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Fossil fuels are stuck in the mud

Carbon ‘entanglement’ makes it hard to avoid fossil fuel exposure, but oil company valuations are likely built on sand

Fossil fuels are stuck in the mud

here are £214.3bn of assets exposed to fossil fuels in the UK investment market – £321.2bn if you include exchange-traded funds (ETFs). And the whole lot is at risk of becoming financially stranded.

Stranded assets is a term coined by the think tank Carbon Tracker. It defines such assets as ‘fossil fuel supply and generation resources which, at some time prior to the end of their economic life, are no longer able to earn an economic return as a result of changes associated with the transition to a low-carbon economy’.

For a long time, scientists have advocated for moving to low-carbon energy sources to protect thefuture of the planet. Now governments have started to commit to such moves, albeit at a pace that is slower than what many scientists say is needed. Even the traditionally climate-change-sceptic Conservative party has pledged to make the UK carbon neutral by 2050, putting greater emphasis on the need to prepare for potentially stranded assets (although that does assume Boris Johnson will stick to his word).

From investors’ perspective, the transition to carbon-neutral energy sources threatens the value of assets invested in companies that have fossil fuel exploration, extraction and production at the core of their activities.

Mark Campanale, founder of Carbon Tracker, believes the common understanding of value in investments does not suffice under these circumstances.

‘If advisers are making recommendations for UK equity income funds, they will look at the shares paying the highest dividend. But some of those are the most exposed to the energy transition.

‘While they may be paying dividends today, the capital value of the shares may depreciate as demand for oil and gas falls and as policy intervention such as carbon pricing damages the viability of their business. The traditional valuations make big assumptions about each company being able to develop their businesses,’ Campanale says.

Discretionary fund manager (DFM) Quilter Cheviot says it is not burying its head in the sand with these risks. Gemma Woodward, executive director and director of responsible investment at Quilter Cheviot says, ‘All analysts are looking at the companies we invest in and asking, “How are they dealing with the climate transition?”’

For Quilter Cheviot, that might include questions about where reserves are and how accessible they are. Woodward says the DFM assesses how committed a company is to dealing with the climate transition by looking at how related objectives have been tied to executive pay.

‘How do you change the culture? How do you change the DNA of a company? People’s wallets can sharpen concentration on that sometimes,’ she says.

Fund Fund size Fossil Fuel Involvement*
L&G Global Infrastructure Index £420m 66.6%
JPM Natural Resources £573m 60.5%
First State Global Listed Infrastructure £1.9bn 51.1%
BlackRock Natural Resources £53m 49.5%
Junior Oils Trust £6m 35.6%
Lazard Global Listed Infrastructure £1.4bn 29.6%
Schroder Income £1.7bn 26.9%
Schroder Recovery £1.1bn 22.8%
Vanguard Global Emerging Markets £88m 19.6%
Man GLG UK Income Retail £1.1bn 17.8%

*Not all funds on the FE Analytics’ Adviser Fund Index have a Morningstar fossil-fuel score. This table lists the most fossil-fuel-involved funds of those that did have a score. Source: Morningstar

Accounting For Governance

Executive pay is one metric fund managers can use. But consistent, reliable data that represents the ESG-linked risks of a company are hard to obtain. How companies value their own assets is an issue Woodward describes as ‘incredibly controversial’. It is also a key piece in the numbers puzzle that helps investors understand the risks they are taking.

Quilter Cheviot declined to comment on climate risk in accounting. But 29 investors managing combined assets of over £1tn were concerned enough to send a letter about this to the Big Four auditors – KPMG, Deloitte, EY and PwC – in January 2019.

The letter begins, ‘We are writing as a group of long-term investors to ask [you] to incorporate explicitly climate considerations into the audit of companies that are materially exposed to transitions risks through decarbonisation.’

The group includes asset managers Aegon, Merian Global Investors, Royal London, Hermes and Sarasin, which is spearheading the initiative.

Natasha Landell-Mills, head of stewardship at Sarasin says, ‘Climate risks are material for companies’ reported assets and liabilities, and this will have an impact on profitability and potential dividend-paying capacity.’

She says governments should consider mandated accounting, which is aligned with the Paris Agreement and the emissions reduction targets enshrined within it.

