Fossil Fuel Risk Through Economic and Financial Markets

Fossil Fuel Risk in

Financial Markets

Joli Holmes

February 2014

Forward

The following report was researched from documents available from September 2013, to Febru-

ary 2014. It’s intended purpose is to be informational and discussion-provoking, but in should

no way be used as investment advice. The report has been divided into three sections. Part 1 dis-

cusses how and why fossil fuels have recently become riskier assets to hold. Part 2 examines

how stranded assets could impact investors and the risks some investors have already taken,

and part 3 discusses how investors can address systemic problems arising from stranded assets

in their own portfolio.

Contents

Summary 1

Part 1: Risky Investments 2

Increasing Prices and Decreasing Demand 3

The First Stranded Assets 10

Fossil Fuel Companies Response 15

Valuations and Lack of Transparency 19

Part 2: Risky Investors 21

Public Banks 22

Private Banks 24

Asset Owners 30

Part 3: Responsible Investors 32

Sustainable Investment 33

Options for Investors 35

Investor Response to Stranded Assets 38

Conclusion 40

In 2009, at the United Nations Climate Change Conference (UNCCC) in Copenhagen, world

leaders agreed to limit increases in global average temperatures to 2° Celsius. Although a 2°C

target was agreed upon, no legally binding agreements resulted from the 2009 UNFCCC, which

would have legally restricted the cause of temperature rise—carbon emissions.

The Carbon Tracker Initiative revealed in recent reports that aggregate reserves listed on public

stock exchanges exceeded the 2°C warming target. Carbon Tracker estimates that there are

2,860 Gt of carbon dioxide listed on the world’s stock exchanges and that 60-80% of these re-

serves cannot be combusted without exceeding the 2°C target.1

The International Energy Agency (IEA) as well as other researchers have estimated carbon

budgets for the next 35 years under a 2°C target. A carbon budget sets a maximum threshold of

carbon emissions that can be combusted cumulatively over a given time period. The IEA has

estimated a budget of 960 GtCO2 from 2000-2050, with an 80% probability of staying under 2°

C.2 The Carbon Tracker Initiative has estimated a carbon budget of 900 GtCO2 for the years

2000-2050, correlating with an 80% probability of limiting warming to 2°C.3 The Carbon Track-

er’s budget is slightly lower than the IEA’s, because the IEA assumes the future viability of car-

bon capture and storage (CCS). Regardless, the world has already used a significant portion of

this budget, leaving only about 565 GtCO2 remaining for the next 35 years.4

Reserves that cannot be sold and used will lose considerable value and become stranded assets.

Stranded assets are economic resources, whose values have become significantly downgraded,

or unemployable, prior to the end of their useful life. Traditionally firm valuations are based on

the company’s historical performance and return, but current valuation methods neglect the

value lost from unburnable carbon. New environmental regulations, competing energy sources,

socio-political pressures, and other market forces threaten the performance and value of fossil

fuel companies.

Summary

Summary

1 (2013.) Unburnable Carbon 2013: Wasted Capital and Stranded Assets. Carbon Tracker Initiative & The Grantham Re-

search Institute, LSE.

2 (August 13, 2013). Petroleum Production Under the Two Degree Scenario (2DS). Rystad Energy.

3 (2013.) Unburnable Carbon 2013: Wasted Capital and Stranded Assets. Carbon Tracker Initiative & The Grantham Re-

search Institute, LSE.

4 Ibid

1

Part 1: Risky Investments

Traditionally most fossil fuel companies have had good returns and allowed investors to diversi-

fy their portfolios through the energy sector. Recently however, fossil fuel companies are seeing

rising costs from additional government regulation, as well as unconventional extraction tech-

nologies. Part 1 of this report seeks to elucidate why fossil fuel companies may not return the

same dividends as they have in the past, which assets are particularly at risk, how fossil fuel

companies have responded to changing market conditions, and other transparency issues that

shareholders face. Every investment holds some level of risk, but the possibility of stranded as-

sets, has changed how many investors are viewing fossil fuels.

Increasing Prices and Decreasing Demand

International Regulation 3

Direct Regulation 4

Carbon Tax 5

Cap and Trade 6

Company Responses to Carbon Pricing 7

Indirect Regulation 8

Competitive Renewables 9

The First Stranded Assets

Coal 10

Types of Coal 10

Peak Coal in China 11

Oil Sands 12

Classifying Oil 12

Oil Sands and the Risk of Stranded Assets 13

Other Factors that Risk Stranded Assets 14

Fossil Fuel Companies Response

Non-Diversified Coal 15

Shelved Projects 15

Divestment 16

Diversified Mining Companies 17

Utility Companies 18

Market Valuations 18

Valuations and Lack of Transparency

Cost vs. Fair Value Accounting 19

Unstandardized Reporting 19

Changing Stock Market Requirements 20

2 Part 1: Risky Investments


Copenhagen (also known as COP15, after the Conference of Parties first established in Berlin,

19955) was the first Conference of Parties that could have plausibly ended in a legally binding

emissions reduction agreement. This would have obliged countries to start abating and regulat-

ing carbon emissions from their largest emitters, but COP15 finished with emissions reduction

pledges and nothing more.

Further negotiations have been pursued at successive Conference of Parties in 2010, 2011, and

2012 without success of a legally binding emissions reduction agreement. Despite the absence of

an agreement from the last four COP negotiations, many countries have taken climate action

through new efficiency standards and national carbon markets in hope of meeting the agreed up-

on 2°C target. Both the United States and other developed countries have made commitments

within the last year to curb funding to foreign coal-fired power plants, in an effort to decrease

carbon emissions.6

International negotiations were held most recently in Warsaw, November 2013, however expecta-

tions of future emissions reduction agreements rest at the larger negotiations planned for Paris

in 2015. Any resulting regulation from COP21 in Paris isn’t expected to be implemented until

2020.7 Although the world lacks any international regulation, national regulation still remains a

factor in fossil fuel valuations.


5 (2014). Background on UNFCCC: The International Response to Climate Change. United Nations Framework Convention on Climate Change.

6 (2013.) Unburnable Carbon 2013: Wasted Capital and Stranded Assets. Carbon Tracker Initiative & The Grantham Research Institute, LSE.

7 (2014). Warsaw Outcomes. United Nations Framework Convention on Climate Change.

3

International Regulation


Direct Regulation The two most common types of direct carbon regulation are a carbon tax and a cap-and-trade

emissions system. Direct regulation, also known as command and control (CAC) regulation, can

be implemented at the international, national, regional, or even local level. The UNEP Finance

Initiative has identified 35 different carbon pricing systems already in effect around the globe,

from small region systems in California, British Colombia, and Quebec, to larger national sys-

tems in Canada, Denmark, Switzerland, Australia.8 Emissions trading systems are appearing in

developing nations like Costa Rica, Mexico, China, and Chile, and the world’s economic power-

houses the US, Great Britain, and the European Union.9 Emissions trading systems and carbon

taxes, two of the most effective economic instruments to curbing carbon pollution, are being en-

acted across the world, through a bottom-up approach.

A carbon tax effectively raises the price of polluting firms by imposing a tax on emissions. Firms

that can efficiently abate carbon will do so to avoid paying the tax, and firms that cannot will be

forced to pay the tax, in effect neutralizing pollution inefficiencies created in the market.

A cap and trade system works a little differently. A total emissions limit is set and emissions per-

mits are distributed among polluters. Polluters that can efficiently abate emissions will do so,

and sell their permits to firms that cannot abate as easily. Though the systems differ slightly,

with more costs falling on the firm and more government revenue generated under a carbon tax,

they can both achieve economic efficiency through the reversal of negative externalities pro-

duced by polluters. However, the additional costs incurred from carbon pricing systems could

raise fossil fuel company costs, and force less efficient companies to exit the market.

Other types of direct regulation such as increased efficiency standards will also generate addi-

tional costs to both fossil fuel producers and consumers, which could result in decreased de-

mand for fossil fuels. In September 2013, the US Environmental Protection Agency (EPA) author-

ized a new emissions limit for coal and gas fired power plants. The new standards would set a

CO2 emissions maximum of 1,100 pounds per megawatt-hour for new coal-fired power plants. On

average US coal plants emit almost 700 pounds of CO2 per megawatt-hour higher than the new

standard.10

New plants will have to employ carbon capture and storage (CCS) technology to cap-

ture 20-40% of their emissions, to be approved.11


8 (July 2013). UNEP FI Investor Briefing: Portfolio Carbon. UNEP Finance Initiative. 9 Ibid. 10 Lenny Bernstein, Juliet Eilperin. (September 19, 2013). EPA Moves to Limit Emissions of Future Coal- and Gas-Fired Power Plants. The Washington Post. 11 Ibid.

4


Carbon Tax Several countries have started to implement different carbon pricing systems. The UK, France,

and Australia were the first to mandate carbon taxes. Generally pricing starts low, and becomes

more stringent as firms have time to adjust to a low-carbon economy.

