26 February 2023
Why moving away from fossil fuels makes pure economic sense
Thomas Da Costa Vieira
In this article, I show how fossil fuels are no longer sound investments, especially compared to renewable energy. The data is unequivocal: fossil fuels are losing investors, and us (as pension fund members), money. This means that there are no reasons left to wait: even for purely economic reasons, we, and our pension fund managers, should divest from fossil fuels now.
We are at a turning point: despite recent events (see more on this below), the fossil fuel industry is facing inevitable threats to its financial performance and even existence, and for investors such as pension funds and their members, it now makes pure economic sense to move away from fossil fuels. The threats the fossil industry is facing are many, and interrelated: from climate policy (the development of legislation increasingly threatening fossil fuel viability), to financial (ranging from divestment risk to stranded asset risk), legal (increasing exposure to legal action by citizens), and even geopolitical/competition risk (countries developing competing national strategies based on renewables)[1].
In particular, in the medium-term, the development of climate policies will accelerate to try and meet the Paris Agreement’s targets, with the effect of reducing capital flows to oil and gas companies (research shows this has already started[2]), and threatening the industry’s profitability and very existence.
Stranded asset risk – whereby assets become unexploitable and have to be written down – poses an existential threat to the industry, with over 88% of proven coal reserves, 52% of gas reserves, and 35% of oil reserves needing to remain unexploited to maintain average temperatures below 2°C (and that’s as of 2015 – the figures will be higher now)[3]. Economic losses from stranded assets are forecasted to be enormous, with up to $12 trillion (in 2016 terms) of financial value, or 15% of global GDP, set to ‘vanish off investors’ balance sheets’[4].
Crucially here, individuals will bear most of the final losses, with pension funds in particular holding $681 billion of potentially worthless assets. Research shows that these dangerous assets are disproportionately held by pension fund members in the US and UK – in other words, us. In the UK, individuals hold 75% of all the assets at risk of being stranded, meaning that ‘most of the market risk falls’ on regular citizens, collectively exposing us to billions in losses[5].
Now, against this background, investments in fossil fuels continue, based on the frequent claim that removing fossil fuels from an investment portfolio impacts returns for investors. Is this actually true, though?
Well, researchers can now assert that this is a ‘mythical’ claim and that fossil fuel divestment has no effect on long-term returns[6]. Indeed a flurry of research has shown that diverse portfolios which exclude fossil fuel assets outmatch or even outperform traditional portfolios containing fossil fuel assets. These findings have been observed and replicated across world regions and going as far back in time as a full century ago[7]. For example, the following graph (available here) shows the performance of the MSCI ACWI (a main worldwide stock market index) and compares portfolios including fossil fuels against those which exclude fossil fuels:
In fact, not only is this the case, data now shows that fossil fuels have increasingly turned into an underperforming asset class, as opposed to the increasing returns of the renewable energy sector. Mounting evidence shows that fossil fuels have actually underperformed for at least 8 to 10 years, while renewable energy stocks have actually outperformed both fossil fuels and the overall market in the same period.
Indeed a joint Imperial College Business School and International Energy Agency report found that that since 2010, across all portfolios that were considered, ‘renewable power generated higher total returns relative to fossil fuels’[8] (see table from that report below).
How has this happened?
In short, the turning point can be located around 2014-2015, when changing fundamentals, greater climate concerns and the energy transition all led the fossil fuel industry towards consistent underperformance compared to MSCI ACWI, while the renewable energy industry, boosted by subsidies (which are still extraordinarily lower than the direct and indirect subsidies that fossil fuels enjoy), competition, innovation and economies of scale, started enjoying consistent outperformance with higher returns and lower volatility, and rose above MSCI ACWI[9].
Thus, research everywhere started reaching the same conclusions: in the US context, it was found that ‘portfolios that divest from fossil fuels and invest in clean energy perform better than those with fossil fuels’[10]. Similarly, analysis showed that even in the Canadian context, a particularly fossil fuel-heavy financial market, fossil-fuel free investing ‘increases risk-adjusted financial returns’ compared to the traditional, fossil fuel-heavy Canadian TSX 260[11]. Other researchers comparing traditional investment funds with fossil fuel-free investment funds in the Eurozone context also found that ‘the investment strategy to divest the fossil fuel companies actually paid off, and the funds, after cleansing such exposures, performed better’[12]. The conclusion is thus that ‘investors with long-term horizons should avoid oil on investment grounds’[13].
The data is unequivocal: investors who chose to divest from coal, oil and gas have enjoyed higher averaged, risk-adjusted returns compared to other investors — as well as ‘enhanced diversification benefits’ due to renewables’ ‘lower correlation to the broader market relative to fossil fuels’[14].
