exclusion of such commodities from a portfolio resulted in a degree of relative underperformance. A five-­‐year timeframe, however, resulted in outperformance for all divested portfolios, with the best result of 12.47% achieved by Portfolio 3, where all three sectors representing fossil fuels production have been screened out. This time period represents the post-­‐crisis economy for most countries. The column “Percentage of index excluded” also shows how much of the All World Index is excluded, in value terms, through the screening action. Where funds are released by selling fossil fuel stock, their re-­‐deployment must be considered. There are re-­‐investment options available other than a simple investment back into existing holdings, ex-­‐
13 fossil fuels. Funds could be invested in innovations for instance, renewable energy, or proxies such as the FTSE ET50 and the RENIXX (Renewable Energy Industrial Index), or in a managed fund specialising in the sector. Examples include IMPAX Environmental Markets, Triodos Renewables Fund and the Bluefield Solar Income Fund. Figure 4 shows Portfolios 4, 5 and 6 with different levels of exclusion, ex-­‐oil & gas, ex-­‐service and equipment companies, ex-­‐gas and electric utilities and ex-­‐mining, and in the FTSE ET50. The returns in Figure 4 show underperformance for portfolios that re-­‐invested in the FTSE ET50, rather than into the broader screened index as per Figure 3, reflecting the poor performance of this index and its underlying components over the two periods. Figure 4: Second set of divested portfolios, with reinvestment options and their returns !!
10y!to!
30/09/2014!
(annualised)!
9.24%%
MSCI%All%World%TRI!
Portfolio!4:%MSCI%AC%World%TRI%
ex%Oil,%Gas%&%Fuels%%
w/reinvestment%in%FTSE%ET50%
Portfolio!5:%MSCI%AC%World%%
ex%Oil,%Gas%&Fuels%%
ex%Energy%Equipment%&%Services%%
w/reinvestment%in%FTSE%ET50%
Portfolio!6:%MSCI%AC%World%TRI%
ex%Oil,%Gas%&%Fuels,%Energy%
ex%Equipment%and%Services%
ex%%Metals%&%Mining%%
w/reinvestment%in%FTSE%ET50%
5y!to!30/09/2014!
(annualised)!
Percentage!of!
index!excluded!!
Sharpe!
Sharpe!
ratio!10y! ratio!5y!
11.77%%
0%!
0.452!
0.819!
8.72%%
%
11.65%%
8.28%%
0.382%
0.782%
8.68%%
11.54%%
9.43%%
0.371%
0.777%
8.50%%
11.07%%
10.97%%
%
0.508%
0.329%
%
As previously stated, investors may wish to take a selective approach to screening the Metals & Mining sector and focus on coal companies. Investors may also wish to position or ‘tilt’ their portfolio in relation to Oil, Gas & Fuels companies. Figure 5 shows four tilted portfolios: Portfolio 7 comprises of ex-­‐selected oil & gas companies while Portfolio 9 is made up of ex-­‐selected oil, gas and coal companies. Portfolio 8 excludes selected oil and gas companies and Portfolio 10 excludes selected oil, gas and coal companies and funds in both Portfolio 8 and 10 are reinvested in the screened index and in the FTSE ET5010. The oil companies excluded constitute a group of companies identified by NGO, the Carbon Tracker Initiative, which have the committed the most capex to production with over USD 80 breakeven oil price (for deep-­‐
water, arctic and oil sands projects). The coal companies excluded constitute the largest twenty listed companies by coal production numbers, as of October 2015. 10
The FTSE ET50 is an index which measures the performance of companies whose core business is in the development and operation of environmental technologies and comprises of the fifty largest environmental technology companies globally, by market capitalisation 14 Figure 5: Third set of divested portfolios via tilting, with reinvestment options !
MSCI$All$World$TRI$
Portfolio!7:$MSCI$AC$WORLD$TRI$$
ex$selected$oil$companies$
Portfolio!8:$MSCI$AC$WORLD$TRI$$
ex$selected$oil$companies$$
w/reinvestment$in$FTSE$ET50$
Portfolio!9:$MSCI$AC$WORLD$TRI$$
ex$selected$oil$&$coal$companies$
Portfolio!10:$MSCI$AC$WORLD$TRI$$
ex$selected$oil$&$coal$companies$$
w/reinvestment$in$FTSE$ET50!