The United Kingdom implemented a carbon floor, which raises the price of carbon like a tax, for

electricity producers in April 2013. The price of carbon increases each year, starting at £18.08

tCO2 in 2015, and increasing to £21.20 tCO2 the following year, and £24.62 tCO2 in 2017.12

In September 2013, France announced that it too would be implementing a carbon tax that

would commence in 2014. France is planning to use profits from the tax to invest in a low-carbon

energy transition.13

Previous Prime Minister Julia Gillard, successfully inaugurated Australia’s first carbon taxing sys-

tem in July of 2012. High emitters paid $23 per tonne to emit in 2012, $24.15 tCO2 in 2013, and

$25.40 tCO2 in 2014.14

A transition to a cap-and-trade system was expected to follow three to five

years after the carbon tax went into effect, but after a change of government parties in Septem-

ber 2013, the carbon tax is in the process of being repealed.15

The carbon tax was enacted to help

Australia achieve a 5% reduction in emissions by 2020, which it is no longer on target for.16


12 HM Revenue & Customs. (April 1, 2013). Carbon Price Floor: Rates from 2015-16, Exemption for Northern Ireland and Tech-nical Changes. 13 Reuters. (September 21, 2013). French Carbon Tax to Yield 4 bln Euros in 2016-PM. 14 (2012). Carbon Prices FAQs. Energy Australia. 15 Ben Packham and James Massola. (January 23, 2012). Australia to Have Carbon Price from July 1,2012, Julia Gilliard An-nounces. The Australian. 16 Ibid.

5



Cap and Trade The most established cap and trade is the European Union’s Emissions Trading System devel-

oped in 2005. However, the system has had little effect on reducing emissions because trading

prices are still depressed from the global economic downturn in 2008, yielding the allowances

worthless. Permits were worth over 30 euros in 2008, but now are trading at below 5 euros.17

The

ETS also only covers about 45% of the EU’s emissions, but is entering its third phase.18

In the

third phase the cap is proposed to decline by 1.74% per year, which will increase the price of the

permits.19

The EU had also proposed to withhold new allowances from entering the market,

compensating for a market that is oversupplied by an estimated 2 billion permits.20

China has also started taking steps towards a carbon market. The Chinese government mandat-

ed that Beijing, Chongqing, Hubei, Guangdong, Shanghai, Shenzhen, and Tianjin, China’s largest

cities, must implement a cap-and-trade system by 2013.21

Shenzhen was the first city to comply

with this new rule, and in June 2013, it débuted its first emissions trading system. The govern-

ment may choose to implement a nation-wide carbon market in 2015, based on results from the

pilot program.22

In early 2013, California introduced the first cap-and-trade program in the United States. Firms

based in California that emit more than 25,000 metric tons of CO2 emissions must comply with

the program, which accounts for sectors responsible of 80% of California's emissions.23

The state

plans to initially allocate a number of free allowances to discourage relocation to other states

that lack carbon policies. The state plans to use revenue generated by the regulation to invest in

a recently created Greenhouse Gas Reduction Account and to other GHG mitigation projects.24

Washington, Oregon, and British Columbia (Canada) agreed to sign a climate pact with Califor-

nia in October, 2013. This pact is a move to strengthen and align regional climate policies, such

as standardizing efficiency requirements, and will likely include a carbon pricing component.25

Together Washington, Oregon, California, and British Columbia represent the 5th largest econo-

my in the world.26

Although there isn’t an international binding agreement to limit carbon emissions yet, some

governments are introducing carbon regulation at national or regional levels. As exemplified by

the EU’s ETS, carbon regulation systems are relatively new strategies of market regulation, and

could take time to produce the desired effects.

6


Company Responses to Carbon Pricing

A new report by the Carbon Disclosure Project identified that 29 of America’s largest corpora-

tions have started to include an internal price on carbon, including some fossil fuel companies.27

Chevron Corporation, Exxon Mobil Corporation, Royal Dutch Shell, ConocoPhillips, and British

Petroleum, five of the world’s largest oil and gas producers, were among the 29 corporations to

disclose their use of an internal price, or shadow price on carbon.28

Duke Energy and American

Electric Power, two of the US’s largest power producers, have also included a shadow price on

carbon. A shadow price is used to help companies predict future costs, growth expectations, and

strategies regarding climate change and future regulation.


17 (December 10, 2013). European Parliament Voters to Adopt Carbon Supply Cut. Reuters. 18 Carbon Trust. (November 2013). EU Emissions Trading Scheme (EU ETS). 19 Ibid.19 (December 10, 2013). European Parliament Voters to Adopt Carbon Supply Cut. Reuters. 20 (December 10, 2013). European Parliament Voters to Adopt Carbon Supply Cut. Reuters. 21 Ben Caldecott. James Tilbury. Yuge Ma. (December 16, 2013). Stranded Assets Programme: Stranded Down Under? Uni-versity of Oxford and the Smith School of Enterprise and the Environment. 22 Kathrin Hillle. (June 18, 2013). China Launches First Carbon Market in Shenzen. Financial Times. 23 Mac Taylor. (February 16, 2012). The 2012-13 Budget: Cap and Trade Auction Revenues. Legislative Analyst’s Office. 24 Ibid. 25 Michael Wines. (October 28, 2013). Climate Pact is Signed By 3 States and a Partner. The New York Times 26 Reuters. (October 24, 2013). California, Oregon And Washington To Sign Climate Pact With British Columbia. Huffington Post Green. 27 Carbon Disclosure Project. (December 2013). Use of Internal Carbon Price by Companies as Incentive and Strategic Plan-ning Tool 28 Ibid.


Indirect Regulation Fossil fuel companies and intensive industries are also starting to face the challenge of indirect

government regulation. Regulation that constricts water usage, targets health care, or increased

pollution abatement, could have an effect on a firm’s costs, resulting in reduced dividends to

shareholders.

Fossil fuel production is a very water intensive industry—from coal production to hydrofrack-

ing. HSBC found that since the start of the 21st century, China’s production levels of coal have

tripled, and its total water resources have decreased by 13%.29

Due to likely future water short-

ages, China may choose to constrain the coal industry’s water usage. This could severely impact

the ability of coal companies to produce coal, which would increase company costs, and de-

crease the values of coal producers. HSBC found that China Shenhua’s stock prices have the po-

tential to decrease by 26% and China Coal by about 45% if China continues to be strained for

water through 2030.30

A recent report on air pollution in China announced average life expectancy was 5.5 years short-

er in northern China, where the majority of its coal operations are located.31

Higher rates of

lung cancer, heart disease, and strokes have also been reported in northern China.32

Health

concerns have fast become the center of attention and the focus of protests, campaigns, and

new government policy. Chinese cities have started to publically disclose fine particle pollution

levels for public safety reasons, and China has banned new development of coal-fired power

plants in some of its largest cities.33


29 Simon Francis, Kirtan Mehta, Jenny Cosgrove, Summer Huang, Wai-Shin Chan. (June 2013). China Coal and Power. HSBC Global Research. 30 Ibid. 31 Leslie Hook. (July 8, 2013). China Smog Cuts 5.5 Years From Average Life Expectancy. Financial Times. 32 Ibid. 33 Heffa Schucking. (November 2013). Banking on Coal. BankTrack.

8



Fossil fuel companies are also starting to feel pressure from other competing energies. In 2008,

the price of thermal coal peaked at close to $136/ton, but has dropped since then to only $77/ton

in August 2013.34

Thermal coal prices have dropped because of low natural gas prices and other

market forces. The already depressed thermal coal prices may see prices depreciate even more as

renewables enter the competition as well.

Solar photovoltaic (PV) electricity is becoming cost competitive with fossil fuels. Deutsche Bank

forecast that solar will be cost competitive without subsidies by 2014, and it expects global solar

demand to increase by 20% from 2013 to 2014.35

Markets for solar in Australia, Brazil, Denmark,

France, Japan, Italy, Spain, and Turkey are expected to reach grid parity, where the cost of elec-

tricity is less than or equal to traditional sources of energy by 2015.36

Although most governments are still heavily invested in fossil fuels, many are turning more to-

wards renewable energy solutions. A report by the Renewable Energy Policy Network found that

in 2012, 50% of additional electricity generation in the US came from renewables, 70% of addi-

tional electricity generation in the EU was renewables, and overall 50% of new electricity genera-

tion worldwide was renewables.37

In 2012, Chinese wind power generation increased more than

coal and nuclear power generation.38

In the next few decades it is likely that the costs of renewable energies will decrease further. The

operational costs of a fossil fuel company are increasing as new sources of coal, oil, and gas be-

come harder to develop and extract. Renewables however, only require initial start-up capital

and capital for maintenance over their useable lifetimes, contrasted to fossil fuel-fired plants

which require a constant require supply capital for fuel.

9

Competitive Renewables

34 Clyde Russel. (August 14, 2013). Australian Coal Industry in Final Stage of Grief. The Sydney Morning Herald.

35 Becky Beetz. (February 26, 2013). Deutsche Bank: Sustainable Solar Market Expected in 2014. PV Magazine. 36 (October 3, 2013). Stranded Carbon Assets. Generation Foundation. 37 Ibid. 38 Ibid.



Quality and type of coal are important factors

when considering the risk of stranded assets.

Metallurgical or coking coal is primarily used in

steel production and currently lacks an equiva-

lent substitute, so prices have remained higher.

But coking coal only constitutes 13% of world

coal production, with thermal coal making up

the remainder.41

Thermal coal is particularly at risk because it is

mostly used to fuel coal-fired power plants. As

pollution regulations have become more strin-

gent and other energies, in particular natural

gas, have become more competitive, the price

of thermal coal has decreased significantly.

Thermal coal is the easiest fossil fuel to replace

with renewable energies, contrasted to fossil

fuels such as oil, or liquefied natural gas (LNG),

which are used mostly for transportation pur-

poses, and lack similar substitutes.

Lignite (brown) coal is the most vulnerable

type of coal because lignite has a low energy

content. Lignite is also used mostly in power

generation, which exposes it to greater invest-

ment risk as well. Bituminous coal is a higher

grade of coal, and is used in both thermal and

metallurgical coal production, putting it at less

risk of becoming stranded. Anthracite, the

highest quality coal has the highest energy con-

tent making it the least vulnerable coal re-

sources.42

Types of Coal

10

The world’s commitment to limiting global

temperature increase to 2°C has created a

situation that is not ideal for fossil fuel com-

panies. It is possible that through regulation

and other market forces some fossil fuels will

start to be phased out, causing stranded as-

sets. Rystad Energy, found that under the 2°

warming target 78% of coal assets could be-

come stranded, compared to 35% of oil and

38% of gas assets.39

Coal is likely to become stranded before oil

or gas because of its environmental impact

and high contribution to carbon emissions.

