Divestment has long been a controversial topic and practice in the investment industry.
For decades, institutional investors around the world – many encouraged by stakeholders – have chosen to divest from specific asset classes, sectors or companies on ethical or financial grounds.
The fossil-fuel divestment campaign is very much alive today; 155 foundations have signed the Divest Invest pledge and the value of assets represented by institutions and individuals committing to some sort of divestment from fossil-fuel companies has reached $5 trillion.
Beyond the adverse moral implications of investing in products that are precipitating climate change, divestment campaigners argue that fossil-fuel investments expose institutional investors to the risk of stranded assets, implying that when industry or government acts to effect a swift transition to a low-carbon economy, many fossil-fuel reserves will be rendered unburnable and thus sharply devalued.
Although this argument has merit, there are reasons for investors to take a more nuanced approach to managing climate-change risks in their portfolios. Investment professionals often push back against divestment pressure, given a number of theoretical and practical issues with taking such a blunt action in a fiduciary context.
Most notably, practitioners typically argue that divestment limits the investable universe, which, according to Modern Portfolio Theory (MPT), inherently reduces long-term risk-adjusted return potential. In addition, investors may prefer to stay invested in fossil-fuel companies in order to engage with management and influence change.
Similarly, investors have been grappling with how best to profit from investments in ‘climate solutions’, defined generally as technologies that reduce greenhouse-gas emissions or improve the resilience of assets against physical climate impacts.
Investors harbour many different views on how to position such investments within a portfolio (that is, as a hedge against deterioration in fossil fuel-intensive assets, as a pure source of alpha generation within a thematic portfolio, or as some combination of the two).
Questions also persist about the size and diversity of the opportunity set and the ability for investors to access this theme across asset classes. Past attempts to capitalise on climate solutions have also been hampered by over-exuberance (for example, early-stage clean tech underperformance in the mid-to-late 2000s) and regulatory risk (as in Spain).
Answering these questions can prove challenging for investors operating within existing dominant risk-modelling and management frameworks.
Back-testing in a time of climate change
To understand the impact of fossil-fuel divestment, or investment in climate solutions, on portfolio risk/return, practitioners naturally turn first to the historical record, though the question remains as to what extent past data can be relied on to make long-term predictions regarding the future effects of climate change, which is a phenomenon that has not yet fully manifested and has no proxy in history.
It is also unclear to what extent markets are pricing climate change into valuations and what potential large changes in policy, technology and weather patterns may unfold over the coming years and decades.
Moreover, most asset allocation modelling tools in use today are based on MPT and heavily influence most strategic decisions.
This speaks to the power of quantitative modelling techniques and their ability to reduce complex systems into more readily interpretable numbers. However, we believe that the full complexity of economies and markets cannot be measured or captured entirely in mathematical models and that these models benefit from qualitative supplementation.
To this end, we have attempted to marry a complex risk with an existing quantitative risk-assessment framework, to make it more approachable. Our technique for climate-change risk assessment was initially described in our Investing in a Time of Climate Change report.
This research informed the development of four scenarios aligned with temperature rises 2-4 degrees above pre-industrial average. It also identified four risk factors: technology, resource availability, physical impacts and policy (TRIP). The scenarios developed reflect plausible outcomes and represent a broad global consensus on how certain futures might unfold. The multiple risk factors acknowledge that climate change is not one risk; rather, it is a diverse basket of risks that manifest economically in different ways.
The low-carbon transition premium
In a recent paper, to test whether the investment decisions the Divest Invest pledge contemplates might result in a low-carbon transition premium, we developed several asset classes that were fossil-fuel free and sustainable, with associated TRIP factors.
Sustainable investments are typically positioned to avoid areas most exposed to risks climate change poses, while being positively aligned with the shift to a low-carbon economy. In developing the sustainable asset classes, we assumed such investments had greater positive sensitivity to the technology and policy risk factors, relative to standard asset classes.
Using these new asset classes, we built a sample Divest Invest foundation portfolio, ran it through our climate change model and compared it with a more traditionally managed ‘base’ foundation portfolio, one that maintains exposure to fossil fuels and does not tilt towards climate solutions.
We found that the Divest Invest portfolio outperformed the base portfolio under our +2 degrees transformation scenario.
This result is attributable to the Divest Invest portfolio’s lack of exposure to fossil fuels and its tilt towards sustainable assets, suggesting that if an investor envisages a favourable policy and technology environment leading to a +2 degrees outcome, then both reduction in exposure to carbon-intensive assets and positive allocations to sustainable investments should be considered to improve results.
This being said, the future of climate-change mitigation action (including global or regional policy and continued technological advancement) is uncertain, and other climate-change outcomes are possible.
For instance, while our transformation scenario is broadly consistent with the baseline goal of the Paris Agreement, the ability to meet this goal will be influenced by global ambition (for example, the Paris Agreement also includes a reference to a more desirable +1.5 degrees outcome) and political realities (the country emission commitments submitted going into Paris are not yet sufficient to meet a +2 degrees goal). Other scenarios thus warrant further consideration if investment decision-makers deem them more probable or more important – from a risk-management perspective – over the relevant time horizon.
Investors can use a climate scenario analysis to better determine if they wish to be climate-aware future takers or future makers. Future takers will manage climate-change risks and pursue related opportunities, irrespective of which scenario comes to pass.
Future makers will determine which scenario is best for long-term investment outcomes and make a concerted effort to influence its occurrence. As an increasing number of investors look to position themselves either as future takers or future makers, continued market innovation to meet related demand for investment solutions that positively align portfolios with a shift to a low-carbon economy will be critical.
Progress is being made in scaling certain market segments (for example, the growth in green bond issuance), and an increasing number of funds are being developed to suit a broad range of investors, though much more remains to be done. We look forward to working with a range of investors to help them understand their climate risks and develop appropriate risk management.
Alex Bernhardt, is principal and US responsible investment leader at Mercer