“Thus, asset managers should divest from fossil fuels strictly on the basis that they are losing themselves, and investors, money.“
What are the implications for pension funds, and for us, as members?
Well, what all these research findings show is that ‘a socially responsible investment strategy … also happens to be beneficial from a financial point of view. Therefore, it can also be applied by investors that are bound to fiduciary duty’[15]. In other words ‘it is possible to divest from fossil fuels and achieve a higher risk-adjusted return by including clean energy. In sum, divestment does not entail the dereliction of fiduciary duty’[16].
Thus, asset managers should divest from fossil fuels strictly on the basis that they are losing themselves, and investors, money. Indeed Blackrock, the world’s largest asset manager, lost $90 billion from 2009-2019 due to ‘myopic management’ that saw the company retain holdings in the underperforming fossil fuel sector[17]. As this graph from Carbon Tracker shows (see the full report here), the sector has been losing investors money for a decade:
The exact same conclusion holds for us – and this is why a recent article by researchers in the field was entitled “Want a richer pension? Divest of fossil fuels”. In it, they make clear that pension fund managers should divest from the fossil fuel sector, and be reassured of the financially sound character of their decision, instead of continuing to lose us money[18].
Now, there is a last question you might be asking yourself: what about recent events? Isn’t the Ukraine conflict, and the whole cost of living crisis, proof that fossil fuels are profitable again and for the foreseeable future?
Yes, fossil fuels are very profitable at the moment, but like in previous times, the current boom will not last. What the research I have discussed above shows is that over time, despite periods of extraordinary wealth accruing to investors, the risk-adjusted, average returns of fossil fuels are no greater, or even below, that of other assets.
The war and its effect on the economic fundamentals of fossil fuels should thus be understood through a medium and long-term outlook, especially in our case (a pension fund, and its future beneficiaries). A Carbon Tracker analysis found that despite the recent rises in energy prices, it is irrational for fossil fuel companies to invest in long-term, high-cost projects since those will become operational precisely when demand for oil in particular is projected to fall, leaving stranded assets and wasted capital expenditure. Analysts concluded that $530 billions in capital expenditure alone could be wasted as projects fail to deliver commercial returns when demand starts declining during the 2020s, and oil prices fall back to c.$40/barrel. This amount would double to more than $1 trillion of wasted capital expenditure under a c.$30/barrel scenario[19].
Besides, while the Ukraine-Russia crisis has temporarily boosted the financial performance of fossil fuel assets, analysts note that the conflict and the energy debates around it are actually making the shift to renewable energy accelerate. Observers thus note that not only is renewable energy a good short-term and long-term investment, it also has been performing extremely well recently, with all of the main renewable energy companies such as Ørsted, Siemens and Sunrun experiencing double digits in share price growth[20]. Financial analysts also note that as renewables have proven to be investments that are less volatile and less correlated with the business cycle, the sector can provide investors good defensive protection in times of uncertainty like the current period[21]. As a whole, the renewable energy sector’s performance continues, with rapid technological improvements, decreasing costs, and the rate of new capacity installations at an all-time high[22].
Thus, despite recent events, fossil fuels have passed a turning point, and it is time for society and our pension fund managers to act like it.
[1] Krane, J. (2017) ‘Climate Change and Fossil Fuels: An Examination of Risks for the Energy Industry and Producer States’, MRS Energy & Sustainability, 4. Available at: https://doi.org/10.1557/mre.2017.3
[2] Cojoianu, T., Ascui, F., Clark, G. L., Hoepner, A. G. F., and Wojcik, D. (2019) ‘The Economic Geography of Fossil Fuel Divestment, Environmental Policies and Oil and Gas Financing’, SSRN Electronic Journal. Available at: http://dx.doi.org/10.2139/ssrn.3376183
[3] Bos, K., & Gupta, J. (2019). Stranded assets and stranded resources: Implications for climate change mitigation and global sustainable development. Energy Research & Social Science, 56
[4] Mercure, J. F. et al. (2018) ‘Macroeconomic impact of stranded fossil fuel assets’, Nature Climate Change, 8, pp. 588-593.
See also Mercure, JF., (2021) ‘Reframing incentives for climate policy action’, Nature Energy, 6, pp. 1133-1143. Available at: https://doi.org/10.1038/s41560-021-00934-2
[5] Semieniuk, G., Holden, P. B., Mercure, J. F., Salas, P., Pollitt, H., Jobson, K., … & Viñuales, J. (2021). Stranded Fossil-Fuel Assets Translate into Major Losses for Investors in Advanced Economies. Nature Climate Change.