Burning coal is thought to release about

twice as much carbon dioxide as natural gas,

and has other known negative externalities.

A recent study by leading climate and energy

scientists found that even the most efficient

coal-fired power plant emits about 750

gCO2/kWh, while an efficient gas-fired pow-

er plant emits around 350 gCO2/kWh.40

Coal



The development of China’s economy in the last century has spurred a huge increase in demand

for energy sources, and because of this the International Energy Agency (IEA) predicted in 2012

that coal would become the leading fuel by 2030.43

China currently makes up more than 50% of

global coal demand, which encouraged many mining companies to significantly develop more

coal assets, railways, and ports, in preparation to meet the expectation of increased demand.44

Because China controls more than 50% of global demand through its domestic market, it has a

large impact on the price of coal, and has essentially become the price setter for coal interna-

tionally.45

But recently due to increased pressure for higher health standards, efficiency im-

provements, and other competing energies, China has announced plans to peak its coal usage at

4 billion tons in the next few years. Citi analysts predict that China will peak its coal consump-

tion by 2020, possibly as early as 2014.46

There is also a threat of a shale gas boom in China, which would further decrease demand for

coal and depress prices. Somewhat under the radar, China’s natural gas resources are huge, the

largest in the world. China’s total recoverable gas resources are almost equivalent to the com-

bined resources of Canada and the US, more than 15% of the world’s total resources. China is

also planning on increasing shale gas from production from an expected 6.5 billion cubic meters

(bcm) to 60-100 bcm from 2015 to 2020.47

China faces more technical issues than the United

States, water scarcity issues, and a dearth of pipelines which are necessary to exploit this re-

source, but the potential still remains.

Peak Coal in China

11

39 (August 13, 2013). Petroleum Production Under the Two Degree Scenario (2DS). Rystad Energy. 40 Ogunlade Davidson, Peter C. Frumhoff, Niklas Hohne, Jean-Charles Hourcade, Mark Jaccard, Jiang Kejun, Mikiko Kai-numa, Claudia Kemfert, Emilio La Rovere, Felix Christian Matthes, Michael MacCracken, Bert Metz, Jose Moreira, William Moomaw, Nebojsa Nakicenovic, Shuzo Nishioka, Keywan Riahi, Hans-Holder Rogne, Jayant Sathaye, John Schellnhuber, Robert N. Schock, P. R. Shukla, Ralph E. H. Sims, Jeffery Steinfeld, Wim C. Turkenburg, Tony Weir, and Harald Winkler. (November 18, 2013). New Unabated Coal is Not Compatible with Keeping Global Warming Below 2°C. European Climate Foundation. 41 (September 2013). Coal Facts 2013. World Coal Association. 42 (2013). What is Coal? World Coal Association. 43 Ben Caldecott, James Tillbury, Yuge Ma. (December 16, 2013). Stranded Assets Programme: Stranded Down Under?. Uni-versity of Oxford and the Smith School of Enterprise and the Environment. 44 (September 4, 2013). The Unimaginable: Peak Coal in China. Citi Velocity. 45 Ben Caldecott, James Tillbury, Yuge Ma. (December 16, 2013). Stranded Assets Programme: Stranded Down Under?. Uni-versity of Oxford and the Smith School of Enterprise and the Environment. 46 (September 4, 2013). The Unimaginable: Peak Coal in China. Citi Bank. 47 Ben Caldecott, James Tillbury, Yuge Ma. (December 16, 2013). Stranded Assets Programme: Stranded Down Under?. Uni-versity of Oxford and the Smith School of Enterprise and the Environment.



Other unconventional fossil fuels such as

bitumen, the technical term for oil sands,

also has a higher likelihood of becoming

stranded. Unconventional fossil fuels are

produced using newer extraction technolo-

gies, such as fracking, which is highly con-

troversial. Oil sands are more likely to be-

come stranded assets than regular crude oils,

because they have higher costs due to a

more restricted market and intensive refine-

ment processes.

12

Oil Sands Just like brown coal, bitumen also appears on

the low end of quality. Bitumen’s physical prop-

erties, such as high density and high sulphur

content, both require more refinement than

traditional crude oil, making it a lower quality

fossil fuel. High quality crude oil is labelled

‘light’ and ‘sweet’. The light refers to its low

density, and sweet refers to its low sulphur con-

tent.48

Oil sands are considered ‘heavy’ oils and

often ‘sour’, requiring a lot of refining and mak-

ing them the most expensive to produce.

There are three principal benchmarks used for

oil. West Texas Intermediate (WTI), Brent

Blend, and Dubai sell the highest quality of

crude oil, and are frequently used as compari-

sons. Generally WTI sells a bit higher than

Brent Blend, which sells a bit higher than Du-

bai. The WTI benchmark is used in the US,

Brent Blend is used in Europe, and Dubai is

used in the Middle East. Other producers of oil,

like Canada or Mexico, have their own bench-

marks which can be compared to any of the

main three to determine the price of oil per

barrel.49

Classifying Oil

48 (2014). The Classification of Petroleum. Petroleum.co.uk 49 Ibid.



Oil Sands and the Risk of Stranded Assets Oil sands could also be a risky investment. Recently there has been a big push to create new in-

frastructure from Canada to the Gulf Coast in the United States, because Western Canada can

only process 15% of its current heavy-oil production.50

Because of pipeline shortage, Canadian

oil sands prices have depressed, and the price difference between WTI and the Canadian bench-

mark, Western Canadian Select (WCS), has increased to $30 per barrel.51

Analysts from Royal

Bank of Canada, TD Bank, and Goldman Sachs have found that if Keystone XL is built, WCS

prices would increase, making oil sands more profitable. This increase in price would help im-

prove bitumen producer’s stock prices and credit ratings, which could result in additional in-

vestment. In the short term, investors could see good returns, but as carbon regulation increases

and other energies become more competitive, oil sands could become riskier investments.

Like coal, oil sands have high carbon emissions and other negative environmental impacts. On

average Canadian tar sands result in 17% more CO2 emissions than traditional crude oil per bar-

rel.52

Bitumen is also produced by unconventional production methods such as hydrofracking.

Although fracking has provided a gateway to accessing more fossil fuels, such as shale gas, it is a

highly controversial technology. Fracking, like coal, is very water intensive, and could suffer un-

der future water constraints.

Oil sands projects also appear at the high end of the cost curve and have variable break-even

points. Estimates from Goldman Sachs, Rystad Energy, and others estimate a break even point

of $50-$150/bbl.53

However, decreased demand from other competitive energies and increasing

carbon policies could drive the price of oil down, yielding projects at the high end of the cost

curve unprofitable. Already demand for Canadian oil has decreased over the past few years be-

cause the US, Canada’s largest importer, has increased domestic production of shale gas and

shale oil. The US was the largest producer of oil and natural gas globally in 2013, competing di-

rectly with Canada.54

Like coal, oil sands risk stranding from market forces such as direct, indi-

rect, and competing energies.

50 (2013). Keystone XL Pipeline (KXL): A Potential Mirage for Oil-Sands Investors. Carbon Tracker Initiative. 51 Ibid. 52 Ibid. 53 (June 2, 2013). Getting Oil Out of Canada: Heavy Oil Diffs Expected to Stay Wide and Volatile. Goldman Sachs & Co. 54 (2013). Keystone XL Pipeline (KXL): A Potential Mirage for Oil-Sands Investors. Carbon Tracker Initiative.

13



Other factors could also influence which assets become stranded first. Assets that are located in

more unstable regions politically, or use additional technology, which correlates to higher costs,

are more vulnerable of becoming stranded. The most common examples are assets located in

North Africa, which has been very politically unstable in the last few years, and the Arctic. As-

sets in the Arctic risk stranding because of the additional technology employed to exploit these

resources.55

Other Factors that Risk Stranded Assets

55 (October 30, 2013). Stranded Carbon Assets. Generation Foundation.

14



The multifaceted economic, financial, and

environmental factors that control the debate

surrounding unburnable carbon make it hard

to predict how fossil fuel companies will be

impacted in the future. However, some com-

panies are already feeling the effects of re-

duced demand, and they are the pure coal

companies.

The values of pure coal companies such as

Whitehaven or Coalspur are particularly at

risk from stranded assets. In a recent analy-

sis, Citi Bank suggested that up to 33% of

Whitehaven’s value could be at risk from

stranded assets.56

In contrast, diversified

mining companies such as BHP Billiton or

Rio Tinto, won’t likely be as affected by un-

burnable carbon.

In the last two years thermal coal producers

have seen their share prices slipping. Arch

Coal’s share prices have dropped 73%, and

Peabody’s 52% over the last two years.57

Chi-

na Shenhua Energy Company and PT Bumi

Resources have also dropped significantly.

Patriot Coal, a United States producer filed

for bankruptcy in 2012.58

Coal companies in

general are struggling, due to the depressed

price of thermal coal, but pure coal producers

are greater at risk.

Non-Diversified Coal Shelved Projects Because the price of coal is low, some compa-

nies have started to ‘shelve’ certain projects.

They are waiting to develop their assets until

they will be more profitable in the future.

