Investing in alternatives to fossil fuel stocks

Institutions ranging from universities to public pension funds are under increasing pressure to consider divestment from fossil fuel companies whose activities are leading contributors to climate change. While much of the attention has been focused on whether to divest, the discussion is evolving to include ways to manage a multifaceted investment challenge. The traditional belief of many investors has been that fossil fuel stocks are essential to generating portfolio returns. However, it is our contention that the sources of return that fossil fuel stocks have been relied upon to deliver can be replaced by investment in other vital resource solution providers. And when adequate consideration is given to the significant risk from carbon exposure that fossil fuel stocks pose, investment solutions can be created that are in the best interest of both institutions and our global society.

At a most basic level, investors expect fossil fuel stocks to be a significant source of returns, providing access to a number of long-term growth themes including resource scarcity, infrastructure investment and emerging market growth that are expected to drive investment returns for decades. We believe investors can access these secular drivers of growth in other ways. Energy demand will need to be met, but we believe investment in cleaner, more efficient energy solutions have better long-term prospects given the need to meet demand while reducing greenhouse gas emissions. While the demand for energy is one key example of resource scarcity, water and food are even more essential resources, and their demand is also expected to accelerate through midcentury. Most of this growth in demand across all three vital resources is being driven by population growth and changing demographics in emerging market countries as they industrialize and grow. Essential infrastructure investment to meet the increase in demand and more efficiently manage resource provisions will need to be made across water, food and energy in both the developed and emerging markets.

To date, most institutional portfolios have been underinvested in stocks providing solutions to the need for low-carbon energy, food and water. Instead of investing in fossil fuel stocks, companies providing renewable energy, energy efficiency, water and agribusiness can be viewed as replacements for the drivers of growth expected from traditional energy stocks. We believe that when the risks and rewards are fully considered, the opportunity for investment across these four areas is stronger than investment in conventional energy stocks.

Energy demand is expected to grow by 33% by 2030 alone, according to McKinsey Global Institute, but given the carbon emissions of fossil fuels, renewable sources and more efficient uses of energy will need to grow if we are to avert the worst implications of climate change. The International Energy Agency estimates that $16.9 trillion will need to be invested in power generation, transmission and distribution and more than 75% of this investment will be in renewable generation and higher capacity, more efficient transmission and distribution, according to Citi Climate Change Universe. This capital will be deployed in the development of renewable technologies as well as technologies and infrastructure for increased energy efficiency, providing a wide opportunity set of diverse companies in which to invest.

While renewable energy stocks suffered in the immediate wake of the global credit crisis, we have seen the beginning of what we believe will be a sustained, strong, recovery. With the costs of wind and solar continuing to decline, it's reasonable to expect they will help reduce the reliance on fossil fuels over the next 10 years. There will also be a renewal of pressure on policymakers to accelerate the path to a low-carbon economy as more people comprehend the implications of not reducing carbon emissions and continue to experience firsthand the consequences of rising global temperatures through extreme weather. Any policy movement in this direction would support renewable and energy efficiency stocks relative to conventional energy stocks.

Investing in companies providing water solutions can also access strong investment returns driven by resource scarcity, emerging market growth and the need for infrastructure investment. Water is our most vital resource, not only for sustaining life but also for economic growth as an essential input across many industries. It is a finite resource, and unlike oil, there is no substitute. Less than 1% of the world's water is available for use and this limited supply is increasingly threatened by pollution, particularly in emerging market countries as they grow and industrialize.

Historically, water demand has grown at twice the rate of population and is expected to grow by 41% by 2030, according to McKinsey Global Institute. An estimated $22 trillion investment will be required to meet the need for water through 2030, which is expected to be the largest component of global infrastructure spending through 2030, according to Jacobs Securities. This extensive capital commitment will be deployed through companies working to provide solutions.

Similarly, agricultural solutions providers will also be driven by resource scarcity, emerging market growth and the need for infrastructure investment. The supply of arable land for farming is relatively fixed, with approximately 38% of the earth's land currently used for farming, according to Jonathan A. Foley, writing for Scientific American. Demand for food is expected to expand by at least 70% by midcentury, according to a Goldman Sachs report, largely driven by economic growth in emerging markets. In order to meet the demand for food, we will have to find ways to dramatically increase crop yields and distribute produce more efficiently, which will require massive investment in companies providing machinery, precision agricultural technology and infrastructure. An astonishing 30% of the food produced across the globe goes to waste as lack of adequate infrastructure to handle and transport produce is a key constraint in both developing and developed regions. The Food and Agricultural Organization estimates that in the developing world alone, $9.2 trillion in investment will be needed to meet agricultural needs through 2050.

There are also more significant risks to conventional energy stocks. John Fullerton of the Capital Institute reports that limiting the rise in global temperatures to 2 degrees Celsius will require stranding of fossil fuel reserves with an economic value of approximately $20 trillion, creating a potentially devastating shock to the global economy and a huge liability for the entire conventional energy sector. The problem is that current investment horizons are not adequately taking these risks into account. But given the actual long time horizons of most institutional investors, should not these risks be given some probability? And once these risks are accounted for, will not stocks of companies providing renewable energy, energy efficiency, water and agribusiness solutions prove more compelling on a risk/reward basis? Even moving a portion of assets from conventional energy stocks to low-carbon energy, water and agribusiness stocks will enable investors to not only retain exposure to sources of growth, but also create a natural hedge against carbon related liabilities.

Investors need to incorporate the longer-term risks embedded in fossil fuel stocks as they develop their equity strategy for the next 10 years and consider accessing the same drivers of growth through other areas of the equity market. While an immediate wholesale move out of traditional energy stocks may not be practical or prudent, investors need to develop a plan for managing exposure to the risks of fossil fuel stocks and identifying alternative investments that provide exposures to attractive returns from growth drivers of resource scarcity, infrastructure investment and emerging market growth. This could involve a carefully constructed plan for divestment that manages costs of divestment and weighs the opportunity to influence change at big oil companies through active engagement. It should also involve exploring increasing exposure to water, agribusiness, renewable energy stocks and clean tech companies providing energy efficiency solutions.

Such a well constructed plan would be in the best long term interest of both institutions and our planet.

Steve Falci is head of strategy development for sustainable investment at Kleinwort Benson Investors.