Forward looking asset owners with a long-term perspective are recognising that the risks related to ownership of fossil fuels have increased. Today, the potential for value destruction arising from government intervention to reduce future greenhouse gas emissions is much more significant than the underlying risk of climate change itself.
In response, Impax has developed a way of using well established investment management tools to establish a new approach to managing fossil fuel risk within equity portfolios. This approach explores the potential impairment to future cash flows of companies whose valuations are linked to fossil fuel assets (i.e. the coal, oil and gas exploration and production (E&P) companies). Thus it is flexible and designed to evolve as climate change investment risk changes.
We have been running three model portfolios based on the MSCI World Index, each of which reduce E&P exposure to varying degrees, and in order to preserve energy price (factor) exposure, replace it with Energy Efficiency stocks. (Energy Efficiency stocks maintain exposure to the energy markets but benefit from any increase in carbon taxes.) The models have been re-balanced four times over the past year in response to MSCI Index weightings and updates to our proprietary fossil fuel risk analysis.
Our model now indicates a larger shift into Energy Efficiency from E&P than one year ago (1.65% vs 0.95%) resulting in portfolios as shown below¹.
Impax SmartCarbon™ portfolios as at 1 September 2016
¹In considering this switch, investors should also note that the E&P Stocks and Energy Efficiency stocks are exposed to other risks that are not described here.
The full methodology behind this work can be accessed here
While 12 months is too short a time period to draw firm conclusions from this data, it is worth noting that during this period the risk of climate change policy intervention has increased significantly, the oil price has been volatile and lower prices in future are more likely and finally, Energy Efficiency markets are showing sustained positive returns.
Crucially, the SmartCarbon™ portfolio represents only a partial sell-down of many fossil fuel stocks, so those investors wanting to engage with companies and seek to persuade them to change strategy will still have a seat at the table.
Investors adopting our “SmartCarbon™” approach will gain not just a portfolio that is designed to reflect climate change risk as measured today, but, more importantly, a framework for managing this issue in the future.
In time, it is likely that the market values of all stocks will incorporate climate change risk. However, investors who position themselves ahead of the inevitable improvement in disclosure should out-perform.
Changes to the SmartCarbon™ model portfolios for the last six months:
The changes to the allocation have been influenced by the following:
- Our updated fossil fuel risk analysis indicates that the introduction of a Carbon Prices would have a larger adverse impact on oil and coal producers because the associated cost penalty will represent a higher proportion of their (depressed) profits than one year ago.
- Over the period, E&P companies have benefited from the partial recovery in the oil price, and now represent a larger proportion of the MSCI World Index at 4.65% relative to 4.53% last year, while energy service companies have declined to 1.92% from 2.20%.
- Another notable development during the period was the merger between Royal Dutch Shell and BG Group. The weighting of the former within MSCI World Index has increased by 16% during the year.