Glencore Xstrata put its $7 billion Wandoan

coal project and $1 billion Balaclava coal ter-

minal ‘on ice’ in September.59

Glencore stat-

ed that this was only a short-to-medium term

decision, because it still considers coal a valu-

able commodity.

Analysts estimate that at current prices of

$77/ton, down from $136/ton in 200861

, 30%

of the world’s coal production is unprofitable,

which is why some companies have shut-

down production.60

Wood Mackenzie, an an-

alyst company specializing in energy, metal,

and mining industries, estimated that when

the price of coal falls below $96/ton USD,

more than 50% of Australian coal mines op-

erate at a loss.62

Unless demand for thermal coal increases, it

is unlikely that coal prices will rise, and re-

turn projects to their prior profitability. This

creates risk for investors, because coal has

already become the most stigmatised fossil

fuel, and will likely be the first to become

stranded assets.

56 (April 8, 2013). ‘Unburnable Carbon”—A Catalyst for Debate. Citi Velocity. 57 Thomas Biesheuvel and Jesse Riseborough. (December 05, 2013). Glasenberg Raises Glencore’s Bet on coal as BHP Pauses: Energy. Bloomberg. 58 Thomas Biesheuvel and Jesse Riseborough. (November 21, 2013). Coal Seen As New Tobacco Investor backlash: Commodi-ties. Bloomberg 59 David Uren. (October 29, 2013). Pipeline Suggests Life in Economic Boom. The Australian 60 Clyde Russel. (August 14, 2013). Australian Coal Industry in Final Stage of Grief. The Sydney Morning Herald. 61Thomas Biesheuval and Jesse Riseborough. (December 05, 2013). Glasenberg Raises Glencore’s Bet on Coal as BHP Pauses: Energy. Bloomberg. 62 Ben Caldecott, James Tillbury, Yuge Ma. (December 16, 2013). Stranded Assets Programme: Stranded Down Under?. Uni-versity of Oxford and the Smith School of Enterprise and the Environment.

15



The divestment campaign has primarily focused on large institutional investors, but large mining

companies have taken steps to divest their coal assets as well.

BHP Billiton, a diversified mining company, announced in November 2013, that it was pulling out

of plans to develop a large new port along the Queensland coast in Australia. A study by the Cen-

tre for Policy Development found that coal ports in Queensland are operating at only 65% capac-

ity, due to decreased demand.63

The CEO of BHP, Andrew McKenzie, also stated in August 2013,

that BHP was probably finished investing in coal for some time, but would instead be refocusing

on developing petroleum, copper and potash assets.64

Rio Tinto, another large international mining company, has also started to divest some of its coal

assets. Rio recently sold its share in the Clermont coal mine, the third largest coal mine in Aus-

tralia, and one of its newest and largest coal operations.65

It is also trying to sell its Blair Athol

coal mine, and Coal & Allied Business, valued with the Clermont mine at $3.2 billion AUD.66

At the end of October 2013, CONSOL Energy announced that it would be selling more than half

of its coal operations to Murray Energy, worth $3.5 billion USD.67

Although 80% of CONSOL's

revenue was generated through its coal assets last year, CONSOL said it would be focusing on

growing its natural gas industry because coal operations aren’t as certain among impending reg-

ulation.68

Sherritt International Corporation, the largest thermal coal producer in Canada, announced at

the end of December 2013, that it would be selling its coal assets worth $946 million ($891 million

USD).69 Sherritt said it would be concentrating on its nickel mining business, where it had a

competitive advantage already.70

Energy and fossil fuel companies are considering the future implications of a low-carbon econo-

my and already starting to divest assets that will deliver low returns in the future.

Divestment

63 Laura Eadie. (November 2013). Too Many Ports in a Storm. The Centre for Policy Development. 64 Michael Rowland. (August 25, 2013). Inside Business Sunday 25 August. ABC News 65 (October 3, 2013). Rio Tinto Signs $1b Deal to Sell Clermont Coal Mine Share. ABC News. 66 (October 3, 2013). PRT-Rio Tinto Hands Mothballed Australian Coal Mine to Linc Energy. Reuters. 67 Paul J. Gough. (December 5, 2013). CONSOL Closes on $3.5B Coal-Mine Sale. Pittsburgh Business Times. 68 Ernest Scheyder. (October 28, 2013). CONSOL to Sell 5 W. Va Mines as Coal Regulations Increase. Reuters. 69 (December 24, 2013). Sherritt to Divest of Coal Assets for $946 Million and Focus on Core Businesses. The Wall Street Journal. 70 Ibid.

16



Although diversified mining companies are safer with regard to the potential of stranded assets,

they still pose some investment risks. Both Rio Tinto and Vale, both large coal miners, have sold

assets to pay off debts and meet shareholder demands for better returns this year. Rio an-

nounced in October 2013, that it sold almost $3 billion USD of divestments from an assortment of

operations.71

Vale also divested about $3 billion USD of assets in 2013 to cover costs.72

Glencore Xstrata, another diversified natural resources company has struggled the past few

years. It has recently shelved a few of its larger projects, as mentioned above, and is trying to sell

almost half of its capacity at the Wiggins Island Coal Export Terminal Pty (WICET). The terminal

was built to relieve insufficient port capacity in 2011.73

But since 2011, coal prices have dipped

steeply, and WICET owners have suffered losses due to an oversupply of port capacity. Wood

Mackenzie analyst consultants estimated that only half of the capacity of the 3.5 billion AU pro-

ject will be used.74

Although the value of diversified mining companies is much less at risk than pure coal compa-

nies, some have still faced hardships from reduced demand for coal. If coal demand were to de-

crease further, under the stranded assets scenario, mining companies could face further costs

and devaluations.

Fossil fuel companies are also still investing more capital expenditures (CAPEX) in fossil fuels,

despite already having enough reserves to increase the global average temperature by 4–6°C.

Carbon Tracker found that the top 200 coal, gas, and oil companies spent $674 billion USD find-

ing and developing more fossil fuel reserves just over the last year.75

In contrast fossil fuel com-

panies only paid $126 billion USD to shareholders in dividends over the same time period.76

In

Australia alone, a study estimated that $100 billion AU is expected to be invested in coal mining

projects.77

The $100 billion will be invested over the course of 15 years and could result in strand-

ed assets if demand remains low or decreases further. The capital from shareholders that fossil

fuel companies continue invest in research and development of reserves may never see positive

returns as the world transitions away from fossil fuels.

Diversified Mining Companies

71 (October 28, 2013). Rio Sells off $1b in Australian Coal Assets. The Sydney Morning Herald. 72 Rich Duprey. (November 15, 2013). Vale Has a “For Sale” Sign on Everything. Daily Finance. 73 Ben Caldecott, James Tillbury, Yuge Ma. (December 16, 2013). Stranded Assets Programme: Stranded Down Under?. Uni-versity of Oxford and the Smith School of Enterprise and the Environment. 74 Ibid. 75 (2013.) Unburnable Carbon 2013: Wasted Capital and Stranded Assets. Carbon Tracker Initiative & The Grantham Re-search Institute, LSE. 76 Ibid. 77 Ben Caldecott, James Tillbury, Yuge Ma. (December 16, 2013). Stranded Assets Programme: Stranded Down Under?. Uni-versity of Oxford and the Smith School of Enterprise and the Environment.

17



Utility companies have also

starting to question coal.

FirstEnergy Corp, a US elec-

tricity provider announced

in July 2013, that it expects

to deactivate two additional

coal-fired power plants, af-

ter deactivating nine the

previous year. FirstEnergy

says that its decision is

based on compliance costs

with the EPA’s Mercury and

Air Toxics Standards

(MATS) and impending fu-

ture regulation.78

In December 2013, Ameren

Corporation, an electricity

provider, sold five coal-fired

power plants to Dynegy In-

corporated. Ameren sold the

plants because it wants to

focus on its natural gas op-

erations, and greater earn-

ings to customers and share-

holders through cheaper

electricity prices.79

Utilities Market Valuations Any investor in mining operations knows the risks attached, but

many investors have failed to incorporate the likelihood of

stranded assets into their current valuations of fossil fuel compa-

nies.

Equity valuations can be subjective, and often the market value

does not match the company’s perceived value. Part of a compa-

ny’s value is based on future expected prices, or potential prices

of commodities and its historical return.80

This makes fossil

fuels valuations risky because it is unlikely the future of fossil

fuels will repeat the past. A report by HSBC reported that the

market cap of oil and gas companies could drop by 40-60% if

the price of oil decreased to $50/barrel.81

In a recent report by

The Carbon Trust and McKinsey & Co, analysts found that more

than 50% of the valuation of an oil and gas company is created

from year eleven and onward.82

If assets do start to become

stranded, the value of a fossil fuel company could drop, damag-

ing shareholders portfolios.

Investors also frequently use a Reserves Replacement Ratio

(RRR) as an indicator of the value of a fossil fuel company.83

The

RRR measures proven reserves added to a company’s resources

over the course of one year. A RRR of over 100% indicates a com-

pany is adding more to their reserves than they are producing,

and is used as a predictor of future revenues. But with unburna-

ble carbon introduced into the mix of market factors, RRR will

cease to be a reliable indicator of company value and could hurt

potential investors.

18

78 (July 9, 2013). FirstEnergy to Deactivate Two Coal-Fired Power Plants in Pennsylvania. FirstEnergy. 79 (December 03, 2013). Ameren, Dynegy Close Deal on 5 Illinois Coal Plants. Associated Press. 80 (2013.) Unburnable Carbon 2013: Wasted Capital and Stranded Assets. Carbon Tracker Initiative & The Grantham Re-search Institute, LSE. 81 Paul Spedding, Kirtan Mehta, and Nick Robins. Oil & Carbon Revisited: Value At Risk From ‘Unburnable’ Reserves. HSBC Bank Plc. 82 (2008). Climate Change—A Business Revolution? Carbon Trust. 83 (January 2011). Reserves Replacement Ration in a Marginal Oil World: Adequate Indicator or Subprime Statistic? Green-peace.