[6] Grantham, J. (2018) ‘The mythical peril of divesting from fossil fuels’, London School of Economics Commentary, 13 June. Available at: https://www.lse.ac.uk/granthaminstitute/news/the-mythical-peril-of-divesting-from-fossil-fuels/
[7] Auke Plantinga and Bert Scholtens, ‘The Financial Impact of Fossil Fuel Divestment’, Climate Policy, 21 (1), pp. 107-119. Available at: https://www.bankofengland.co.uk/-/media/boe/files/events/2016/november/the-financial-impact-of-divestment-from-fossil-fuels-speaker-slides
FTSE Russell (2014) FTSE Developed ex Fossil Fuel Index Series. Available at: https://research.ftserussell.com/products/downloads/FTSE_Stranded_Assets.pdf
Willis, J., Spence, P. (2014) The Risks and Returns of Fossil Fuel-Free Investing. Sustainable Insight Capital Management Report. Available at: https://www.sicm.com/docs/FFFI-Booklet.pdf
Trinks, A., et al. (2018) ‘Fossil Fuel Divestment and Portfolio Performance’, Ecological Economics, 146, pp. 740-748. Available at: https://doi.org/10.1016/j.ecolecon.2017.11.036
[8] ICBS-IEA (2021) Clean Energy Investing: Global Comparison of Investment Returns. Imperial College Business School and International Energy Agency Joint Report. Available at: https://www.iea.org/reports/clean-energy-investing-global-comparison-of-investment-returns
[9] ICBS-IEA (2021) Clean Energy Investing: Global Comparison of Investment Returns. Imperial College Business School and International Energy Agency Joint Report. Available at: https://www.iea.org/reports/clean-energy-investing-global-comparison-of-investment-returns
[10] Henriques, I., and Sadorsky, P. (2018) ‘Investor Implications of Divesting from Fossil Fuels’, Global Finance Journal, 38, pp. 30-44. Available at: https://doi.org/10.1016/j.gfj.2017.10.004
[11] Hunt, C., Weber, O. (2019) ‘Fossil Fuel Divestment Strategies: Financial and Carbon-Related Consequences’, Organization & Environment, 32 (1), pp. 41-61. Available at: https://doi.org/10.1177/1086026618773985
[12] Guo, X., et al. (2022) ‘The impact of fossil fuel divestments and energy transitions on mutual funds performance’, Technological Forecasting and Social Change, 176, pp. 1-7. Available at: https://doi.org/10.1016/j.techfore.2021.121429
[13] Grantham, J. (2018) ‘The mythical peril of divesting from fossil fuels’, London School of Economics Commentary, 13 June. Available at: https://www.lse.ac.uk/granthaminstitute/news/the-mythical-peril-of-divesting-from-fossil-fuels/
[14] ICBS-IEA (2021) Clean Energy Investing: Global Comparison of Investment Returns. Imperial College Business School and International Energy Agency Joint Report. Available at: https://www.iea.org/reports/clean-energy-investing-global-comparison-of-investment-returns
[15] Hunt, C., Weber, O. (2018) ‘Want a richer pension? Divest of fossil fuels’, The Conversation, 12 April. Available at: https://theconversation.com/want-a-richer-pension-divest-of-fossil-fuels-93850
[16] Henriques, I., and Sadorsky, P. (2018) ‘Investor Implications of Divesting from Fossil Fuels’, Global Finance Journal, 38, pp. 30-44. Available at: https://doi.org/10.1016/j.gfj.2017.10.004
[17] IEEFA (2019) Inaction is BlackRock’s Biggest Risk During the Energy Transition. Institute for Energy Economics and Financial Analysis Report. Available at: https://ieefa.org/wp-content/uploads/2019/07/Inaction-BlackRocks-Biggest-Risk-During-the-Energy-Transition_August-2019.pdf
[18] Hunt, C., Weber, O. (2018) ‘Want a richer pension? Divest of fossil fuels’, The Conversation, 12 April. Available at: https://theconversation.com/want-a-richer-pension-divest-of-fossil-fuels-93850
[19] Carbon Tracker (2022) Managing Peak Oil: Why rising oil prices could create a stranded asset trap as energy transition accelerates. Available at: https://carbontracker.org/oil-price-surge-could-spark-climate-busting-investment-in-new-projects/
[20] Norton L. (2022) ‘As The War Worsens, Renewable Stocks Are Surging’, MorningStar, 1 March. Available at: https://www.morningstar.co.uk/uk/news/219285/as-the-war-worsens-renewable-stocks-are-surging.aspx
[21] Fidelity International (2022) ‘Long-term tailwinds still in play for renewables’, 25 March. Available at: https://professionals.fidelity.co.uk/articles/expert-opinions/2022-03-25-chart-room-long-term-tailwinds-still-play-renewables-1648196401191
[22] Deloitte (2022) 2022 Renewable Energy Industry Outlook. Deloitte Report. Available at: https://www2.deloitte.com/us/en/pages/energy-and-resources/articles/renewable-energy-outlook.html
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