Fossil Fuel Divestment Guide

Fossil Fuel Divestment Guide

Don’t Let Wall Street Fool You: Real Divestment is Hard.

Climate conscious funds promise you the moon. They argue they can invest in a way that’s sustainable for the climate without sacrificing investment performance. Firms that behave responsibly, so the argument goes, can expect higher earnings in the long-run, creating an opportunity for investors to reap higher returns. Are they correct?

Indeed, if you go to the website of an ESG fund like Parnassus Global Equity, you’ll see them report fund performance roughly on par with the S&P 500. A fund that gets me the return from the US stock market AND invests ethically? What’s not to like?

“Despite reporting on-par returns, the total growth of the Parnassus Global Equity fund between 1992 and 2019 was just 213% against an S&P return in excess of 600%.”

Plenty. Despite reporting on-par returns, the total growth of the Parnassus Global Equity fund between 1992 and 2019 was just 213% against an S&P return in excess of 600%.

Granted, this is a particularly extreme example, but it’s also true that other long-standing climate-conscious funds such as those managed by Calvert or Green Century lagged behind the S&P 500 since their inception in the mid-1990s.

The lesson here is simple...

You Can't Divest With a Single Index Fund.

Using the carbon-free index funds ICLN, CRBN, SPYX, and ESGE — by far the largest divested index funds — one would not do much to reduce their carbon emissions.

Typically, these funds will divest from some fossil fuel firms, but funnel a lot of that money into other fossil fuel firms. For example ICLN — which has a mandate to focus on renewable energy — invests about 8% of its assets in two fossil fuel utilities, not much different than the ~9% invested in the S&P 500 (data as of July 30, 2019).

This is in part because the universe of publically-traded renewable energy stocks is so small that it’s difficult to manage a multi-hundred-million-dollar fund by relying solely on renewables-only firms.

But it's reflective of a deeper truth: When investing in “clean” funds, you are ceding your ability to make moral choices about what “counts” as a fossil fuel firm to the asset manager(s). 

They may decide that fracking, for example, is a clean fuel because it is cleaner than coal and begin shifting towards those firms. They can also do this without notifying the investors –ie. you.

Few of the largest Fossil Fuel Free or Low Carbon funds beat the S&P 500 on both key metrics: reducing fossil fuel company exposure & lowering the carbon footprint of the portfolio.

Look Before You Leap

This does not mean you should never invest responsibly. There’s enormous value to aligning financial goals with values on climate change. 

Divestment from “bad actors” needs to be done with a risk-neutral approach; Climate divestment, for example, could be offset with sector tilts and the creation of custom assets in the rest of the portfolio to replicate the performance of the S&P 500 and capture the risk exposure of energy and utilities firms. 

Rather than managing return, investors need to be focused on managing their risk.

Sector Risk:

By broadening the screen, most clean funds are heavily weighted towards the financial and technology sectors – Facebook, Alphabet, and Apple often make up more than 10 percent of a fund’s holdings. Since these sectors have performed well over the past decade, it’s no surprise that clean funds have, too. 

This is a sword that cuts both ways – a shock to those sectors would leave an ESG investor worse off than otherwise. Even the day-to-day difference in performance between the sectors can lead to a long-term erosion of your assets. This mismatch between a fund’s holdings and the broader stock market leads inevitably to “tracking error” with the S&P 500.

Asset-Specific Risk:

Due to the large number of restrictions most clean funds firms place on stock-picking, funds typically own just 30-50 stocks. Yet this small number of holdings means that the fund is more sensitive to risks to individual firms. This renders your portfolio more vulnerable to big shocks to individual stocks, and further increases the fund’s tracking error.

Even small tracking errors can lead to large losses. From Jan 2016 to Jan 2019, the SPYX fund – which tracks the S&P but screens out most fossil fuel firms – grew by 31.90 percent compared to 34.94 percent for the S&P 500. On an initial deposit of $10,000, that gap would have left an investor in SPYX $1,623 worse off over those three years. Since 1987, the Calvert Equities fund – a flagship carbon-free fund – grew by 141.37% against 309.60% from the S&P 500 due to tracking error.

What are the Risks of Divestment?

1

Fossil fuel firms benefit from energy-price inflation

Oil & gas inflation drives consumer inflation

Most folks are familiar with the frustrating and seemingly interminable price increases at the gas pump. Indeed, oil prices have a significant impact beyond the pump. Oil is a crucial input cost for businesses, so when prices go up, some of that increase gets based on to consumers. From 1990 to 2017, for every $1 dollar increase in oil prices, consumers can expect to pay $0.21 more not just at the pump, but across their entire consumption basket.

When oil prices are high, non-oil firms suffer.

Grossly over-simplified, nearly every firm is an oil producer or oil consumer. Oil is synonymous with modern industrial transportation: planes, trains, automobiles, and container ships all use oil.

So when oil prices increase, costs for businesses that consume oil -- everyone else -- go up.

2

Fossil fuel firms benefit from global GDP growth

Energy consumption goes up with GDP growth

Worldwide GDP growth goes hand in hand with higher demand for energy -- and therefore, fossil fuels. Besides electricity generation, heavy industry is a huge consumer of energy in developing economies: think of Britain, the United States, and Germany in the 19th century or South Korea and Japan in the 20th.

Fossil fuel firms provide 90% of the world's energy

Unfortunately, fossil fuels continue to underpin global energy consumption despite rapid technological advancement. Replacing it requires completely overhauling society's energy production & transmission infrastructure, so any energy transition will take some time. Industrial processes and transportation tend each to account for about 1/4 of energy consumption; even if countries get serious about deploying renewables, countries that pursue an industrialization model of development will increase their demand for fossil fuels.