Cost vs. Fair Value Accounting The valuation model that most fossil fuel

companies use can be deceiving and could

increase shareholder risk.

Currently company valuations are often de-

termined using historical cost analysis,

among a number of other factors. But a dis-

cussion paper prepared by the International

Accounting Standards Board (IASB) discour-

aged the use of cost analysis because it can-

not accurately predict future cash flows from

an asset.84

A mining or oil & gas company

might invest a lot of CAPEX into exploration

and development, but yield little additional

feasible reserves. Alternatively, a company

might expend little capital, but find a pletho-

ra of additional reserves that are feasibly re-

coverable. The relevance of cost analysis also

diminishes as market forces change, such as

future prices.

The Carbon Tracker Initiative has suggested

an alternative valuation to cost basis account-

ing—fair value analysis. Though fair value

does tend to be more subjective than cost ba-

sis accounting, it does account for stranded

assets. Fair value accounting interprets a

number a different inputs. The recoverable

quantity of fossil fuels, the geographic and

economic feasibility of recovery, the produc-

tion profile, and future prices are several of

the inputs in its valuation. 85

Fair value ac-

counting accompanied by an enforced 2°C

target will likely yield very different company

valuations than current.


Unstandardized Reporting The Committee for Mineral Reserves Interna-

tional Reporting standards (CRIRSCO) and Pe-

troleum Resource Management System (PRMS)

classification systems are generally the most

popular systems used for financial reporting of

fossil fuels. However, the US Securities and Ex-

change Commission (SEC) and the United Na-

tions Framework Classification for Fossil Ener-

gy and Mineral Resources (UNFC) are two oth-

er common classification systems.86

The lack of

unity among reserves reporting systems also

call into question the credibility of fossil fuel

company valuations.

The most significant assets of an extractive

company are generally its reserves and re-

sources, and are the main sources of future cash

flow for the company. The definitions of re-

serves and resources are not straightforward

however, and hold a significant amount of vari-

ability. This makes the actual value of a compa-

ny much harder to quantify and less accurate.

Reserves are already classified based on the

probability of extraction. Proven reserves have a

90% chance of extraction, probable reserves

have a 50% chance of extraction, and possible

reserves have only a 10% chance of extraction.87

As the world starts to move towards a lower

carbon economy it is possible that shareholders

will see some proven reserves pushed to proba-

ble reserves, and some probable reserves

pushed to possible reserves as the margin be-

tween revenue and cost starts to erode. This

would also decrease a company’s value.

19


Changing Stock Market Requirements Under most current stock exchange listing requirements companies aren’t required to disclose

their greenhouse gas emissions, although that is starting to change.

Recently the United Kingdom has taken steps towards enforcing an integrated reporting require-

ment to list. As of October 2013, companies will be required to report emissions from combus-

tion of fuel and operations of facilities.88

Companies that will be affected are those that have

been listing on the London Stock Exchange, as well as companies listed on the NYSE or

NASDAQ, but incorporated in the UK.89

Denmark and South Africa have also implemented integrated reporting requirements in order to

list. South Africa’s stock exchange, the Johannesburg Stock Exchange, requires companies to dis-

close a corporate sustainability report integrated into its financial performance report or explain

why not.90

Denmark, as of 2010, has mandated integrated reporting for its largest 1,100 private

and state-owned companies.91

France however, has arguably taken the strongest action to inte-

grate ESG issues into its listing requirements. Companies listed on French exchanges, as well as

subsidiaries of other countries, will be required to disclose the consequences of their social and

environmental activities, in order to list.92

This is part of France’s new Grenelle II law from

2010.93

This will include insurance companies, financial companies, and investment firms.94

Although the UK, France, Denmark, and South Africa are starting to require integrated report-

ing, it won’t be very useful to investors until future emissions are mandatory to report. Most

companies that are already disclosing their emissions are only measuring their own-entity emis-

sions, but aren’t disclosing the potential emissions they have in their reserves. New stock market

requirements have the potential to increase transparency to investors and could expose compa-

nies that are most at risk from stranded assets and most carbon intensive.


84 Glenn Brady, Riaan Davel, Sue Ludolph, Aase Lundgaard, Joanna Spencer, Mark Walsh. (April, 2010). Discussion Paper:

Extractive Activities (EADP). IASB.

85 (2013). Carbon Avoidance? Accounting for the Emissions Hidden in Reserves. Carbon Tracker Initiative and ACCA.

86 Glenn Brady, Riaan Davel, Sue Ludolph, Aase Lundgaard, Joanna Spencer, Mark Walsh. (April, 2010). Discussion Paper:

Extractive Activities (EADP). IASB.

87 Ibid.

88 (2013). The Companies Act 2006 (Strategic Report and Directors’ Report) Regulations 2013. Government of the United Kingdom. 89 (2013). Mandatory Carbon Reporting. Carbon Trust. 90 (July 2013). UNEP FI Investor Briefing: Portfolio Carbon. UNEP Finance Initiative. 91 Ibid. 92 (2012). How France’s New Sustainability Reporting Law Impacts US Companies. Ernest & Young. 93 Ibid. 94 Ibid.

Part 2: Risky Investors


Fossil fuel companies are posing risks to investors. How far in the future investors may see im-

pacts on their portfolios is uncertain, but the risk is still there. Part 2 will discuss which asset

owners and banks, as investors of fossil fuel companies, are not taking the right steps to protect

their assets from risks emerging from climate change.

Public Banks

Private vs. Public 22

No Longer Funding Coal 23

Private Banks

Lack of Environmental Stewardship 24

Sustainability Indices 25

Voluntary Initiatives 26

Mountain Top Removal 27

Investment Banking vs. Lending 28

Coal Ownership 29

Asset Owners

Pension Funds 30

Index Exposure 30

Asset Management Problems 31

Private vs. Public

Public Banks


Public banks are funded by states or federal governments. An example of a public bank is the

U.S. Export-Import Bank. Banks like the World Bank and the European Investment Bank are al-

so public banks, but known as multilateral development banks. Private banks are those that are

privately owned and managed. The largest private banks are J.P. Morgan Chase, Morgan Stanley,

Bank of America, and Citi Bank, all United States’ companies. Other well-known international

private banks are Australia New Zealand Bank Group, Commonwealth Bank, Deutsche Bank,

Credit Suisse, Royal Bank of Scotland, Bank of China, Standard Chartered, and HSBC. The dis-

tinction between private and public banks is an important one, because private banks lend mon-

ey to make a profit. These banks have an obligation to invest safely to guarantee safe invest-

ments from their clients. Public and investments banks are often funded by governments and

different aid programs. They too have the responsibility to invest responsibly, but their primary

purpose is not to make a profit, but to encourage development and improve the lives of people

worldwide.

22

Public Banks

4: Risky Investors

Cumulatively the World Bank, U.S Ex-Im Bank, and European Investment Bank (EIB) have in-

vested more than $10 billion into coal projects in the last five years alone.95

But in mid-2013 these

public and development banks decided to start transitioning away from coal.

The World Bank catalysed the movement in July 2013, when it announced it would no longer be

funding coal-fired power plants.96

However, funding will still be provided when no other alter-

native is possible, but electricity needs are necessary for continued development.

Following the lead of the World Bank, the U.S. Import-Export Bank announced it would stop the

funding new coal-fired power plants as well.97

This announcement followed President Barack

Obama’s pledge to end U.S. support of overseas coal-fired power in June 2013.98

Since June the

UK, Denmark, Finland, Iceland, Norway, and Sweden have made similar statements promising

to end overseas funding of coal.99

The EIB announced in July, that it would be introducing a new emissions performance standard

for all fossil fuel power generation, several days after the World Bank’s first announcement.100

Embedded in its new policy was a maximum emissions cap of 550 grams CO2/kWh necessary to

receive funding.101

A study found that most coal-fired power plants emit about 1000 gCO2/

kWh.102

The limit excludes most new coal-fired plant designs except for the most efficient

plants equipped with carbon capture and storage technology.

In December 2013, the European Bank for Reconstruction and Development, following suit of

the other investment banks, announced that it too would no longer fund coal-fired power

plants, except in rare cases.103

This comes with a new investment strategy centered around ener-

gy efficiency and emissions reduction.104

No Longer Funding Coal

95 Mark Drajem. (August 06, 2013). Coal at Risk as Global Lenders Drop Financing on Climate. Bloomberg. 96 (July 16, 2013). World Bank Group Sets Direction for Energy Sector Investments. The World Bank Group. 97 Mark Drajem. (July 19, 2013). Ex-Im Bank Halts Funding Review for Vietnam Coal Plant. Bloomberg. 98 Mark Drajem. (June 26, 2013). Obama’s Overseas Coal Pledge to Curb Ex-Im Bank Financing. Bloomberg. 99 Fiona Harvey. (November 21, 2013). UK to Stop Funding Coal Projects in Developing Countries. The Guardian. 100 (July 24, 2013). EIB to Reinforce Support for Renewable and Energy Efficiency Investment Across Europe. European Invest-ment Bank. 101 (July 24, 2013). European Investment Bank Turns Away from Coal Financing as New Emissions Performance Standard is Agreed. E3G. 102 Ogunlade Davidson, Peter C. Frumhoff, Niklas Hohne, Jean-Charles Hourcade, Mark Jaccard, Jiang Kejun, Mikiko Kai-numa, Claudia Kemfert, Emilio La Rovere, Felix Christian Matthes, Michael MacCracken, Bert Metz, Jose Moreira, William Moomaw, Nebojsa Nakicenovic, Shuzo Nishioka, Keywan Riahi, Hans-Holder Rogne, Jayant Sathaye, John Schellnhuber, Robert N. Schock, P. R. Shukla, Ralph E. H. Sims, Jeffery Steinfeld, Wim C. Turkenburg, Tony Weir, and Harald Winkler. (November 18, 2013). New Unabated Coal is Not Compatible with Keeping Global Warming Below 2°C. European Climate Foundation. 103 Alex Morales and Marc Roca. (December 11, 2013). EBRD Scraps Most Financing for Coal Power Plants. Bloomberg. 104 Ibid.