As data from Morningstar shows, there are hundreds of billions of pounds of UK investors’ money at risk with stranded assets. In the UK, excluding funds where no data on fossil fuel exposure was available, the £214bn exposed to fossil funds translates to 5.1% of the market having fossil fuel involvement.

FE Analytics’ Adviser Fund Index, which uses a panel of advice firms to see the 150 most commonly recommended funds in the UK, shows that it is possible to get a picture of fossil fuel exposure in an average balanced portfolio (see table above for the 10 most exposed). Although only a guide, it shows such a portfolio might typically hold 6.8% in fossil fuels and that a third of held funds have invested in fossil fuels.

John Ditchfield, adviser and head of responsible investment at Helm Godfrey, points out this figure is predictable for a UK investor, because major UK fossil fuel companies Shell and BP are in the FTSE 100.

‘If you are an advised client in the UK, you will have between 25% and 35% of your portfolio in UK companies, and they will be big companies. As a result, you will have a chunk of fossil fuel holdings,’ he says.

For Ditchfield, it is important that clients are given the option to screen this exposure out. But advisers also have to be aware of what Campanale calls ‘carbon entanglement’ – sectors that are carbon-intensive and could be hit by tighter policies to reduce emissions.

‘To what extent is the economy entangled with high carbon?’ he asks. ‘Cement, steel, aeroplanes – we reckon that something like 40% of markets are carbon entangled.’

Campanale says that for advisers to find funds positioned to avoid the worst exposures, they need a good fund manager who knows how to manage the broader energy transition risk.

‘You have people like Impax, funds from Schroders, Legal & General and others that are trying to position themselves for a low carbon-transition. Just avoiding fossil fuels doesn’t mean you avoid the problem.’

Going into this level of detail around risk is not common in passive funds which, by their nature, are less engaged in underlying assets. In the UK, 7.93% of ETFs are involved in fossil fuels. 

Passive escape

Many advisers have moved towards passives and outsourcing investments to get the most cost-effective solution for clients, as well as allowing firms to focus on coaching and planning.

London-based Addidi Wealth is one firm that favours recommending trackers for clients.

Dagless points out that the market would continue to efficiently provide returns if the value of fossil fuel companies dropped steadily. In that instance their place on the index would be taken by more valuable companies. If the drop in value was sudden, however, she acknowledges this would pose an issue for many investors.

‘If it happened in a day, a week or even a month, then there would likely be issues because it is in the top 100 or the top 250 companies in the UK. Everyone within their pensions, in workplace pensions, within any of their portfolios will be invested in all these fossil fuels.’

She says she hopes diversification into other markets would provide some level of protection in such a scenario.

At another point in the intermediation chain, national advice business Tilney’s DFM arm says it is responding to client requests about fossil fuel exposure but does not have its own view on the issue.

‘We don’t sit here and say, “how much exposure should we have to telecoms or oil stocks?” because we are picking fund managers and not building from stocks ourselves,’ a spokesman said.

‘Unless, that is, the client specifically says, “I do not want any fossil fuels in the portfolio.” Then we will have to go and do a portfolio using funds that specifically screen it out, but in doing so you are screening out a large part of the market.’

Andrew Behar, chief executive of corporate social responsibility group As You Sow, wants to wake investors up to what they own. He has found that difficult with passives because of how they are branded. As a result, he has taken legal action against some US trackers that, he says, falsely claim to be free from fossil fuel investments.

Behar has set up the website Fossil Free Funds, which uses Morningstar data and allows you to compare US-based mutual funds on their fossil fuel exposure and carbon footprint. Behar says the team is happy with it but, as is common when it comes to climate-related investment figures, there are glitches.

‘We found an issue where JP Morgan was rated the number one sustainability company. What happened is it put a statement in all its prospectuses saying that “one day we may consider – maybe, possibly, sort of – becoming a sustainable fund”.’

Morningstar’s algorithm picked up all the mentions of ‘sustainable’ and deduced 43% of the funds were sustainable when none of them were, Behar says.

‘We pointed this out to Morningstar, and it was horrified and worked to fix it.’

Informed divestment

One place a bright light is shone on holdings is the Local Government Pension Scheme (LGPS).

