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Risk management

Risk of stranded assets prompts debate over engaging or divesting

112513 metrick
Mercer’s Craig Metrick: “It will be very difficult to engage a … fossil fuel company into not being a fossil fuel company.”

Pension funds and other institutional investors face new pressure to increase their focus on emerging risks triggered by exposure to what might become “stranded assets” of oil, coal and other fossil fuel companies.

Both economic issues and responsible investment motivations are driving attention.

Economically, 10% or more of the worldwide equity market value comes from companies in the business of fossil fuel extraction and production, raising concern among investors.

While pension funds have been grappling with the implications of sustainability, including climate change, “the issue of stranded assets specifically is a new angle,” said Craig Metrick, Denver-based principal and U.S. head of responsibility investment, Mercer Investment Consulting Inc.

“We think climate change risk is something that is worth considering and preparing for,” Mr. Metrick said.

“We absolutely think this (stranded assets) is a subject that won't go away,” said Roger Urwin, global head of investment content, Towers Watson & Co., London.

“There is an investment point at the heart of this” issue, Mr. Urwin said. “Funds that continue to own their market weighting in these fossil fuels will at some stage (risk) the potential for a diminution in value arising from the fact these (fossil fuel) reserves become unburnable because of public policy” restrictions on carbon.

The value at risk from a combination of unburnable reserves, lower demand and lower prices “would be equivalent to 40% to 60% of the market capitalization of the affected companies,” according to an HSBC report on oil and carbon.

Of $12 trillion in assets of combined U.S., U.K. and other regional public pension funds and university endowments, equity divestment of oil and gas companies could range from $240 billion to $600 billion, and about half that range for debt holdings, according to a report from the stranded assets program of the University of Oxford's Smith School of Enterprise and Environment.

Investors and their constituencies that have begun to act on the issue of stranded assets fall largely into two camps. One calls for engagement with companies, seeking to move them to align more to green energy sources. The other has campaigned to pressure asset owners to divest.

A group of 70 institutional investors led by Ceres — a coalition of investors, environmental groups and other organizations encouraging companies to address climate change and other sustainability issues — seeks discussions with fossil fuel companies on mitigating the long-term environmental impact of their energy resources. The group includes the California Public Employees' Retirement System; California State Teachers' Retirement System; New York State Common Retirement Fund; PMI Railpen Investments, which oversees the 18 billion ($29 billion) Railway Pension Trustee Co. Ltd.; and Scottish Widows Investment Partnership.

Asking hard questions

Jack Ehnes, CEO of the $171.9 billion CalSTRS, West Sacramento, and a director of Ceres, during a Ceres teleconference in October, said, “Clearly the path to get to a better place comes from working through these business strategies” and engaging the companies in discussion “and asking hard questions ... but not from stepping away from the (companies) and selling our securities to someone else.”

But in Massachusetts, legislation introduced Jan. 22 and pending in the Joint Committee on Public Service, directs the $53.9 billion Massachusetts Pension Reserves Investment Management Board, Boston, to divest companies that produce, distribute and support fossil fuels.

If the bill would become law, it would limit MassPRIM's investment opportunity set, increasing risk and making “it even more challenging ... to achieve the actuarial rate of return assumption” of 8%, Michael G. Trotsky, MassPRIM executive director and chief investment officer, wrote Sept. 10 to the leadership of the joint committee.

In Norway, the 4.921 trillion kroner ($811.5 billion) Government Pension Fund Global, Oslo, faces pressure from the country's Labor Party, which this month called on it to divest coal-related assets.

Storebrand Group ASA, a Lysaker, Norway-based investment manager with 471 billion kroner in assets under management, announced July 2 the exclusion of 18 energy companies from its investments.

“If global ambitions to limit global warming to less than 2 degrees Celsius become a reality, many fossil fuel resources will become unburnable and their financial value will be dramatically reduced,” Christine Torklep Meisingset, Storebrand head of sustainable investments, said in a statement at the time.

Mercer recommends clients at least review their investments and “make their own decision on how realistic or long term they think the risk is” and consider their strategic options, Mr. Metrick said. Those options might include engagement with companies, which “may be one of the most important things that can be done,” he said.