23

Lack of Environmental Stewardship

Private Banks


BankTrack found the top ten funders of coal mining were Citi Bank, Morgan Stanley, Bank of

America, JP Morgan Chase, Deutsche Bank, Credit Suisse, Industrial and Commercial Bank of

China, Royal Bank of Scotland, Bank of China, and BNP Paribas. Many of these banks have envi-

ronmental policies in place and label themselves as responsible and environmentally committed

banks. Some pride themselves on their commitment to renewable energy though investment,

but neglect to mention their funding of fossil fuels.

BNP Paribas claims its commitment combatting climate change, but it is the 10th largest funder

of coal mining.105

Bank of America was included on the Dow Jones Sustainability Index (DJSI) in

2013, but is one of the largest financers of Coal India, one of the purest coal companies still sur-

viving.106

Australia & New Zealand Banking Group was named the 2013-2013 Industry Group

Leader by the DJSI in September 2013, but are the largest Australian financer of coal.107

There is a

division between how banks are presenting themselves and how climate-focused they actually

are. Increasingly banks are identifying climate change as a credit, operational, and reputational

risk, but still pursue clients that are contributing to this systemic risk. Banks have also started

calling for their clients to address climate change risks through the adoption of CCS and higher

efficiency standards, shifting responsibility of mitigating emissions to their clients.

24

105 (2013). A Responsible Bank 30 Key Facts. BNP Paribas. 106 Nijmegen. (September 13, 2013). “Sustainable” Badge for Bank of America Stretches Credibility of Dow Jones Sustainabil-ity Index. BankTrack. 107 (September 13, 2013). Results for 2013 Dow Jones Sustainability Indices Review, Industry Group Leasers Named. Getting to Sustainability.

Private Banks


The FTSE4GOOD’s objective is to provide a index that aligns with the values of socially respon-

sible investors. FTSE4GOOD excludes companies that produce controversial products such as

tobacco, weapons, and uranium companies, but neglects the recent stigmatization of fossil fuel

companies and the risks they pose. In FTSE4GOOD’s annual assessment, mining, oil, and gas

companies are considered high impact companies and must meet high standards to be included

on the index. However, financial companies like banks, which also take on a considerable

amount of risk, are only considered medium or low impact.108

Companies included in the

FTSE4GOOD indices must show a commitment to pubic reporting, and the presence of envi-

ronmental policy, but do not have to disclose projects that they are financing. Portfolio risk is-

n’t a factor in qualifying for inclusion on a sustainability index like FTSE4GOOD, although an

overwhelming majority of a bank’s risk would come from its portfolio.

FTSE does offer several carbon-tilted indices, developed with the Carbon Disclosure Project.

The carbon-tilted indices are supposed to act as a hedge against climate change risk, but the

indices still contain fossil fuel companies. Companies included in emission intensive sectors

have been reweighed in an effort to control climate change risk, but the energy sector

weighting within the index hasn’t changed.109

The Dow Jones Sustainability Index (DJSI) is another frequently referenced sustainability index.

The DJSI has many subset indices that exclude high impact industries such as alcohol, gam-

bling, tobacco, and weapons companies, but like FTSE4GOOD doesn’t exclude fossil fuel com-

panies.

Like FTSE, banks also aren’t obligated to report the projects they finance, only are required to

disclose their direct environmental impacts. Direct environmental impacts include their per-

sonal energy consumption and other environmental policies that they have mandated. The

DJSI, like the FTSE4GOOD ranks banks based on their personal emissions, not the emissions

locked into their lending portfolios. The DJSI also produces sector sustainability leaders each

year despite these problems, which can be misleading to investors. If the FTSE4GOOD and the

DJSI were to require information about project and emissions finance, the rankings that they

provide could be less deceiving and more useful to investors looking to protect their assets.

Sustainability Indices

25

108 (2006). FTSE4Good Index Series Inclusion Criteria. FTSE.

109 (February 28, 2013). FTSE CDP Carbon Strategy Index Series. FTSE.

Voluntary Initiatives

Private Banks


Many firms, including banks, have started to respond to a number of different voluntary disclo-

sure initiatives. Initiatives like the Carbon Disclosure Project (CDP), the Global Reporting Initia-

tive (GRI), and the UNEP Finance Initiative (UNEPFI) have surfaced with the intention of

providing greater transparency to shareholders and the public. Many of the reporting agencies

have similar end goals, but the number of initiatives leads to a lack of standardized reporting.

Because disclosure is voluntary, initiatives like CDP and GRI, also receive a range of reporting

consistency, which isn’t useful to investors. Consistent emissions reporting is useful for predict-

ing valuations under changing market conditions, and it offers a more comprehensive idea of a

company’s strategy over the short, medium, and long-term. Though voluntary reporting is a

good start, the information that is available is more helpful to bank’s reputations than to inves-

tors interested in acting responsibly or protecting their portfolios.

Carbon Disclosure Project asked companies to report using an emissions protocol developed by

the Greenhouse Gas Protocol (GHG Protocol). The protocol isolates emissions into three scopes.

Scope one includes all direct greenhouse gas emissions. Scope two includes indirect greenhouse

gas emissions from consumption of purchased electricity. Scope three includes other indirect

emissions. Currently, companies choosing to disclose only have to provide emissions for scopes

one and two, and scope three is optional.110

Scope three also doesn’t include emissions associat-

ed with lending and investment. Only 6% of financial reporters of the CDP chose to report emis-

sions associated with lending and financing in 2013.111

GHG Protocol is updating the protocol to

include emissions from value chains. A value chain includes all of the activities of a firm, includ-

ing investment and lending, that gives the firm the ability to deliver a specific product.112

In 2008, three US banks, Citi, JP Morgan Chase, and Morgan Stanley started a new voluntary ini-

tiative called the Carbon Principles. Although the intention of the Carbon Principles is to ad-

dressing carbon risk in financing, all three initiators are still at the top of charts in coal lending.

Though the Carbon Principles were enacted for banks to adhere to, they actually seem to focus

more on the clients responsibility to the climate, rather than the banks. The Carbon Principles

encourage clients to limit emissions, and to invest in low carbon and renewable technologies,

exonerating banks from financing companies with high emissions. The Carbon Principles also

call for a balanced portfolio approach, seeking to incorporate a range of energies, but with the

expectation that because coal has fulfilled energy needs in the past, it will continue to do so in

the future.113

Although banks are calling for further due diligence and advanced screening, it

seems unlikely that many commercial banks are actually helping facilitate the transition to a low

carbon economy.

26

Mountain Top Removal

Private Banks


Mountain top removal (MTR) is an extremely destructive type of coal mining that banks are fi-

nancing less frequently. MTR has had serious environmental and health impacts on nearby com-

munities. Bank of America has claimed that it has started to phase out companies whose pre-

dominant method of mining is MTR.114

TD bank also says it doesn’t finance MTR coal mining.115

Neither does Credit Suisse.116

But a report by BankTrack points out that a lot of banks won’t provide a loan that directly fi-

nances MTR, but they will provide a general corporate loan to a company. A general corporate

loan doesn’t necessarily finance MTR, but could finance any portion of a company’s business.

Some banks that say they aren’t financing MTR often mean they aren’t directly financing MTR,

but they still finance companies that use in MTR techniques.

BankTrack in collaboration with the Rainforest Action Network (RAN) and the Sierra Club,

found that many of the largest US banks didn’t uphold their claims. Bank of America claimed

that it would start phasing out financing of companies who extracted coal predominantly

through MTR, but still continues to lend to Alpha Natural Resources LLC, Arch Coal Inc., CON-

SOL Energy, and Patriot Coal Corporation, who all use MTR technologies. In fact Band of Ameri-

ca has provided 43% of the underwriting needs for MTR coal mined in Appalachia.117

Like Bank

of America, Citi Bank also provides funding to Alpha Natural Resources, Arch Coal, Patriot Coal,

and other companies that engage in MTR, despite using what Citi considers appropriate due dil-

igence.118

Morgan Stanley does not finance companies whose primary form of coal extraction is

MTR, but still supports Alpha Natural Resources, Patriot Coal, Arch Coal, and TECO Energy.119

Wells Fargo claims to have a limited and declining relationship with companies engaging in

MTR, but is still financing CONSOL Energy, Arch Coal, Alpha Natural Resources, and TECO En-

ergy.120

When banks say they don’t finance mountain top removal, many still do but under the

cover of a general corporate loan.

110 (March, 2004). The Greenhouse Gas Protocol A Corporate Accounting and Reporting Standard. World Resources Insti-tute and World Business Council for Sustainable Development. 111 (October 29, 2013). FOR IMMEDIATE RELEASE: New Guidance Will Help Financial Institutions Measure Emissions from Lending and Investment Portfolios. Greenhouse Gas Protocol. 112 (2013). Corporate Value Chain (Scope 3) Accounting and Reporting Standard. Greenhouse Gas Protocol. 113 (2009). Carbon Principles Q & A. The Carbon Principles. 114(2013). CDP 2013 Investors CDP 2013 Information Request: Bank of America. Carbon Disclosure Project. 115 Responsible Financing. TD Bank. 116 Heffa Schucking. (November 2013). Banking on Coal. BankTrack. 117 (2012). Dirty Money: U.S. Banks at the Bottom of the Class. BankTrack, Rainforest Action Network, Sierra Club. 118 Ibid. 119 Ibid. 120 Ibid.