10y$to$
30/09/2014$
(annualised)!
9.24%$
5y$to$30/09/2014$
(annualised)!
Sharpe$
ratio$10y$
11.77%$
Percentage$of$
index$
excluded$$
0%!
Sharpe$
ratio$5y$
0.452!
0.819!
8.78%$
11.85%$
5.14%$
0.425$
0.830$
8.71%$
11.78%$
5.14%$
0.395$
0.782$
8.68%$
11.92%$
6.19%$
0.646$
0.842$
8.61%$
11.19%$
6.19%$
0.592$
0.782$
$
As indicated earlier, the ET50 has underperformed, relatively, over the past decade as a whole and over the past five years, therefore lowering performance. It is worth noting that an investment 10 years ago which was realised after five years (September 2004 to September 2009), outperformed the MSCI All World Total Return index, giving an annualised return of 15.18% versus 8.19%. Figure 6 illustrates how a £1000 investment in the MSCI All World, with dividends reinvested, has performed over a ten-­‐year time frame. It also shows the performance of two screened portfolios. The highly volatile performance of the FTSE ET50 over the period can clearly be seen. Figure 6 – Selected portfolios performance over 10 years to 30/09/2014 Figure 7 shows how a £1000 investment has performed over a five-­‐year timeframe for portfolios similarly constructed, displaying the degree of outperformance for the fossil free index and dramatic underperformance for the FTSE ET50. 15 Based on the back testing portfolios examples, we can affirm that the point in time at which divestment is made is crucial to portfolio performance from that point onwards, given potential for relative under-­‐or out-­‐performance. A point in time reflects the broad contextual factors including the global financial crisis, environmental event risks and the current political priorities. Similarly the timing of reinvestment and the decision of how and where to reinvest has a large effect. Figure 7 – Selected portfolios performance over 5 years to 30/09/2014 The period used for data analysis spanned from September 2009 to September 2014, and since then a number of external conditions have changed which affect the energy economy – oil, gas and coal prices have declined bringing many stock prices down with them. Some energy company shares have also decreased dramatically, while others have cut capital expenditure plans and avoided dramatic market reactions. Meanwhile, a number of environmentally positive companies have seen strong performance in share prices. As already noted earlier, the Paris Agreement has also set a new tone for global investments in low carbon innovations. These are all factors which would change the performance data. Another factor to consider is that the return numbers quoted above are for total income data, which includes dividends and stock price performance. Investors such as endowment funds and pension funds typically require income from their portfolios. Although total return includes dividend income, it is not clear from total return data how much of that aggregate number comes from dividends and how much from stock price performance, indicating that our data analysis alone is inadequate as a guide to divestment suitability based on performance. Quantifying divestment risks Investees or fund trustees proposing a partial or full divestment of fossil fuel assets must consider that returns can only be understood if they are risk-­‐adjusted. This is particularly important for funds designed to provide bursaries, salaries or other running costs over long periods of time or into 16 perpetuity, as is the case with many endowments. Most event and long-­‐term thematic risks associated with fossil fuel production do not apply to wind turbines and solar PV installations. Such increased risks bring volatility and investors expect to be paid a premium for exposure to greater market volatility. In Figures 4, 5, and 6, the two columns to the right of the tables show the Sharpe ratio for each of the backtested portfolios created. The Sharpe Ratio measures risk-­‐adjusted performance, calculated by subtracting the risk-­‐free rate (in this case the average 3-­‐month LIBOR, in sterling, logged monthly, over the period) from the rate of return for the portfolio and dividing this by the standard deviation of the portfolio returns. The higher a fund's Sharpe ratio, the better a fund's returns have been relative to the risk it has taken on. This is the formula: Sharpe ratio = (Portfolio return – Risk-­‐free rate) / Portfolio standard deviation The results show higher Sharpe ratios – or better risk-­‐adjusted returns – for most screened portfolios over ten years, and for all screened portfolios over five years (where funds released by not holding fossil fuel stocks and sectors are reinvested in the screened index, rather than the ET50). Based on our analysis of historical data, the Sharpe ratio provides economic evidence that divesting in fossil fuel leads to better returns. Aside from ethical and environmental arguments, investors concerned with the long-­‐term health of their investments may wish to reconsider investments in fossil fuels. Investor decisions at the individual may not have a substantial influence but larger investment funds and influential institutions such as pension funds that are concerned with the long-­‐
