Forget divestment, all capital markets are queasy on climate

The risk for fossil fuels is now on the downside, with contraction more likely. Climate change has expanded from social cause to real and present investment headache.

Recent debate about the ANU’s investment process masks the fundamental shift underway in capital markets on climate change. Claims of a deeper social purpose in the form of poverty eradication through continued expansion of fossil fuels are not likely to cut through with global markets. The story investors need to hear from fossil fuel companies is a credible plan for their operations under a range of possible warming scenarios, including a carbon-constrained world that limits warming to 2 degrees.

The likely consequences of climate change are sinking in to global capital markets. This is as a result of a maturing of investors' understanding of the impacts of climate change and greater awareness that the emissions profiles of some industries and energy sources are incompatible with a stable climate.

Universal agreement between nations to limit warming to 2 degrees, ever-tightening climate regulation and growing public concern are looming large and are likely to impact investments regardless of what laggard governments do. As a result, climate change is seen as a core investment risk rather than primarily as a social cause.

The financial risks for emissions-intensive industries become clearer to investors by the day. When the International Energy Agency says that to limit warming to 2 degrees, two-thirds of proven fossil fuels cannot be burned, a big red warning light starts flashing on investment screens around the world. New exploration, high cost operations, single purpose infrastructure, emissions-intensive fuels and processes are all financially vulnerable. Every market shake-up sees winners and losers and this one will be no different. Investors will increase the cost of capital or avoid assets that are likely to be stranded, just as with every market transition since markets began.

Granted, fossil fuels will be used for as long as society will tolerate the environmental damage they cause, but rather than the use of emissions-intensive energy sources such as thermal coal growing indefinitely, the risk is now on the downside and contraction is more likely. The IEA’s central ‘New Policies’ scenario sees coal use growing by only 0.7 per cent per year to 2035. New climate and energy policies since mid-2013, including Beijing’s recent thermal coal pollution standards and 6 per cent thermal coal import duty, plus the US’s Clean Energy Plan, further reduce the already marginal growth prospects. To assume that thermal coal markets will grow indefinitely would require an investor to bet that climate policies will not tighten any further in major markets. That is a bet few informed investors would be prepared to take.

Investor concerns about the preparedness of fossil fuel companies for a low carbon transition appear well founded. A recent analysis by Carbon Tracker found that only 21 per cent of 81 sampled coal, oil and gas companies globally disclose evidence of scenario analyses of different temperature increases. Only 7 per cent of the sample use these scenarios to stress-test their project portfolio and capital expenditure plans against a 2-degree world. If companies won’t address climate risks, investors will have to do it themselves.

Divestment decisions, while always open to investors, are just one of the ways to reduce emissions-intensive investment exposures. The approaches being adopted by institutional investors – including avoiding new investments, encouraging companies to return capital to shareholders rather than continue exploration, engaging portfolio resources companies on their activities and making new investments in low-carbon assets – all improve the climate risk positioning of portfolios.

Established producers will not be deprived of all their capital overnight, nor will institutional owners who are focused on long-term shareholder value simply cast the cleaner, least cost producers aside. But the greater than 50 per cent underperformance by coal sector stocks in the last two years may simply be a precursor to a broad market restructuring and capital reallocation in a period of deeper emissions reductions.

At the recent UN Climate Summit in New York, institutional investors confirmed that the capital shift from high carbon to low carbon is underway. Notable announcements include the $100 billion Portfolio Decarbonisation Coalition for institutional investors, a $400 billion allocation to low and zero carbon activities by insurance companies, not to mention the $50 billion worth of fund divestment announcements by endowment and faith based investment institutions. These decisions are best understood as examples of a broad and accelerating investment trend on climate and emissions risk. To criticise any individual investor for its approach is to avoid the substance of the issues.

Despite the protestations about the social good of fossil fuels, when it comes to allocating capital, markets will do what capital markets always do – reallocate capital from risky, low-growth sectors to those with better prospects. Unless the fossil fuel sectors can develop credible low carbon transition plans, that embrace rather than repudiate climate action imperatives, they will face the same fate.

Nathan Fabian is chief executive of the Investor Group on Climate Change.