27

Investment Banking vs. Lending

Private Banks


BankTrack has provided a much clearer picture of private banks sustainability commitments.

Many large commercial banks continue to lend to fossil fuel companies through loans or invest-

ment banking, even with the risk of stranded assets. Investment banking, as known as under-

writing, is one way that companies raise more capital. A bank buys new shares or bonds from a

company and then sells the bonds and shares to large investors, such as asset owners. The bank

doesn’t take on any direct risk when underwriting, but instead facilitates transactions between

investors and companies.

A bank takes on risk when it lends to companies. BankTrack found that since 2005, the year the

Kyoto Protocol went into effect, 165 billion euros (equivalent to about $224 billion USD), has

been invested or lent to the world’s largest fossil fuel companies. Of the 165 billion euros, banks

provided about 74.4 billion (equivalent to almost $100 billion USD) through direct lending.121

Since 2005, lending to coal companies has increased by 397% through 2012.122

Already banks are starting to see the impacts of the risky investments they made. A new coal ter-

minal at Wiggins Island, Australia, was proposed in 2011, during an export capacity bottleneck.

Since the planned capacity expansion, coal prices have dropped so much that coal companies

are shelving projects and closing unprofitable mines. The $3.5 billion (AUD) project at Wiggins

Island is only running at half capacity in its first stage, and has resulted in financial losses for in-

vestors. Australia New Zealand Bank Group (ANZ) and Westpac Banking Corp (WBC), two of

Australia’s largest banks invested in this project, are having to absorb losses.123

Losses have to-

talled $3 billion among those invested.124

Banks that have lent money to fossil fuel companies could face large problems as if fossil fuel as-

sets do start to become stranded. To put the risk they face into context, the financial worth of

the recent credit crisis was $2 trillion, compared to a conservative estimate of fossil fuel reserves

worth $20-$27 trillion.125

Clients of banks should be aware that banks participating in risky lend-

ing strategies could fail, as evidenced from the global financial crisis in 2008, and investments

could suffer.

121 Heffa Schucking. (November 2013). Banking on Coal. BankTrack.

122 Ibid.

123 Elisabeth Behrmann and Paulina Duran. (October 15, 2013). Coal Slump Leaves Australia Port Half-Used, Lenders at Risk.

Bloomberg.

124 Ibid.

125 Joshua Humphreys. (May 2013). Institutional Pathways to Fossil-Free Investing: Endowment Management in a Warming

World. (Fossil Free).

28

Private Banks


Beyond Lending–Ownership Apart from financing fossil fuel companies, many large investment banks actually own coal-fired

power plants and coal mines. Coal-fired power plant Boardman belongs to Bank of America.126

Cogentrix belongs to Goldman Sachs.127

And coal plants Powerton and Joliet are owned by

Citi.128

Most coal fired power plants are built to last 40-50 years.129

However under the 2°C target and

correlating carbon budget, it likely that new-coal fired power plants will be shut down or be-

come impaired before their useful economic life, resulting in financial losses.

Goldman Sachs also owns two coal mines and a coal port in Colombia, through its subsidiary

Colombian Natural Resources. In its Environmental Policy Framework Goldman Sachs states its

responsibility as a ‘leading global financial institution’ and wishes to play a constructive role in

the environmental challenges130

, but recently purchased the two coal mines and port in May

2012.131

Some major banks have a direct interest in continuing to fund coal companies, despite

the risk of stranded assets to investors.

126 (2012). Dirty Money: U.S. Banks at the Bottom of the Class. BankTrack, Rainforest Action Network, Sierra Club. 127 Ibid. 128 Ibid. 129 Ogunlade Davidson, Peter C. Frumhoff, Niklas Hohne, Jean-Charles Hourcade, Mark Jaccard, Jiang Kejun, Mikiko Kai-numa, Claudia Kemfert, Emilio La Rovere, Felix Christian Matthes, Michael MacCracken, Bert Metz, Jose Moreira, William Moomaw, Nebojsa Nakicenovic, Shuzo Nishioka, Keywan Riahi, Hans-Holder Rogne, Jayant Sathaye, John Schellnhuber, Robert N. Schock, P. R. Shukla, Ralph E. H. Sims, Jeffery Steinfeld, Wim C. Turkenburg, Tony Weir, and Harald Winkler. (November 18, 2013). New Unabated Coal is Not Compatible with Keeping Global Warming Below 2°C. European Climate Foundation. 130 Goldman Sachs Environmental Policy Framework. Goldman Sachs. 131 Reese Ewing. (May 29, 2012). Vale Sells Colombia Coal Mines to Goldman Sachs-led Group. Reuters.

Pension Funds

Asset Owners


Asset owners are investment institutions like

pension (or superannuation) funds, sover-

eign wealth funds, endowments, founda-

tions, and insurance companies.

The most common type of asset owner that

people invest with is their pension or super

fund. Pension funds are set up to help people

save money for retirement. Sometimes pen-

sions are assigned through the workplace,

and investors have little choice of who they

invest with, but sometimes investors chose

their pension fund.

Pension and superannuation funds provide

an assortment of funds based on growth per-

centage rates that investors can choose. At

minimum, most funds offer cash savings,

conservative, growth, and high growth op-

tions. These funds have varied risks and re-

turns based on differing concentrations of

asset classes. The most common asset classes

are fixed interest, equity, real assets, and cash

investments.

Fund members should consider how their

pension funds are managing the risks from

stranded assets, and how different funds con-

tain different levels of climate risk.

30

Most asset owners invest with both active and

passive fund managers, which have different

risk and return rates. Asset owners who are in-

vested passively must consider fossil fuel risk as

it applies to a specific index.

Different stock exchanges and indices have

different exposures to fossil fuels, though most

have an exposure of 9-12%.132

The London

Stock Exchange (LSE) has a much higher expo-

sure to coal than the New York Stock Exchange

(NYSE). Although the NYSE has more fossil fuel

reserves listed, it is much more biased towards

oil and gas, than coal. The LSE has 49 GtCO2

listed compared to the NYSE’s 36 GtCO2.133

Re-

ported coal reserves make up close to 17% of

the NYSE’s fossil fuel concentration and 43% of

the LSE’s fossil fuel concentration.134

Moscow

and the combination of Shanghai and Shenzen

exchanges also have high exposure to fossil

fuels.135

Because coal has a higher chance of

becoming stranded first, passive investors fol-

lowing the LSE are also more at risk than pas-

sive investors following the NYSE.

132 Joshua Humphreys. (May 2013). Institutional Pathways to Fossil-Free Investing: Endowment Managing in a Warming World. Fossil Free. 133 (2013). Unburnable Carbon 2013: Wasted Capital and Stranded Assets. Carbon Tracker Initiative & The Grantham Re-search Institute, LSE. 134 Ibid. 135 Ibid.

Index Exposure

Asset Owners


Asset Management Problems Fossil fuels, though risky, are unlikely to excluded from an investment portfolio because they

provide diversification across the market. Diversification acts as a hedge against the volatile na-

ture of the market. But diversification is only part of the problem.

Most asset owners don’t generally manage their own money. Asset owners will generally man-

age only a small portion of their investments internally, and outsource most investment man-

agement to fund manager (also known as asset or investment managers).

The flow of money starts with a fund member who invests his/her money with an asset owner.

In general, the fund member selects one of at least four funds offered and the asset owner in-

vests the fund member’s money. But the different funds are actually managed by an assortment

of fund managers, sometimes hundreds, depending on how large the asset owner is. Each fund

also contains a portfolio of companies. It is this web of money exchange that allows asset own-

ers to diversify their assets, but also creates transparency issues for fund members.

Although there is significant risk from fossil fuels, there is also risk from climate change in gen-

eral. The Asset Owners Disclosure Project has estimated that up to 55% of the average invest-

ment portfolio is exposed to risks from climate change, but in many portfolios fossil fuels only

account for 5-10% of the portfolio.136

Power stations, the chemical industry, cement industry,

smelters, transportation, miners, are all very fossil fuel industries that would be impacted by

stranded assets as well. Fossil fuel companies provide significant risk for portfolios, but the

problem is more overarching.

31

136 (2014). Global Climate Index 2013-14. Asset Owners Disclosure Project.

Part 3: Responsible Investors


Pension funds, sovereign wealth funds, endowments, foundations, and insurance companies are

the world’s largest investors. Naturally, as universal owners, they are all invested in the fossil

fuel industry. Already many asset owners are starting to question their investments in the fossil

fuel industry and the industry’s response to climate change. At the end of October 2013, 70 asset

owners and managers, managing more than $3 trillion of assets asked 45 of the world’s largest

fossil fuel and power companies to disclose how they were responding to financial risks posed by

climate change.137

Part 3 discusses options available to investors concerned with the risks that

climate change poses, as well as examples of how other investors are engaging with portfolio risk

from climate change.

Sustainable Investment

Sustainable Fund Managers 33

Sustainable Funds 33

Greening Bonds 34

Options for Investors

Identify 35

Shareholder Engagement 35

Diversifying and Tilting Investments 36

The Divestment Campaign 37

Investment Risk 37

Investor Response to Stranded Assets

Private Pension Funds 38

Public Pension Funds 39

Endowments 39

137 (October 2013). Investors Ask Fossil Fuel Companies to Asses How Business Plans Fare in a Low-Carbon Future. Carbon Tracker Initiative.