term returns of their investments may divest from fossil fuels based on economic robustness. The aggregate actions of these influential investors as discussed earlier may potentially challenge current fossil fuel intensive paradigm by creating a new pattern of investment globally and support the shift to a green TEP. 6. Conclusion Divestment campaigns have raised public awareness and encouraged new investment patterns by discouraging investments in carbon intensive energy industries. They revealed the importance of ‘moral’ bankruptcy for industries that have a negative impact on society. The movement has rapidly expanded from a grass root movement to include influential organisation including pension funds, banks, media companies and governments. Meanwhile, at the global policy scale, political leaders have agreed at Paris in COP21 to limited climate change to a 2°C, which sets a global long-­‐term position to reduce carbon emissions. The technological economic paradigm (TEP) is a framework that can be applied to explore a potential shift from the current fossil-­‐fuel energy paradigm to a green paradigm. While it is too soon to asses if these influences will effect a change to a new green paradigm, the potential is evident in existing and emerging technologies, which combined with social and institutional change could contribute to the shift. New TEPs exhibit key characteristics and we show the potential for a transformation to a green TEP by drawing on four key characteristics identified by Freeman and Perez (2008). We argue that these four characteristics apply to renewable energy technologies, and are being stimulated either directly or indirectly through the divestment movement and the subsequent investment in low carbon innovations. The moral arguments for divestment may be compelling for a select group 17 of conscious actors but at a wider scale, investors within the mainstream market are interested investments returns. We demonstrate that the economic case for divestment is strengthening, and risks associated with investment in the fossil fuel industry are growing. These could in turn encourage diversion of investments from fossil fuel and help create new patterns of investments internally (characteristic 1 of a new TEP) and more indirectly, support the wave of investments in low carbon innovations (characteristic 2). This would support the intended financial commitments of the Paris Agreement, as well as create a signal to the market to further invest in the growing renewable energy sector (characteristics 3). Finally, we consider how the change to investment patterns could be seen as a new pattern of consumption or emerging consumer behaviours (characteristic 4). We considered the economic argument for fossil fuel divestments and focused on the risks associated with stranded assets. Companies with a high capital expenditure and higher operating costs, as seen in oil sands developments, have a higher risk of stranded assets under certain conditions. Additionally, volatile and decreasing fossil fuels prices would reduce revenues, rendering higher cost developments economically infeasible. There are also other external contextual factors in the form of regulatory and policy risks that may place pressures on the fossil fuel industry. Divestment of fossil fuel investments from portfolios is one approach to managing stranded assets risks. To examine the total return implications of divestment, backtested portfolios were constructed for five and ten year periods. The MSCI All World Index was used to create the portfolios, and different sectors were then screened out, namely Oil & Gas, Energy Equipment & Services and Metals & Mining. Screened portfolios outperformed the non-­‐divested portfolio over five years to September 2014 but underperformed over ten years to the same endpoint. Reinvestment options were also considered for the cash released through divesting fossil fuel sectors, with funds either reinvested into the screened index or into a proxy for environmentally positive companies, the FTSE ET50 Index. Reinvestment into the ET50 led to relative underperformance, although we note that an analysis of different timeframes may have yielded different results. To test the risk of divesting from fossil fuels, we measured the Sharpe Ratios of the various backtested portfolios. The results show better risk-­‐adjusted returns for most screened portfolios over ten years, and for all screened portfolios over five years (where funds released by not holding fossil fuel stocks and sectors are reinvested in the screened index, rather than the ET50). It should also be noted that the time series runs to the end of Q3 2014. 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