But Mr. Metrick was less sanguine about engagement prospects.

“I think it will be very difficult to engage a ... fossil fuel company into not being a fossil fuel company,” Mr. Metrick said. “But for investors that need to remain in those markets, you can hopefully engage and work out ways to select the best company and make the companies in that market better, and work toward a better financial and physical environment.”

Mr. Urwin said Towers Watson recommends asset owners start off by reviewing their carbon exposure and their mission values and investment beliefs. Then, he said, they “are in a position to move forward with the subject.”

“I would be more positive about the forces of engagement in the future than the forces of divestment,” he said. “Divestment is a move to exclude potentially up to around 10% of the global equity capitalization from the investment portfolio, carrying consequences for the risk/reward trade-off“ and reducing portfolio diversification, Mr. Urwin said.

“Other investors will fill in” if some divest, he said. “The consequences may not be helpful to the cause that you are trying to pursue ... to try and change behaviors of these companies to be more aligned with a renewable low-carbon economy.”

David Richardson, New York-based managing director, Impax Asset Management Group Inc., which specializes in resource optimization investments, including from energy efficiency and alternative energy sources, echoed Mr. Metrick's sentiment. “I'm not optimistic fossil energy (companies) will become new energy anytime soon,” Mr. Richardson said.

At Exxon Mobil Corp., Alan Jeffers, Irving, Texas-based spokes-man, said considering the massive energy demand, “There is no viable alternative” to fossil fuels. Mr. Jeffers said he didn't know the status of Exxon Mobil shareholder engagement efforts on climate change. “We take very seriously any issue brought by shareholders,” he said.

In terms of aligning more with alternative sources, Mr. Jeffers said the company's focus “is to provide safely energy that comes from the development of oil and natural gas” and not moving to alternatives.

Waiting to divest

In the divestment area, Norwegian pension fund officials haven't decided to implement the Norwegian Labor Party's divestment request.

Paal Bjornestad, state secretary in Norway's ministry of finance, which oversees the Norwegian fund, said in an e-mailed response to questions, “No decision has been made to divest from coal-related investments. ... The objective for the management of the GPFG is to achieve good financial returns given a moderate level of risk.”

“The fund is not a suitable environmental policy instrument,” Mr. Bjornestad said in the e-mail. “To deviate meaningfully from this strategy will require convincing financial evidence supporting the decision.”

University endowments also have been pressured to divest.

Drew Faust, president of Harvard University, Cambridge, Mass., in October rejected divestment of fossil fuels from the school's $32.7 billion endowment fund.

Not "warranted or wise'

In a letter to the Harvard community, Ms. Faust said while she supports addressing climate change, “I do not believe, nor do my colleagues (at Harvard) that university divestment from the fossil fuel industry is warranted or wise.”

She added: “Generally, as shareholders, I believe we should favor engagement over withdrawal. In the case of fossil fuel companies, we should think about how we might use our voice not to ostracize such companies but to encourage them to be a positive force both in meeting society's long-term energy needs while addressing pressing environmental imperatives.”

Brown University, Providence, R.I., also last month rejected divestment from coal companies for its $2.9 billion endowment fund.

The Oxford school established the stranded assets program last year to understand the potential risks and impact to business, policymakers and others, and develop strategies to manage potential consequences.

Mercer's Mr. Metrick said, “There is some scientific consensus” that only a certain amount of carbon can be burned without taking the climate through a critical ceiling. “If all those proven reserves (of fossil fuel companies) were burned, that would take us way above the ... threshold.” As a result, “many scientists and others think ... those assets would be stranded” and the value of the companies would decline.

So far, there is no public policy or regulation restricting such carbon use, Messrs. Metrick and Urwin said.

But Mr. Urwin said it's very likely carbon pricing and carbon taxing “will become part of the global system in a matter of years. ... It's a matter of speculation when that might occur.” n

This article originally appeared in the November 25, 2013 print issue as, "Risk of stranded assets prompts debate over engaging or divesting".