Unburnable Carbon – a test case for ESG outperformance?

Earlier this year, I was invited to Zurich to present our thoughts on integrating ESG metrics through broad portfolio construction. An intimidating prospect, for several reasons:

  • It was Julie Hudson (London-based sustainability analyst at UBS – definitely worth reading her research as she is massively smart and thoughtful, and a Promethean figure in the world of institutional ESG investing) who first cracked my mind open regarding sustainability investing at an SRI In The Rockies conference in the early 2000’s. Julie was on the attendee list.
  • The EU mandated ESG screening for all public pension plans around the same time, and Europe-based institutional investors have nearly $7trillion in ESG assets (Pensions and Investments, March 5, 2012). Yes, $7trillion. With a “t”.
  • Credit Suisse’s private wealth division has invested on behalf of its clients over $1billion invested in microfinance alone.
  • Several of the transformative institutions that occupy the periphery of impact conversations in the US are based in Europe: Triodos, Euclid, SOS, Le Comptoir de l’Innovation, EMI, etc. etc.

What could I possibly add to the conversation? I was here to learn, and as my grandmother always said, it’s hard to use your ears when your mouth is open.

As it turns out, I had a lot more to add than I thought. Although there are exceptions to the following generalizations, they are sufficiently valid that I’ll put ‘em into print and stand behind them:

First, although Europe has a deep expertise in what I’ll call “social investing” (as distinct from “impact investing”, they are surprisingly behind the curve in market-rate impact investing. Second, although that $7trillion figure I mentioned is huge, nearly all of it is deployed in marketable security strategies. Euro institutions don’t have the same level of exposure to, or comfort with, alternatives investments than their peers in the US. Perhaps Swenson was never translated out of English. And third, our (TCG’s) unique perspective – blending conventional investment analysis with clear intent around impact – plays well to the Euro audience (although my mantra on market rate returns provoked a curious response that I’ll explore in another post).

Despite the rich vein of compare-and-contrast opportunities this conference presented, I just want to extract one them from my presentation: “ESG: promise, persistence or punishment?” This theme sparked a ton of debate in the room, particularly as Paul Solli at Aperio and Bill Page at GEOS generously provided me with the ammunition market data to knock heads with people way above my pay grade (thanks, guys, for making me look so damn smart – you got full credit!).

By posing the question as I did, I had hoped to investigate the notion that ESG screens offer legitimate risk control measures, which in turn should lead to incremental outperformance over time. After all, if one anticipates (for example) a regulation that would eviscerate a given business – the destructive relationship between asbestos and Corning comes to mind – then, in theory, this anticipation should yield improved relative returns. Right?

Rather than torch your precious time, I’ll get to the chase: consensus in the room was that, yes, ESG offered the promise of improved performance, but that this outperformance would appear over hugely long timeframes, and might be nearly impossible to tease out from general market volatility and sector rotation. Fair enough, I thought. All we need is an issue that is big enough and present enough to test the thesis in our lifetimes.

Well, I think we may be looking at it: “unburnable carbon”.

A recent article in The Economist examines the schizophrenic signals that markets are making regarding existing fossil fuel reserves. It is a pretty dense article, so if you want all the details you’ll have to read it yourself. But the essence is this: governments and public companies have more proven reserves that can be burnt, if the scientists are right in predicting that burning more than 1,000 gigatons (GTCO2) between now and 2050 will trigger a global temperature rise of more than 2 degrees Celcius (the limit that most scientists deem prudent and far more than, say, Ho Chi Minh City would appreciate). Rough estimates put global reserves at about 1,541 GTCO2.

There is a pretty tall “if stack” that we’d need to work through to get all the ramifications fleshed out, but the basic math is obvious. We have more fossil fuels than we can burn. Therefore, the logic dictates, some of those reserves should be assigned zero value. But this is absolutely not happening, as much of a public company’s value is derived from future revenue associated with reserves.

There are a few possible explanations. Investors may simply be betting that government resolve will weaken and that the current regulatory environment will change. There are signs that this is already happening, as just a few weeks ago the European Parliament voted against attempts to shore up Europe’s emissions trading system. Or it may be that the markets believe that a “fix” for excess carbon will appear: carbon capture or storage, or geo-engineering come to mind. This seems like a rational bet, as carbon mitigation technology continues to improve. Or it may simply be a case of short-termism: any meaningful climate policy impacting fossil fuel reserves will be years, if not decades away. Why ignore a profitable investment on the potential for far-away legislation to be passed?

But none of these plausible explanations make full sense. Sure, weak governments, hypocritical corporations and short-term focused investors all contribute to this pricing conundrum. I would posit, however, that the answer is mispriced risk.

We talk a lot at Caprock about risk, and pricing thereof. Undergirding this discussion is the broader one of efficient markets. In short, we do not believe that markets are efficient. They mis-price risk all the time. A quick review of recent bubbles – technology, housing, and credit – gives us all the evidence we need to argue against efficient market hypotheses.

The problem for those seeking outperformance is not, therefore, the hurdle of market efficiency. Rather, it is in identifying mid-priced risk that is both large enough, and pervasive enough, that taking the other side of the trade is a profitable proposition.

It may be that we are witnessing the first innings in what may be proof that ESG screens offer outperformance. For, if proven reserves eventually become “unburnable” a lot of companies are going to be re-priced quickly and painfully. But, at the moment, neither the market nor public policies reflect the full risk of a warmer world. The question at hand is: “will they?”