Divestment

I was asked by my good friend Dana Lanza, CEO of Confluence Philanthropy, to orchestrate a panel on values-aligned investing for their annual practitioner’s gathering. This meeting took place last weekend, and while the theme of the panel was not intended to spark a conversation on climate change, it felt like we couldn’t avoid the subject. In fact, notable at the conference was the dominance of the divest/invest topic. It was, quite literally, on everyone’s mind.

Given the flow of recent events, this attention should have been anticipated: increasingly alarmist warnings from the United Nations’ Intergovernmental Panel on Climate Change and the Pentagon; an historic pact by the U.S. and China to reduce carbon emissions; unprecedented agreement at the recent COP20 Climate Forum to rein in greenhouse gas emissions; massive, coordinated marches demanding that world leaders address the threat of climate change; high-profile decisions by university endowments to begin stripping their investment portfolios of fossil fuels; the dramatic and unexpected drop in crude oil prices (and the related collapse of energy-related stocks and bonds); the recent announcement by EON, one of the largest electric utilities in the world, to move to a 100% renewable energy generation platform, etc.

Contrasting with this drumbeat of climate change awareness and action are events that undermine, not the science around climate change, but our commitment to respond: the resurgence of gas-guzzling cars and trucks in the world’s largest automobile market; India’s decision to reverse environmental regulation on its primarily coal-burning electricity sector; the ongoing struggle to pass sharp-toothed environmental regulation; the imposition of tariffs on Chinese-manufactured solar panels; the continued efficacy of climate change skeptics to undermine climate legislation, etc.

Oceans of ink have already been spilled parsing these arguments — moral, philosophical, political, environmental, behavioral and financial — and people smarter and more thoughtful than us have weighed in on both sides. But stewarding as we do billions of investor capital, we have a responsibility to not only have an opinion but to share it.

Before you is a condensed version of our opinion. The question at hand: should investors remove fossil fuel exposure from their portfolio? (Spoiler alert: the answer is a modestly qualified “yes.”)

First, the numbers.

Impax, an asset manager, recently highlighted historical data indicating that, over the past six years, eliminating fossil fuels from the MSCI World index would have improved annualized returns by 0.4% (to 4.5% from 4.1%). And this was before the recent sell-off in the sector. Similar literature from Aperio Group (full disclosure: Aperio is a public equity manager with whom our clients have capital) goes into some seriously arcane and mind-numbing mathematical detail to demonstrate how excluding oil, gas, and consumable fuels would only add 0.77% of tracking error to a Russell 3000-indexed portfolio. To put that number in context, most actively-managed funds feature tracking errors north of 5%. In other words, 0.77% is a small, almost trivial, number. Yet most managers argue that decarbonizing an equity portfolio adds too much volatility. Bravo for life’s little ironies.

Adding to the irony is the notion that a tracking error of 0.77% could just as easily lead to outperformance as underperformance. For example, in Aperio’s back-tested study from Jan. 1, 1988 to Dec. 31, 2013, a carbon-free index experienced higher returns than the Russell 3000 benchmark in 68% of the periods measured. This resulted in an annualized (geometric) return difference of +0.05% in favor of the carbon-free index (10.68% vs. 10.63% for the Russell 3000), and an average rolling 10-year geometric return difference of 0.10%. While this tiny number is statistically immaterial…it is philosophically fascinating, if for no reason beyond that it offers a powerful argument against those who claim an inevitable performance sacrifice when screening fossil fuels.

What is even more interesting is the period during which the data was gathered: generally stable-to-rising oil prices, record profits at oil companies, the formation of thousands of small and growing oil-field services businesses, and before the notion of stranded carbon assets was even conceived. It goes without saying that the recent reversal of these trends will generate a more significant fossil-fuel-free outperformance.

OK. So past performance suggests that no sacrifice is required. But as we all know, past performance is no guarantee for the future. So while we are not in the business of predicting the future, it strikes us that the risks surrounding fossil fuels – regulatory, social and geopolitical – may lead to continued outperformance. As such, we see de-carbonizing a portfolio as a form of risk mitigation just as much as it is a values-alignment decision and potential return enhancer.

