Carbon Free Investing

Going Carbon Free: The Investment Case for Divesting from Fossil Fuels.

In his book, “Collapse: How Societies Choose to Fail or Succeed,” the eminent scientist Jared Diamond examines how some of the great civilizations of the past met their demise. From the Polynesian cultures on Easter Island to the flourishing Anasazi and Maya civilizations to the Norse colonies on Greenland, Diamond documents the same fundamental pattern of catastrophe; Environmental damage, climate change, rapid population growth, and unwise political choices. Today modern civilization appears to be following in the footsteps of these bygone societies when it comes to its current response to the crisis of global climate change. Because our election cycles make it hard to do long-term planning and most investment decisions are based on quarterly results, solving a large-scale problem like global climate change can be difficult. Combine this with the fact that there are still a lot of skeptics in positions of power who think that reports compiled by agencies like the Intergovernmental Panel on Climate Change (IPCC) are the result of diplomatic negotiations, rather than unbiased science, and you have a recipe for inaction.

Contrary to polls, politicians, and many pundits, the science of climate change is clear. Human-caused global warming is well under way as a result of our dependence on fossil fuels. The burning of coal, oil and other carbon fuel sources over the past century has produced almost double the concentration of CO2 in our atmosphere, trapping in solar radiation and slowly warming the planet. While the consequences of climate change have been known in scientific circles for decades, investors and the general public has paid relatively little attention to this problem until recently (if at all). This is unfortunate, because the longer we delay action to solve this problem the harder and more expensive it is going to be to reverse course.

As early as 1990, scientists working for the United Nations warned that without reductions in CO2 levels the earth’s climate would warm by an average of 1 degree Celsius. Such an increase was forecasted to elicit rapid, unpredictable and non-linear responses that could lead to extensive ecosystem damage. Predictions included the melting of glaciers and the loss of drinking water for hundreds of millions of people, the spread of mosquitoes bringing more infectious diseases with them, drought leading to food shortages, sea level rise resulting in the flooding of cities, island nations, and farmland, ocean acidification and the extinction of coral reefs, and increased intensity of extreme weather, such as hurricanes and blizzards. Few political leaders heeded these warnings and now just two decades later, the concentration of CO2 in the atmosphere has surpassed the upper limits set by IPCC scientists. As a result many of the predictions made by climate scientists are coming to fruition.

Now the hope is that we can reduce carbon emissions fast enough to halt warming to just 2 degrees Celsius. To do so, the IPCC has argued that we must prevent atmospheric CO2 concentrations from rising above 450 parts per million (ppm). James Hansen of America’s National Aeronautics and Space Administration, the first scientist to warn about global warming more than two decades ago, argues we will need to reduce carbon concentrations below 350 ppm if we wish to preserve a planet similar to that on which civilization developed and to which life on Earth is adapted. Currently concentrations are at 400 ppm and rising. As the Presidential Climate Action Project (PCAP) noted in 2011; “In order to stabilize CO2 concentrations at livable levels by 2050, global emissions will have to decline by about 60% by 2050 compared to 2010 output levels [This means] that industrialized countries greenhouse gas emissions will have to drop by about 80% by 2050.” To meet this challenge, we must begin now before the task of reversing course becomes hopelessly unattainable. Experts believe that by 2020 worldwide emissions of CO2 must fall by 8% – 10% to give us a fighting chance of reaching the 2050 target set by the PCAP. Thereafter, emissions must continue to fall at a rate of 3.5% per year. Granted, these are a difficult goals, but they are not impossible to meet as long as we begin to act now.

Divesting from Fossil Fuels

Not surprisingly, investing in fossil fuels companies has been very profitable in the past. These companies generate billions of dollars in revenues every year, which they return to investors in the forms of capital gains and dividends. Last year the top five oil companies alone made $120 billion in profit and have hauled in more than $1 trillion in the past decade. It’s this kind of past performance, and the estimated value of their oil large reserves, that is used by institutions as justification for their continued investments in these firms.