Caroline Escott, head of policy and stewardship at the Pensions and Lifetime Savings Association, says LGPS has been ahead of the curve. It has been under pressure from members to divest from fossil fuel investments, but it is struggling to shift its strategy.

‘We know there are LGPS funds that are trying to divest and starting on the divestment journey. They are finding it difficult either for operational reasons or it is just taking them longer to go through the process than some of them had initially considered.’

Disentangling a pension scheme from fossil fuel is a complicated business. Figuring out where to draw the line around what counts as fossil fuel exposure is an industry-wide headache.


Activist investors might ask if it is worth going to these efforts when engaging with fossil fuel companies could cause changes to their culture and practices. However, this argument does not address the risk of stranded assets. It is more a reflection of investors’ desire for their money to do good. Julia Dreblow, director of ESG specialists SRI Services, believes in the power of engagement but is also wary of companies showing no real appetite for change.

‘There is clearly an argument in favour of doing everything we can to encourage oil and gas companies to change what they do. Collaborative engagement initiatives such as ClimateAction 100+ are doing excellent work in this area.

‘That said, some oil companies are advertising their green credentials heavily but according to a recent article in the Financial Times, renewables account for only around 1% of their R&D budgets.

‘This is a shocking example of saying one thing and doing another,’ Dreblow says.

Martyn Brown, an adviser at Poole-based PFM Associates, says he has noticed a ‘return to oil’, but not because advisers see a future in the sector or because they believe in engaging with the companies to change. What has caught investment professionals’ attention is the ability of cash-rich oil and gas companies to buy up smaller renewable energy companies. Brown says this is seen as a reason fossil fuel companies may yet find a profitable future, not as a direct hedge against the risk of a sudden writedown to their value.

Extinction event

Should that happen, there are concerns that no amount of intelligent management of climate-transition risk in a portfolio would entirely protect investors from the consequences.

Landell-Mills tells Reuters the Sarasin-led investor group is motivated by the desire to avoid the losses seen in 2008: ‘The overarching thing is that we don’t want another financial crisis, and this could be a lot worse.’

Ditchfield shares these concerns, making a comparison between what we see today and the kind of embedded risks hidden in the global financial system in the years before 2007.

‘You could probably draw a parallel with what happened in the run up to the financial crisis where, for example, the market wasn’t efficiently pricing the risks associated with certain types of bonds.

‘Right up until the time the financial crisis hit, the market was still pricing bonds as AAA-rated, until the day the value almost completely disappeared on these products.’

He says the dotcom boom is an example of a similar instance in equities, where investors, acting as a mass, failed to understand the nature of systemic risk.

‘The stranded assets hypothesis is trying to advance the prevention of a systemic risk issue,’ says Ditchfield.

Behar does not just see the chance of a crisis, he sees it as inevitable because – after hundreds of conversations with fossil fuel companies – there is no sign of their commitment to a transition.

‘They have incredible engineering prowess. There are so many ways they could transition, but they seem determined to either take their company off the cliff for take the whole economy with it.

‘They are going to continue to invest capital in stranding more assets and stranding more assets. It’s just a form of madness,’ he says.

As Sarasin and its investor group are determined to get the right information to make informed decisions about the chance of Behar’s prediction coming true and the risks investors are taking, more and more finance professionals are on a mission for better data.

Escott says she hopes to use the PLSA’s annual survey of members to find out what proportion of assets are invested in a climate-aware fashion. And the Taskforce for Climate-related Financial Disclosure will introduce rules to make companies disclose their approach to climate risk by 2022, she says.

Quilter Cheviot is also looking to gather more data and ‘dig down’ into fossil exposure in its assets, according to Woodward.

Conversations with clients about fossil fuel investments are bound to get more frequent as headlines about the climate emergency and policies that respond to it gather pace. Those talks will include the performance of sectors and volatility, not just systemic risk factors.

Can you achieve a properly diversified portfolio without fossil fuels? Can you achieve the returns you need? To invest intelligently requires every point in the investment chain, from company to retail investor or pension scheme member, to have an accurate picture of environmental and inancial climate risk. Right now the gaps in this picture are making some nervous about the stability of the system as a whole.

There are so many ways fossil fuel companies could transition, but they seem determined to either take their company off the cliff or take the whole economy with it

ANDREW BEHAR - AS YOU SOW

 

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