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Ditching fossil fuels has little impact on portfolio performance, no matter the investment strategy

Now the bad news: taxing fossil fuel profits probably won’t pay for the green energy transition
August 25, 2020

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Investing in a stock market without fossil fuels could yield pretty much the same returns as investing in a market that includes these companies, according to a new analysis. Moreover, this is the case regardless of how fast the world transitions from fossil fuels to renewable energy.

The findings sound a note of reassurance about climate advocates’ calls for divestment—that is, getting rid of fossil fuel stocks in order to deprive these firms of capital, constrain their activities, and ultimately reduce greenhouse gas emissions.

Researchers analyzed the stock market performance of 6,905 companies around the world over the course of more than four decades, from 1973 to 2016. They grouped these companies into 10 different industries, among them fossil fuel producers (including oil, gas, and coal) and utilities (including renewable energy firms).

Then, they looked at the performance of a stock market index that included just the 6,578 non-fossil fuel companies compared to one that also included the 327 fossil fuel firms and one with only fossil fuel stocks. At first glance, it seems like fossil fuels would be the smarter investment: fossil fuel stocks have historically had higher returns than those of other industries, a fact that fossil fuel firms have often pointed to in order to encourage continued investment.

But the researchers also used an established mathematical model to determine how market returns relate to risk. This analysis reveals that fossil fuel stocks aren’t exposed to any unique risks, but are more exposed to common risks faced by many firms, the researchers report in the journal Climate Policy.

The upshot of this is that higher returns for fossil fuel stocks over long periods reflect the fact that they are riskier investments—not better ones. And portfolio managers should be able to match those returns with a suite of non-fossil fuel stocks that have similar risk exposure. In other words, you don’t need fossil fuel investments in order to do well in the stock market.

A second analysis compared how stock portfolios with or without fossil fuel stocks would fare under investment strategies favored by three different groups of investors: investors who strive to minimize risk, institutional investors, and private investors.

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“If investors divest fossil fuel firms from their portfolios, they limit the universe of investment objects. This reduces diversification opportunities, which could lead to a substantial increase in total risk,” the researchers explain.

But as it turns out, excluding fossil fuels has little impact on the performance of the overall investment portfolio, no matter the investment strategy.

“The results from our study neutralize the arguments that fossil fuel divesting is detrimental for financial returns and that divestment would penalize, for instance, retirees, who depend on investment returns in funded pension schemes,” the researchers write.

Moreover, the results hold even if the next few decades continue to be pretty good for fossil fuel companies. To demonstrate this, the researchers compared portfolio performance during past periods when the number of operating oil rigs worldwide declined to periods when oil rigs increased.

The periods of declining oil rigs model a future in which society smoothly and consistently transitions away from fossil fuels, the researchers say. Meanwhile, the periods of increasing oil rigs model a ‘delayed transition,’ in which fossil fuels remain a big part of the energy mix for a while.

Even in the delayed transition—that is, under conditions that are favorable to fossil fuel companies—a portfolio that excludes fossil fuel stocks can hold its own, the researchers found.

Meanwhile, fossil fuel stocks do worse under the smooth transition scenario than they do under the delayed transition. That’s pretty intuitive, but it points to a public policy consequence that might otherwise be overlooked: “A smooth energy transition will most likely erode the profitability of fossil fuel firms and their ability to invest,” the researchers write. “Therefore, governments cannot rely on the fossil fuel industry to finance the energy transition.”

Source: Plantinga A. and B. Scholtens.The financial impact of fossil fuel divestment.” Climate Policy 2020.

Image: Stocky.AI

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