As concerns about climate change grow, the outcry against investing in fossil fuel companies has grown. Over the past three years a strong political movement has developed calling for colleges, public pension funds, religious congregations, foundations and other endowed non-profit organizations to divest from coal, oil and gas companies. Students at campuses around the country began launching campaigns in 2011 to shut down coal-burning plants on their campuses and to demand that their colleges divest from the worst carbon polluters called the “Filthy Fifteen.” These actions were supported by a wide variety of civic and professional organizations including As You Sow, the California Student Sustainability Coalition, Cold Swarm, Energy Action Coalition, Green Corps, Responsible Endowment Coalition, the Sierra Club, the Sustainable Endowment Coalition, and the Wallace Global Fund.

Last year, the divestment movement took on greater urgency when environmental writer Bill McKibben made an urgent appeal calling for wide scale divestment of college endowments from the world’s largest fossil fuel companies. Following this announcement he helped co-found, which has joined forces with the fossil free movement calling for the divestment from all stocks and bonds of the leading 200 publicly traded fossil-fuel companies, based on their proven oil, gas and coal reserves. There is now a ground swell of support for divestment. Hundreds of campuses in the U.S. and overseas now have active organizations pushing for divestment including Harvard, Brown, and the University of Massachusetts. To date eight colleges, Hampshire College, San Francisco State University, Naropa College, Foothill De Anza Community College, College of the Atlantic, Unity College, Sterling College, and Green Mountain College have agree to divest their endowments from the 200 leading fossil fuel companies. Churches, Mosques and Synagogues across the country, including the 1.2 million member United Church of Christ have announced their decisions to divest. The city of Seattle, is currently looking into ways that they can divest its $1.9 billion pension fund form fossil fuel companies. Legislation has now been proposed in Massachusetts, Vermont and Maine calling for the state pension funds to develop a divestment strategy.

Recently an article by Al Gore and David Blood in the Wall Street Journal has brought national attention to the divestment campaign and highlighted the need to begin investing in alternatives to carbon based energy sources. The divestment movement has gone mainstream and it is now up to investors to begin grappling with the reasons they are still holding on to their investments in fossil fuels. This is likely to result in a lot of soul searching for some and perhaps anger from others who see divestment as risky and destined to hurt returns. The fact that there was no clear consensus on divestment at this year’s premier socially responsible investing conference, SRI in the Rockies, highlights how difficult it is to get investors to adopt a new paradigm, no matter how much they may believe in the cause.

Before university endowments and other institutions are likely to succumb to pressures to divest, fund managers will need to be convinced that divestment will not cause them to incur more risk or sacrifice returns. The issue of risk and return can be looked at in two ways. First, in terms of the historic effects of reducing diversification by removing a large sector of the S&P 500 from an endowments portfolio, and second, in terms of the forward looking risks associated with investing in companies whose primary revenue source is increasingly viewed with concern by the worldwide community.

Diversification Risk

One of the main concerns investors have about divesting, is that fossil fuel companies represent about 9% – 12% of the broader stock market. It is assumed that excluding such a large sector of the stock market will lower portfolio diversity, which will result in greater portfolio volatility relative to the market as a whole. Managers will argue that this increased risk is only acceptable if it results in higher returns. For this to be true, however, the energy sector must have underperformed the broader stock market, otherwise their exclusion would not increase performance. A recent study published by the American Petroleum Industry argues in fact that the energy sector has generally outperformed the stock market over the past decade and that during this time investments by college and university endowments in oil and natural gas company shares have produced the highest consistent returns for those endowments.

While it is true that energy sector stocks as a whole has outperformed the S&P 500 over the past 10 years, most of this outperformance is due to a run up in energy stock prices between 2005 and the market crash in 2008. Since that time energy stocks have underperformed. The conclusions of the AIP study are also based on the assumption that screening energy stocks would have resulted in lower return for endowment portfolios, i.e. that there were no other investment/diversification strategies that they could have effectively used to produce similar returns. The vast majority of empirical studies conducted over the past decade have repeatedly found that negatively screening stocks on a wide range of environmental, social and governance (ESG) issues need not hurt performance and in many cases actually helps boost performance slightly. Furthermore, large scale studies by Deutsche Bank and Mercer have found that the vast majority of studies on the use of inclusive screening on ESG factors resulted in either neutral or positive portfolio performance.

