Here’s a surprising fact: while the spot price of crude oil has rallied more than 70% from the lows of February 2016, fossil fuel equities have barely budged. The XOP ETF, for example, which provides exposure to the oil & gas production and refining industries, is down roughly 12% over the same period. Investors’ reluctance to pay for these securities may be multi-pronged. Explaining their decision to divest all fossil fuel holdings from the University of California’s $13.4 billion endowment and $70 billion pension fund, senior officials stated, “We believe hanging on to fossil fuel assets is a financial risk.” From an ESG perspective, policy frameworks such as the EU’s Technical Expert Group on Sustainable Finance have also recommended that certain fossil fuel companies should be excluded from specific climate-friendly benchmarks, further shrinking the pool of prospective investors. This prompts the question: can a responsible investor own fossil fuel equities?
We turn first to the financial perspective. A central tenet of corporate finance is that a company’s value is the net present value of free cash flow to the firm, which is a function of the size, timing and perceived riskiness of future cash flows. At the right price, even a company facing obsolescence can be a rewarding investment. Warren Buffett has referred to this as “cigar butt investing”, akin to finding a used cigar butt with one puff remaining (though the combination of tobacco and fossil fuels may truly push some investors over the edge). Part of the return to cigar butt investing is simply compensation for the risk that obsolescence will be quicker or more painful than expected. But another complexity with this investing style is gaining confidence that management will allocate capital in line with the firm’s diminishing prospects. If management redeploys free cash flow into projects that won’t ever earn their cost of capital, whatever intrinsic value that existed in the cigar butt is quickly stamped out. In this vein, investors who persist in owning fossil fuel companies are making some combination of bets that (a) hydrocarbons will continue to play a major role in our energy system for the next 30 years; (b) their particular companies will survive the low-carbon transition, perhaps by virtue of low-cost resources, (c) management will continue to allocate capital prudently, and (d) current prices of fossil fuel securities adequately compensate the investor for these risks.
Putting valuation aside, we come to the even thornier question of ethics. As we see it, there are at least two strong arguments against those who divest for philosophical reasons. The first is that when investors sells their stake in a firm, they lose the ability to influence the company from the inside. The work of political economist A.O. Hirschman is instructive in this respect. In ‘Exit, Voice, and Loyalty’, Hirschman posited that consumers who experience deteriorating quality of goods or service have two options: they can either exit the relationship or they can speak up, i.e. “voice”, to effect change. Deciding whether to select exit or voice is partially influenced by the consumer’s loyalty to the organization. This concept applies to “customers” of organizations as varied as countries, churches or firms. A shareholder may not have loyalty to a firm per se, but there’s no denying that shareholders with a long-term perspective can play a vital role in shaping a company’s norms, corporate governance structure and capital allocation decisions through engagement and proxy voting. This is precisely the logic that has driven investor groups like Climate Action 100+ to push high-emitting portfolio companies to adopt climate goals aligned with a 2 degree future rather than simply divesting.
Second, in order to keep global temperature rise below 2 degrees Celsius, we will need a combination of ingenuity, capital and scale. At a recent energy and power sector conference, we were struck by the impressive technical and operational expertise that resides within large companies. Using a broad brush, many of these companies could easily be mistakenly labelled as “fossil fuel companies.” In reality, these companies are evolving and could well end up being the leading corporations of a low-carbon future as investors and employees spur change. The offshore wind industry, for example, is one which will require skillful project management, political savvy and large sums of capital – all areas where traditional energy companies shine.
While these are two good arguments against divestment, we must acknowledge the practical challenges of this approach. At some point, even the most loyal consumer – or committed investor – realizes that “voice” has its limits. Furthermore, some investors have expressed concern that fossil fuel companies are engaging in greenwashing, with token investments in renewable energy dwarfed by capital expenditure on fossil fuel assets. This apprehension is legitimate. But by articulating a clear ESG framework for investing in fossil fuel companies and allying with similarly-minded asset managers and asset owners, responsible investors can invest in these firms while participating in – and perhaps even shaping – the low-carbon transition.