In early June, G7 leaders committed their countries to reducing carbon emissions by 2050 and eliminating them by 2100. Even before the G7 announcement in Germany, there had been concerns expressed over how carbon reductions might impact investors in energy and energy-related companies. If governments legislate reductions in global carbon emissions, the fear is that oil, gas and coal consumption would decline, resulting in capitalized fossil fuel reserves that will never be extracted. These potential surpluses are referred to as stranded carbon assets.
There’s no reason for fear. Instead, plan sponsors should become familiar with the concept of stranded carbon assets and make sure their investment managers evaluate this risk as part of their investment analysis of companies in the energy sector.
Time horizon
For most institutional investors, the timing and implementation of government legislation may surpass investment time horizons. While the liability streams of pension and endowment funds can be long (with benefit obligations for active pension plans stretching out more than 50 years) the investment time horizon for asset mix assessment is considerably shorter—normally five to 10 years. Furthermore, while the definition of stranded asset is open to interpretation, regulatory changes will be incremental over many decades, and the full impact of these changes on cash flows and stock prices in the energy sector are not likely to be seen for many years.
Read: Why pension funds should invest in oil companies
Maximizing return, minimizing risk
As fiduciaries, most plan sponsors are concerned with their responsibility to maximize the investment return of their portfolios to best meet the obligations to their beneficiaries. The investment manager’s primary role is to support clients’ investment obligations while controlling the risks assumed by the portfolio. To achieve this objective in an equity portfolio, it’s important for the investment manager to evaluate the full investible universe of stocks.
One sector of particular focus is Canada’s energy sector, a fundamental part of Canada’s economy and a significant constituent of the Canadian stock market, where energy represented 20.4% of the S&P/TSX Composite Index at the end of June. The energy sector offers a significant opportunity to enhance the value-added potential of a Canadian equity portfolio over the long term given energy’s historical outperformance through several business cycles.
While some observers have suggested investors take a moral stand by removing energy companies from their investment portfolios, such divestment will not expedite the arrival of lower carbon emissions since there are very limited viable fossil fuel substitutes. Moreover, estimates from the International Energy Agency project a steady growth in demand for oil—from 93 million barrels a day in 2014 to 104 million in 2040—driven largely by projected increases in consumption in the developing economies of Asia. Oil production will be required for some time to come, and higher demand and limited alternatives will result in an increase in carbon reliance regardless of how many investors sell their energy holdings.
Read: Pension funds and the rise of responsible investing
Given the projected growth in oil demand, Foyston, Gordon & Payne expects the price of oil to normalize, a situation that may do more to achieve sustainability goals than legislated initiatives. That’s because higher oil prices will drive further energy conservation among consumers, encourage substitute clean energy alternatives, and ultimately reduce fossil fuel demand.
Excluding the energy sector would significantly reduce the universe of Canadian stocks for inclusion in a Canadian equity portfolio and would impair the value-added potential of the portfolio.
Energy stocks and ESG
Plan sponsors should ask their investment managers how they evaluate environmental and regulatory risks in the energy sector. For example, do they actively assess a broader set of environmental, social and governance (ESG) considerations in their analysis of each security they buy and own? Hopefully, the answer is yes, as ESG should be an essential part of any analysis since the components of ESG can negatively impact the price of a stock.
When assessing the risk of stranded carbon assets, there are a number of long term issues to carefully consider, including:
- potential supply side improvements that could reduce future environmental impacts
- the emergence and development of renewable alternatives
- energy efficiency initiatives driven by changes in global supply and demand
- shifting policy changes regarding carbon-based fuel consumption by countries and political leaders
Within this framework, the increasing cost of carbon reduction should be considered as one element of a company’s overall risk assessment. Investment managers should also assess the potential unique risk associated with individual companies within the energy sector. For example, companies with a large reliance on coal production for energy use are most at risk of environmental regulation. Large, well-capitalized oil producers with robust long-term reserves, low costs to replenish these reserves, and strong ESG track records are better able to withstand short-term fluctuations in oil prices and are well positioned to benefit from normalizing oil prices.
Read: Dalhousie won’t divest fossil fuel holdings
The risk of stranded carbon assets should not, on its own, dissuade plan sponsors from investing in a company or in its broader industry sector. However, investment managers should incorporate this risk with a range of other financial factors in the valuation process to assess the relative attractiveness of different investment opportunities. In this manner, they can capture all relevant inputs and risks in their security-level decisions in order to maximize the investment performance of their clients’ portfolios, while prudently managing investment risk. To truly achieve these objectives over time, it’s important not to exclude significant and essential sectors of the economy but rather to properly evaluate and price risk in the context of a fundamental analysis of securities.
Colin Ripsman is vice-president at Foyston, Gordon & Payne Inc. The views expressed are those of the author and not necessarily those of Benefits Canada.