A recent study conducted by the Aperio Group in 2013 showed that over the past 30 years divestment would have added very little portfolio risk and had no significant impact on returns. The analysis first looked at the performance of the Russell 3000 vs. the Russell 3000 excluding the “Filthy Fifteen” U.S. companies judged by As You Sow and the Responsible Endowment Coalition as the most harmful to climate change. Risk, which in statistical terms is quantified as the standard deviation in annual returns vs. the returns of a benchmark, was found to be almost completely unaffected by the removal of these companies. The incremental risk from excluding the Filthy Fifteen relative to the Russell 3000 was 0.0006% (i.e. a standard deviation of 17.6662% for the Screened Portfolio vs. 17.6657% for the Russell 3000), with a theoretical annual return penalty of 0.0002%.When the authors completely excluded the broader energy sector, the incremental increase in portfolio risk was still only 0.0101%, with a theoretical annual return penalty of 0.0034%, or less than half a basis point.

All of these studies, it should be noted, are based on past performance. Using them to project how portfolios will perform in the future assumes that the future will be like the past. As anyone who invests in stocks should know, past performance is not a guarantee of future results. This is likely to be especially true for fossil fuel companies. When the environment in which a company competes changes dramatically, the company must either change or go extinct. When cars began to dominate the transportation market in the 1900s, buggy whip manufacturers couldn’t adapt and quickly went out of business. For fossil fuel companies, factors like climate change and the emergence of alternative energy technologies are likely to have a similar influence on their long-term profitability. Without considering these risks, portfolio managers may come to realize that the historical outperformance of fossil fuel companies over the past ten years may be as illusionary as the tech boon of the 1990s, or the recent housing bubble.

Environmental Risk Going Forward

The estimated value of coal, oil and gas companies rests on the assumption that they can burn all of the fossil fuel contained in their reserves. But is this really the case, and if not, what does it mean for the stock prices of these companies going forward. According to Carbon Tracker and the Grantham Research Institute on Climate Change and the Environment, the known fossil fuel reserves of energy companies far exceed the limits we can burn if our goal is to prevent heating of the climate by more than 2ºC. Yet in spite of this fact, energy companies spent $647 billion in 2012 to find and develop new reserves of oil and coal. These “stranded assets” pose a large risk to investors if companies are prevented from extracting and refining all of their reserves.

Other forms of risk to investing in fossil fuel companies are likely to come in the form of decreased subsidies and increased costs of production. Governments know that the longer we wait to begin to deal with climate change, the more it is going to cost taxpayers to solve the problem. This realization will increase the pressure on governments to reduce their economic support for fossil fuels. Such actions will drive up the price of fossil fuel-based energy. This will increase the competitiveness of alternative energy sources, which may also get a boost from increased subsidies, as government support for fossil fuels diminishes. The need to reduce our reliance on fossil fuels is also likely to produce policies that favor the implementation of some kind of carbon tax, which could further reduce margins and cut into profits. Both of these schemes will affect the performance of extractive energy companies and put severe downward pressure on stock prices.

The Carbon Bubble: Coal, oil and gas companies’ business models rest on emitting much more carbon into the atmosphere than civilization can handle. There is very little acceptance of this fact within the industry, which should make investors nervous. Indeed, the potential climate-related financial risks associated with “stranded” fossil fuel assets loom much larger than supposed diversification risks of excluding conventional energy companies from an investment portfolio.