But the financial data surrounding divestment can be as easily misconstrued as the social and political arguments about climate change itself. And it is only one piece of the complicated jigsaw surrounding climate change and how we react to it. Being systems thinkers, we tend to view the absolutist notion of climate change-driven divestment as a shibboleth rather than a functional perspective. The reason? Because the issue is invoked by politicians, NGOs, journalists, scientists and business people on all sides of the argument as a wheel on which to grind their parochial (proverbial?) axes. Confusion and conflicting agenda reign.

So with all of this in mind, what is our opinion?

Of course the climate is changing. It always has; it always will. The climate does not exist in stasis. Remember The Ice Age? But these shifts take place in geologic time frames. Measuring global surface temperatures for the last 100 years doesn’t prove anything. Yes, it provides us with information that allows us to build models, make projections, draw conclusions and state opinions. But, in our mind, compelling as it is, the data doesn’t offer proof…yet. In our view, what we have is a growing set of important, relevant, meaningful and deeply unsettling data that is beginning to coalesce around an idea. And that idea is that our climate is changing. Fast. Likely exacerbated by man’s behavior, if not caused by it. And with even the most dire predictions of a decade ago already looking far too conservative (which is terrifying for anyone who is paying attention). It may be that if we don’t take dramatic, immediate evasive action, climate change may render our planet broadly uninhabitable.

But what truly sucks is that…we won’t know for sure until it is either too late to do anything about it. Scientific proof lies in the future.

And even if we don’t rely exclusively on science, our natural environment is changing before our eyes. Glacier National Park may not have any glaciers in as few as 30 years. The great annual Himalayan melt-freeze cycles are weakening. New England fisheries are emptying as the cod swim north in search of cooler waters. Changing flora profiles. Changing fauna patterns. Dropping water tables around the world. A navigable Northwest passage. The list is, literally, endless, as every year more observed changes are added. Are these simply short-term fluctuations within geologic climate change patterns? Or do they indicate some sort of inflection point in global temperatures? Our educated guess is on the latter. Full stop.

Consequently, we are positioning portfolios accordingly. Why? Because if we are wrong, the world will remain in status quo. Little financial consequence will be felt. But if we are right, there is a freight train slowly rolling down a long, steepening hill…and we don’t want to be tied to the tracks.

What does this mean, and where does this leave us?

IF man’s behavior is contributing to a form of climate change that makes it increasingly difficult for us to inhabit large parts of our globe, and IF we have the capacity to adjust our behavior – either through the application of technology or through behavior modification – why wouldn’t we? Do we really want to be wrong on this question? Shouldn’t we err on the side of caution, especially if it leads us to consequently imagine a cleaner, more efficient world?

If the emerging answer – from the United Nations and the Pentagon, from American and Chinese leaders, from policymakers representing 190 countries – is “yes, we should,” then we get to look at the next 50 years as one of the most exciting times ever to be an investor. Why? Simply put, because it would represent the Industrial Revolution v2.0. Reimagining our energy complex, our transportation sector, and our supply chains. Destructive capitalism, at its finest and most powerful. And that – the notion of what capitalism can bring to our world – is what makes us interested in, and excited about, the future.

In summary, we are firmly in the camp that we should act, almost regardless of man’s influence on our climate. Geopolitically, economically, culturally, and socially, it makes sense to build a world that is more sustainable and less polluted. Yes, there will be cost (see our blog on German’s decision to tax themselves into developing the global solar market). And, yes, there will be painful adjustments. And yes, the political will needed does not exist. And yes, the amount of capital necessary has not yet been mobilized.

But it is complicated. As an investor, I anticipate fossil fuel underperformance over the coming decades, just as I anticipate the emergence of the post-hydrocarbon economy. As a consumer, I am practical enough to know that it is impossible to live without them. As a traveler, I am grateful for the miracle of oil-fuelled flight. As a resident of northern latitudes, I am equally grateful for natural gas. With all of this in mind, I must make room for the concept of a period of transition, a bridge to the post-hydrocarbon world. But they aren’t going away immediately, as much as the activists may wish them to.

Which is why, for me, the decision to divest is one based primarily on values alignment, with alpha expectation slotting in right behind. As a fiduciary, I understand fossil fuels’ manifold risks, and appreciate the dialogue/debate that goes into how/whether those risks ought to be mitigated. But it would be foolhardy for me to proclaim that the response is obvious, particularly in light of what we still don’t know. Nevertheless, I revel in the conversation, and stand at the ready to thoughtfully and enthusiastically support those who want to lead.