Careless divestment can have costs...

Let's say you divested from fossil fuels in 1970, but maintained your exposure to the rest of the stock market as normal. 

Between 1973 and 1975, oil prices tripled from $4.75/barrel (bl.) to $12.21/bl. Over those three years, the S&P lost a third of its nominal value, ending the period where it had been a decade prior while energy firms became the most valuable companies in the world. Over the course of the whole of the 1970s, you would have received a 10.41% nominal return on the S&P 500. 

However, since consumer prices had risen by 87% over that time, the purchasing power of your wealth would have actually fallen.

This is a deliberately extreme example -- a repeat of this phenomenon isn't necessarily likely, but this kind of thing is what happens on a much smaller scale when energy prices go up.

Indeed, if you go to the website of an ESG fund like Parnassus Global Equity, you’ll see them report fund performance roughly on par with the S&P 500. A fund that gets me the return from the US stock market AND invests ethically? What’s not to like?

Ideally, you would want to replace your fossil fuel assets with stocks or funds that have the same risk / return profile as your divested assets. That's why we developed the "3 Rs" of carbon divestment which focuses on removing carbon assets without jeopardizing diversification.

The Three Types of Climate Divestment & How to Choose the Best One

Climate change poses an existential threat to humanity. The UN estimates that over 1,000,000 species will go extinct by 2100 while entire countries will be swallowed up by rising sea levels, both caused by climate change.

Climate change also poses a direct risk to investors. The International Renewable Energy Agency (IRENA) estimates that $11 trillion in assets will be left “stranded” by climate change by 2030.

Fossil fuel divestment seeks to balance an investors values on climate change with their financial goals. The key trade-off investors face is diversification risk: the more assets an investor changes out, the farther away from the market allocation they get.

In general, there are three broad strands of climate divestment approaches.

Golfers at the Beacon Rock Golf Course in North Bonneville, Wash. play on Sept. 4, 2017. Photograph by Kristi McCluer.

1. "Subtractive" Divestment

In a subtractive approach, investors divest from climate-sensitive firms and leave their remaining investments intact. It's relatively easy to change your allocation this way, but can expose you to hidden costs associated with tracking error and loss of diversification.

Pros

  • Relatively easy to do yourself with the right tools 
  • Doable with low-cost ETFs
  • Some climate-friendly ETFs exist

Cons

  • Can lead to tracking error with the S&P 500
  • Exposes your portfolio to inflation risk
  • Can be hard to manage divestment across large or complex portfolios
  • Some climate-conscious funds are terrible for the environment

2. "Analogous" Divestment

In an “analogous” approach, an investor chooses to swap out stakes in climate-sensitive firms with investments in renewable energy firms. Investors tend to choose this approach when they want to maximize the climate impact of their investments or if they believe renewable energies make good investments.

Pros

  • “Feel good” value of investing in renewable energy
  • Maintain exposure to energy & utilities sectors (~12% of the S&P 500)
  • Possibility for greater climate impact

Cons

  • Greater tracking error with the S&P 500
  • Renewable energy funds tend to be actively-managed, leading to higher fees 
  • Some of the largest renewable energy operators are oil companies, so many funds invest in them
  • Little direct control over what companies you want to divest from

At the end of the day, “social impact” is highly subjective. Your values and financial priorities may not line up with those of the person(s) managing the “climate-driven” fund of your choosing. Truly climate-friendly investing is time-consuming, so you’ll likely end up paying higher fees.

3. "Neutral" Divestment

A “neutral” approach looks at the impact that divestment has on the risk & performance profile of your whole investment portfolio. An investor will take their fossil fuel investments and funnel them into a custom asset or group of assets that, together, mimic the performance and risk profile of the divested assets without contributing to climate change.

Pros

  • Minimizes tracking error
  • Uses low-cost index funds
  • Limits portfolio exposure to inflation

Cons

  • Hard to identify which investments to use
  • Difficult to set up and maintain

Our Approach to Carbon Divestment: The 3Rs

Judging these various divestment methods, the neutral approach stands out for its practicality and compatibility with sound investment principles of diversification and good risk adjusted performance.

At Camelotta, we are in the business of developing and implementing custom tailored portfolios that enable clients to effectively and prudently execute and maintain a properly divested set of investments.

In order to accomplish this, we at Camelotta have developed a unique 3 step approach that we call 3R: Remove, Rotate and Replace

Step 1: Remove

is to figure out how much exposure you have to carbon emissions. Beyond just the energy sector, there are carbon emitters throughout the S&P 500 and other indices. Don’t forget to think about your exposure through international indices and actively traded mutual funds.

Step 2: Rotate

involves an understanding of the effect of the capitalization weighting of the oil companies once they are removed. For example, using the Fama French framework, you might want to underweight the energy sector because it is a large cap growth sector.

Step 3: Replace

involves reinvesting the capital in an asset that achieves the same risk and reward goals as the original set of investments.

In addition to quantifying the amount to Remove and Rotate, we utilize a proprietary combination of investments effectively Replace energy companies in a manner that maintains performance objectives.

Take the Next Step it's Your Moral Imperative!

Schedule a meeting with our team. It's simple

In our meeting we will review your goals for Fossil Fuel Divestment, Your current Fossil Fuel holdings, and develop a plan to effectively divest your portfolio.