According to a recent report by Carbon Tracker and the Graham Research Institute on Climate Change, the overvaluation of stranded oil, coal and gas reserves held by fossil fuel companies is leading to a carbon bubble in the stock market. Based on the size of known reserves, they estimate that 60% -80% of these assets will have to remain underground if the world is to meet existing internationally agreed upon targets to avoid the threshold for “dangerous” climate change. The valuation of fossil fuel companies depends on their ability to extract and refine the fuel held in their reserves. If this carbon remains unburnable, there will be no demand for their product and these assets will become “Stranded Assets” for the fossil fuel companies. Current estimates put the value of total known reserves at $27 trillion, thus a cap on carbon emissions designed to limit warming to two degrees C, could potentially result in losses exceeding $20 Trillion. Publicly traded energy companies have about $7 trillion in carbon assets on their books, much of which cannot be burned. Because most investors are overlooking this fact, the carbon bubble is becoming dangerously inflated. When it pops, investors are likely to feel the pain. More importantly, like the collapse of the housing market, the fallout may have disastrous effects on the economy and the lives of ordinary people, if not dealt with rationally.

Standard & Poor’s, the credit rating agency, has already issued a report describing the risks of negative outlook revisions and potential credit downgrades for the oil sector. The authors of the report conclude that financial models that use past performance and creditworthiness as a way to gage risk may be insufficient to guide investors looking to understand the possible effects of future carbon constraints on the oil sector. The analysts see a deterioration in the financial risk profile of moderate-size energy companies beginning 2014 and spreading to the larger companies beginning in 2017.

Many of the world’s major banks now agree with the assessment that there is a growing concern about the future health of the energy sector. For example, HSBC has warned that 40-60% of the market capitalization of oil and gas companies is at risk as a result of expected cutbacks in CO2 emissions. In response to the Carbon Tracker report, Paul Spedding, an oil and gas analyst at HSBC, said: “The scale of ‘listed’ unburnable carbon revealed in this report is astonishing. This report makes it clear that ‘business as usual’ is not a viable option for the fossil fuel industry in the long term. [The market] is assuming it will get early warning, but my worry is that things often happen suddenly in the oil and gas sector.”

Citibank back in 2009 warned investors in Australia’s vast coal industry that little could be done to avoid the future loss of value in the face of action on climate change. As a bank spokesmen put it, “If the unburnable carbon scenario does occur, it is difficult to see how the value of fossil fuel reserves can be maintained, so we see few options for risk mitigation.”

With all of the concern about climate change from scientists and Wall Street firms alike, why does the carbon bubble continue to inflate? There are really two reasons. First, conventional investors clearly do not believe action to curb climate change is going to happen. They don’t believe the claims made by governments worldwide about imposing measures to restrict the rise in global temperature are credible. Thus, in their eyes, the energy markets are sensibly valued. Second, as in the case with other inflated assets, analysts believe you should ride the gravy train as long as you can before it crashes. Each thinks they are smart enough to get off in time before the crash. As we saw when the housing bubble burst, it’s not so easy to figure out when is the right time to jump.

The End of Subsidies: To have a fighting chance of keeping temperature increases within livable limits, global emissions must begin to decline soon and rapidly if we are to mitigate the worse effects of global climate change.

Currently, global emissions are continuing to increase. A recent study by the International Energy Agency found that CO2 emissions from fossil-fuel burning reached a record high of 31.6 gigatonnes in 2011, a 3.2% increase from 2010 levels. It is worth noting that the increase occurred in the midst of a worldwide economic slowdown, suggesting that fairly drastic measures to curtail carbon are going to have to be implemented almost immediately.

Emissions will continue to rise in the near future and must peak before they begin to decline. Fossil fuels are such a large part of the way we use energy that we cannot immediately move away from them without major economic disruption. However, the sooner global emissions peak the better, because the longer we wait the more costly and sever the decline will need to be to meet carbon reduction goals. For example, delaying the peaking year by only nine years, from 2011 to 2020, changes the maximum rate of emission reduction from 3.7% per year, which is very challenging in itself, to 9.0% each year, which is much more difficult and orders of magnitude more costly

One of prime reasons that fossil fuels remain so cheap relative to other energy sources is that they are highly subsidized. Currently, the U.S. subsidizes big oil to the tune of $7 billion a year. Worldwide Oil Change International estimates that total subsidy for oil could be as high as $1 trillion per year. In 2009, the G20 pledged to phase out fossil fuel subsidies and while little has been done to date, the pressure on governments to do so will surely grow. Around the world governments will have to weigh the cost of continuing subsidies vs. the cost of waiting to cut fossil fuel use.

