Fossil fuels: To divest or not to divest?

For many Local Government Pension Scheme funds, this statistic, together with widespread concern over the impact of climate change, has triggered a discussion about whether fossil fuels should be completely excluded from their portfolio. 

From an ethical perspective, this may seem reasonable. However, if excluding these stocks has a negative impact on a pension fund’s returns over the long term, the pensions committee could be accused of neglecting its fiduciary duties to the members of the scheme. 

Excluding the tobacco sector today has a minimal impact at portfolio level compared with 25 years ago. Will the fossil fuel sector decline to the same extent? 

What evidence exists?

Chendi Zhang from Warwick Business School and Lucius Li from the London School of Economics, in conjunction with Newton Investment Management, researched the impact of ethical investing on returns, volatility and income, and published their conclusions in February 2016.

They screened a universe of more than 10,000 stocks in developed and emerging markets, from 2003 onwards, and calculated the impact of excluding fossil fuels. These stocks constitute around 6.6 per cent of the market capitalisation of developed markets and 7.3 per cent of emerging markets, so represent a sizeable chunk of the global stock market. In other words, divesting from this sector is a key decision for committees.

Li and Zhang concluded that the global impact on returns of excluding fossil fuel stocks was minimal (-0.01 per cent a year) for developed markets during the period from 2003 to present.

Unfortunately, there was a ‘but’ to this conclusion. First, there were regional differences: US -0.31 per cent a year, UK 0.1 per cent a year and emerging markets 1.2 per cent a year.

There was also a variation in returns when considering different rolling three-year periods. In the UK, for example, the impact on three-year returns ranged from -0.85 per cent to 1.81 per cent a year.

Pension fund committees must take this point on board before divesting from fossil fuels. Are they prepared to defend that level of underperformance in equities, if challenged by members at their AGM?

Comparison with tobacco stocks

There are parallels with a similar debate some years ago, over tobacco stocks. 

Li and Zhang’s research covered just over a decade. But what about the very long term? Research by Lancaster University provides some interesting insights for the US market.

Compared with the total return indices for the US stock market, tobacco stocks outperformed. The outperformance of the tobacco sector was extolled as the prime reason why pension funds should still remain invested in these ‘sin stocks’, so there are parallels with the fossil fuel debate.

When tobacco stocks were eventually excluded on ethical grounds by a number of large US pension funds in 2000, including the California Public Employees’ Retirement System, there was a 15 per cent to 20 per cent markdown in value as sale orders hit the market.

Since then, tobacco stocks have outperformed by an average of 3 per cent a year. Yet much of the return was paid out as dividends, rather than reinvesting in the tobacco companies themselves, and this has contributed to a fall in the market capitalisation of tobacco stocks from a high of 3.3 per cent in 1991 to 1.2 per cent in 2015.

Excluding the tobacco sector today has a minimal impact at portfolio level compared with 25 years ago, simply because its percentage of market capitalisation has more than halved.

Will the fossil fuel sector decline to the same extent? Lancaster University’s research concludes that it continues to decline, but remains significant.

At its peak in 1980, the oil and gas sector in the US accounted for 25 per cent of the total market capitalisation. This has fallen, but remains around 8.5 per cent.

Many pensions committees still consider this too significant to approve divesting from the sector. Instead they are turning to shareholder engagement, in order to change the way these companies operate.

Karen Shackleton is an independent investment adviser at AllenbridgeEpic Investment Advisers