Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

A fossil fuel-free future?

We believe climate risks and opportunities can be better addressed through modelling and careful analysis than with the blunt tool of divestment across an entire sector.

 

Investors have witnessed a dramatic acceleration of long-term themes in 2020, as COVID-19 has changed the way we live, work and play. The pandemic may well have also offered us a glimpse of a fossil fuel-free world, with carbon dioxide emissions plummeting.

At the same time, this year’s abrupt slowdown in carbon-intensive industries has brought havoc to global output, providing a glimpse into how a disorderly energy transition could deeply impact the world economy.

So in an effort to insulate investment returns and help tackle climate change, some investors and even institutions have committed to removing the energy sector from their portfolios. But is this the best way of meeting these twin objectives?

Energy matters

Energy stocks certainly stand out as significant detractors from returns, having lagged the wider equity market for a protracted period, by a significant margin. That underperformance has become even more pronounced this year.

The recent weakness comes after a collapse in the price of crude oil, only partially cushioned by the efforts of the OPEC+ cartel, and dividend cuts by oil majors – a move that broke an industry taboo and knocked the confidence of already-concerned investors.

Until a vaccine is found and made widely available, we believe the sector continues to face a strong headwind, whilst equally transitioning business operations to meet the requirements of a low-carbon economy.

The renewable energy revolution has not stopped and policymakers have been emboldened by the crisis to deploy fiscal spending and build back green; for example, the EU has devoted a large chunk of its recovery funds to climate action. 

Walking away

It is clear, then, that the context in which energy companies operate is bleak. And yet – to return to our original question – while we understand the desire of some investors simply to walk away from the sector, we believe this may not be the best course of action for the following reasons:

1. Even though the transition is likely to impact some sectors much more than others, we do not believe they should be considered in isolation. Indeed, it is our view that investment decisions should be informed by a comprehensive framework to evaluate climate risk and temperature-alignment across all sectors.

2. Many sectors can display long periods of underperformance that may or may not be followed by subsequent strong relative gains. This is why diversification remains an important tool for any long-term investor, in our view.

3. By divesting from entire sectors, investors lose their ability to exert a positive influence via active engagement. There is a growing body of evidence that supports the assertion that this engagement can lead to significant positive change.

Finding a climate solution

At LGIM, we are working to help investors navigate the energy transition and address mounting pressure from regulators to demonstrate the integration of environmental, social and governance considerations.

From the first quarter of 2021, we plan to launch a climate solution capability for institutional investors, which will deploy modelling tools developed to measure the climate alignment of their assets. It will also help our investment teams to partner with clients to design and implement ‘Pathways to Paris’ solutions.

We have initially used our climate risk and alignment framework to analyse around 2,000 companies globally. The majority of them are not aligned with the objectives of the 2016 Paris climate accord, raising concerns that some institutional portfolios may be aligned with temperature outcomes of greater than three degrees.

But in addition to posing risks, the energy transition also presents significant opportunities, in our view. And we believe these can be captured through modelling and careful analysis, potentially both effecting positive change and leading to better long-term financial outcomes, rather than adopting the blunt tool of divestment across an entire sector.

 

Appendix: performance of indices cited

 

S&P 500 index

S&P  500 Energy index

30/09/2015-30/09/2016

15.4%

18.9%

30/09/2016-29/09/2017

19.6%

1.46%

29/09/2017-28/09/2018

17.9%

13.9%

28/09/2018-30/09/2019

4.2%

-19.1%

30/09/2019-30/09/2020

15.1%

-45.2%

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