Besides the need to limit CO2 emissions, there are several other forces at work that favor limiting subsidies for fossil fuels. First, the price of fossil fuels has become increasingly volatile since 2004 to the point where subsidies no longer act to help stabilize prices. Much of this increased volatility is due to global geopolitics and the strategic vulnerabilities in energy supply chains. When prices increase worldwide, governments generally increase the subsidies spent on fossil fuel, to the detriment of other energy sources. As the cost of renewable energy falls, however, it will become harder for governments to justify this heavy tilt in price subsidies. Because of declining equipment costs, ostensibly zero fuel costs, and little dependence on unstable supply chains, renewables can provide energy at a more stable price. This means that changes in subsidy policies towards renewables will make it easier for governments to stabilize energy prices and incentivize energy use patterns.

Second, energy users are become increasingly more efficient and autonomous in their consumption of energy. Energy efficiency in the U.S. appears to be dampening demand by 0.7% per year, while most major European countries continue to see significant reductions in energy demand, due to governmental efficiency initiatives. At the same time, energy users are increasingly producing their own electricity. In Germany, where renewables have advanced the most, 37% of the renewable energy generation infrastructure is owned by households. In the UK, over a third of businesses are generating renewable energy on their premises. The most often cited reason people give for wanting to produce their own electricity is a desire to have more direct control over energy costs. This shift in thinking by consumers will progressively weakening public support for fossil energy subsidies paid for by tax-payers.

There is no way to know when and how fast governments will act to reduce their economic support for the coal, oil and gas industries. In the short run, these subsidies help ensure there is a steady supply of energy available for most businesses and consumers. Over the long-term, however, increased climate events and greater awareness of the costs of not reducing CO2 in the atmosphere will put pressure on governments to cut back. This pressure will become even greater as consumers increasingly turn to alternatives for their energy needs. For investors unaware of the impact of subsidies on profits, the withdrawal of taxpayer support may come as a financial shock.

Paying for Carbon: With atmospheric carbon concentrations now in excess of 400 parts per million, a number of countries are requiring companies to pay for their carbon emissions as a way to reduce CO2 pollution. There are many economic methods being used by governments around the world aimed at decreasing emissions, including cap and trade systems, carbon taxes, increased efficiency standards, and incentives or mandates for renewable energy. As these methods become widespread, they will create an economic incentive for consumers to switch to lower-carbon sources of energy.

Governments have already begun implementing programs aimed at making it more expensive to release carbon into the atmosphere. For example, the European Union’s Emission Trading Scheme (EU ETS), launched in 2006, is the first large scale cap-and-trade program for reducing greenhouse gas emissions. As of January 2013, the EU ETS covers close to half of the European Union’s emissions of CO2 and 45% of its total greenhouse gas emissions. The EU ETS covers emissions of carbon from power plants, a wide range of energy-intensive industry sectors and commercial airlines. Australia is considering implementing a carbon trading scheme that they plan to link with the EU ETS in 2015. In the coming years, the EU hopes to link up with other ETS around the world to form the backbone of a global carbon market.

Carbon taxes, which many argue is a better way to cap CO2 emissions, are now becoming widespread. According to the Climate Commission, 33 countries and 18 sub-national jurisdictions will have a carbon price in place by the end of 2013. These taxes affect the price of fossil fuels used by about 850 million people in countries around the world and 20% of global emissions. Even China, one of the world’s largest emitters of greenhouse gas, has announced plans to start taxing coal emissions . Support for pricing carbon pollution is even widespread in the U.S. For example, a poll conducted by YouGov found that 56% of Americans would rather reduce the budget deficit via a carbon tax than through cutting government programs.

There is no doubt that worldwide adoption of cap and trade schemes, and carbon taxes will hurt the bottom line of fossil fuel companies. Margins at energy companies will be squeezed as the cost of extracting and producing fossil fuels go up. Energy intensive industrials that rely on fossil fuels for production will be forced to become more energy efficient and/or increase the use of alternative energy in order to reduce the cost of paying for carbon. This too will affect revenues for conventional energy companies and their prospects for growth.

Energy Transformation

In the long-term, we believe that investing in clean energy, energy efficiency and other sustainable technologies will be more profitable than fossil fuels. Investments in clean energy alone last year were over $268 billion, and while this sector remains volatile, investments are dramatically picking up overseas, especially in China. Renewable energy sources such as solar, wind and geothermal are now reaching price parity with all forms of energy produced from fossil fuels . Meanwhile, more companies are working on developing new technologies to reduce energy consumption in order to reduce the size of their environmental footprint.

To profit from this trend we have replaced the Energy Sector in our portfolio with an Energy Transformation Sector. This sector may account for about 5% – 8% of our equity positions and consist of companies whose products either create energy without carbon emissions or promote greater energy efficiency that reduces carbon output.

Some may see this as a risky move, but from our perspective these investments make sound financial and environmental sense. Renewable energy in particular is experiencing strong growth across the entire planet. In the U.S., renewables accounted for half of all new electrical generation capacity in 2012. The growth in wind energy alone outpaced new natural gas production and add more than double the electrical capacity provided by coal. For all the hype surrounding America’s oil and gas reserves, it is the renewables industry that is putting up the numbers in the creation of a more diverse and resilient energy portfolio.

Furthermore, the International Energy Agency (IEA) predicts that power generated from renewable sources worldwide will exceed that from natural gas and be twice that from nuclear fission by 2016. The IEA also estimates that wind, solar, bioenergy, hydro power, and geothermal will grow by 40 percent in the next five years and make up almost a quarter of the global power mix by 2018. As costs continue to fall, renewable power sources are increasingly standing on their own merits versus new fossil-fuel generation, and we believe they are poised to become a disruptive force in the energy markets in the coming years.

Diversification is an important tool for investing in energy transformation. Otherwise this sector will be too volatile. There is a whole lot more to investing in a carbon free future than purchasing solar and wind stocks. So many of the applications we rely on to make our lives better, from appliances and lighting to transportation and industrial processes, can be designed to use energy more efficiently. Companies that are focused on bringing products to market that improve efficiency will thrive in the coming decades. Because we are still heavily reliant on fossil fuels to produce electricity, poor energy efficiency means higher energy bills for consumers and greater CO2 pollution for the planet, a trend which for obvious reasons will not be allowed to continue.

Invocation in the clean technology field is everywhere and so are the investment opportunities. In the area of power production there are numerous companies manufacturing products that help reduce greenhouse gas emissions, such as smart-grid and metering technologies that deliver energy more efficiently to customers, energy-storage solutions for renewable energy sources that do not produce consistent power 24 hours a day, and waste-to-energy plants that convert landfill waste into useable electricity with almost no carbon footprint. In the transportation field innovations such as electric and plug-in hybrids vehicles, the development of biofuels made from algae, green fuels made from naturally occurring oils, truck engines that run on natural gas and fuel cell technologies are opening whole new vistas to ways we can move people, ship supplies, and grow our food. Companies are improving building and infrastructure efficiency, such as developers of automated control systems, energy efficient heating ventilation and air conditioning systems, home energy management systems and LED and lighting are now major players in restructuring a sector of the economy that accounts for 30% of total greenhouse gas emissions in the U.S.

Transforming the way we use and produce energy is crucial for our survival. As responsible investors we have the opportunity to help usher in this transformation by divesting from fossil fuels and investing in profitable companies that are working to create a carbon-free future. This is good news for the world, and potentially the long-term performance of our portfolios.

Dr. Forrest Hill, PhD was formerly a senior portfolio manager at Harrington Investments.