32

Sustainable Fund Managers



ESG stands for environmental, social, and corporate govern-

ance, and SRI is social responsible investing. Both are often

heavily employed by fund managers who are considered more

sustainable from a financial and an environmental perspec-

tive. The problem is finding those managers. The Forum for

Sustainable and Responsible Investment (USSIF) estimates

that in the US, only one out of every nine dollars is invested

with adherence to SRI strategies, under professional manage-

ment.138

The most progressive asset owners will choose fund managers

based on their employment of ESG and SRI investing tech-

niques. An Australian superannuation fund, Local Govern-

ment Super (LGS), said that it screens its new fund managers

for ESG risk analysis resources, personal ESG expertise, and

external resource services.139

But even fund managers that do

consider ESG risks still invest with fossil fuel companies.

The Asset Owners Disclosure Project (AODP) is a non-profit

organization that researches asset owners susceptibility to cli-

mate change. AODP recently ranked LGS number one in 2012

and number two in 2013 in providing transparency and disclo-

sure to shareholders.140

Despite being aware of climate change

and other ESG issues, LGS says as a universal owner it is im-

possible to avoid investment in companies that will negative

externalities, because of portfolio diversification.

Sustainable fund managers sometimes offer different types of

sustainable funds. Fund managers may also choose to engage

with companies that they feel are meeting sustainability re-

quirements, and may also rely on shareholder proxy voting.

Sustainable Funds Sustainable funds many invest

in renewable energy firms, but

are more likely invested in di-

versified mining companies or

fossil fuel firms who have re-

ceived a ‘best in sector’ qualifi-

cation. ‘Best in sector’ compa-

nies have adopter higher sus-

tainability standards and often

integrate ESG practices into

their business strategies.

Sustainable funds however, are

not consistent. Different man-

aging companies apply their

own screens and requirements

to develop a sustainable fund.

Fund managers may use an as-

sortment of ESG or SRI analyst

tools like positive or negative

screens, and exclusion of cer-

tain companies. Sustainable

funds often exclude companies

that manufacture tobacco

products, weapons and gam-

bling, but few omit fossil fuel

companies.

Investors who have concerns

regarding climate change risk

and their portfolio, may choose

to switch to a manager or fund

using ESG or SRI strategies.

138 (2014). SRI Basics. USSIF. 139 (2013). Fact Sheet: What does Local Government Super’s Approach to Responsible Investing Involve? Local Government Super. 140 (2012). AODP Global Climate Index. Asset Owners Disclosure Project.

33

Greening Bonds



Sustainable funds sometimes have an elevated level of risk that discourages more conservative

investors. Although the equity markets are able to offer a variety of ‘green’ firms, the fixed inter-

est market isn’t. Fixed interest securities have fewer fossil free products available, because the

sectors for renewable energy and energy efficiency are much less aggregated than the tradition-

al energy sector. Bonds, or fixed interest securities are often included in a portfolio to decrease

the risk level of the fund. Recognizing that there is both a problem and an opportunity, in the

market for green bonds, the Carbon Disclosure Project collaborated with the Network for Sus-

tainable Financial Markets to create the Climate Bonds Initiative (CBI).

The fixed interest securities market is actually larger than the equities market, making it a nec-

essary part of the transition away from fossil fuels. The International Energy Agency has esti-

mated that $1 trillion USD per year will need to be invested in efficiency and renewable technol-

ogies for the next 36 years to transition to a low-carbon economy.141

That type of capital can on-

ly invested by the private sector through equity and fixed income markets. The Climate Bonds

Initiative estimated that the transition to a low-carbon economy could occur if the world’s larg-

est pension funds invested 1% of their capital in low-carbon bonds, such as CBI, each year for

about 10 years.142

Climate Bonds are a new type of bond, and only offered on certain markets or through certain

banks. However, if investors were to demand a greater number of green or climate bonds, the

supply would increase. Sustainable investors face challenges in the both the fixed income and

equity markets, but as demand for these assets grows, supply will also.

141 (2013). Climate Bonds Can fund the Rapid Transition to a Low-Carbon Economy. The Climate Bonds Initiative. 142 Ibid.

34

Identify



As fiduciaries, fund managers have the legal

responsibility to consider any systemic mar-

ket risks, such as the possibility of stranded

assets. Fiduciaries and individual investors

should first identify their exposure to fossil

fuel companies and the risk that this lends to

their portfolio. Fossil fuels are also related to

other sectors such as the cement and chemi-

cal industries. As previously discussed, it’s

necessary to understand that the quality and

related risk of fossil fuels vary tremendously.

Coal and oil sands are the most at risk, and

would have the most impact on a portfolio at

this stage. Fiduciaries should also take care

to factor in the risk of impending govern-

ment legislation, competitive substitutes,

and other market factors.

In November 2013, Bloomberg released its

Carbon Risk Valuation Tool (CRVT), the first

of its kind. Investors can choose different

valuation models based on fair-value analysis

or discounted cash flows.143

The tool offers

five different oil price scenarios that can be

adjusted to reflect the investor’s assump-

tions.144

CRVT is in its beta stage, so Bloom-

berg is seeking feedback on the tool. But

CRVT is serving as a catalyst towards more

discussion about stranded assets. The tool’s

goal is to provide investors with a better idea

of how their stocks and returns could be im-

pacted when the world starts to move more

quickly towards a low-carbon economy.

Investors should also review their bank’s

lending strategies. Bank’s that aren’t lending

prudently could fail in the future and invest-

ments could suffer.

Shareholder Engagement Investors and fund members should engage

with their fund managers about risks from cli-

mate change. The more pressure that asset

owners and fund managers feel from fund

members and investors, the more likely they

will be to engage with fossil fuel companies.

Fossil fuel companies are aware that under a 2°

scenario 60-80% of their reserves cannot be

combusted, but they will continue to spend

CAPEX on exploration and development until

the world’s demand for fossil fuels decreases. As

long as there is a profitable market, fossil fuels

will be supplied. But by pressuring fossil fuel

companies to answer questions about mitigat-

ing run-away global warming, and the imple-

mentation of carbon risk in to their long-term

strategy, they may start to change, as some al-

ready have.

Another part of engagement is being present in

company decisions. Shareholders do hold pow-

er, but have the right to exercise this power

through proxy voting at company annual gen-

eral meetings (AGM). At BHP Billiton’s last

AGM, held in October 2013, the first four ques-

tions posed by shareholders were about climate

change and BHP’s strategy.145

At the AGM

shareholders tried to elect Ian Dunlop, who was

previous head of Australian Coal Association

and employee of Royal Dutch Shell, but now

works as an environmental activist. Although

Dunlop only received 4% of the vote in London,

and 3.5% of the vote in Perth, this is a primary

example of investors are starting to engage with

fossil fuel companies.146

35

143 (November 25, 2013). Bloomberg Carbon Risk Valuation Tool. Bloomberg. 144 Ibid. 145 Georgia. (November 28, 2013). BHP AGM. 350 Australia. 146 Sue Lannin and Pat McGrath. (November 21, 2013). Climate Change Activist Ian Dunlop Appears to Have Failed to Gain a Seat on BHP Billiton’s Board. ABC News. 147 (2011). Climate Change Scenarios—Implications for Strategic Asset Allocation. Mercer LLC. 148 Ibid.



Diversifying and Tilting Investments Investors interested in diversifying their portfolios should engage in strategic asset allocation

(SAA). Mercer, an investment consulting agency, found that SAA is attributable to over 90% of

the fluctuations in a portfolio over time.147

Traditionally investors have diversified across main

asset classes like equity, fixed income, real estate, cash investments, infrastructure, and their

different sub-groups. But Mercer found that it is necessary to diversify across sources of risk to

protect asset against stranded assets.148

Diversifying across sources of risk implies underweighting sectors exposed to high carbon emis-

sions, such as utilities, cement, and fossil fuel sectors. Investors can also hedge against fossil

fuel investments through investment in industries that will succeed in a low-carbon economy.

Low-carbon bonds, companies specializing in energy efficiency, and renewable energy are ex-

amples of investments that would likely succeed in a low-carbon world.

Investors can tilt their portfolio away from carbon intensive sectors, but they can also tilt their

portfolio away from certain companies. Pure coal and oil sands companies are higher risk than

more diversified mining companies or oil & gas enterprises. Investors can choose to only invest

in less risky fossil fuel companies, or can heavily overweight less risky companies to hedge

against the riskier ones.

36



Skeptics of divestment have argued that it could

negatively impact a portfolio. However studies

by Aperio Group, Impax Asset Management,

Advisor Partners, and MSCI have found that

portfolios with a low fossil fuel concentration or

none have performed as well or better than

those invested in fossil fuels.152

Most portfolios are hedged against the volatility

of the markets by diversifying their portfolios,

so there has been concern that divesting from

fossil fuel companies and intensive industries

will increase portfolio risk. Modern portfolio

theory says that for any additional risk under-

taken in a portfolio, a corresponding increase in

return should occur to make any investment

worthwhile. Although it is not clear if there will

be a corresponding increase in return, Aperio

Group, an investment management firm that

specializes in SRI and ESG practices, calculated

additional investment risk from divestment to

be 0.0034%.153

Aperio Group forecasted a track-

ing error of 0.5978%, benchmarked against the

Russel 3000, compared to an average tracking

error of 5% for large institutional investors,

such as asset owners. 154

A tracking error is a

measure of the deviation from benchmark in-

dex.

Divestment Campaign Investment Risk A recent study released by University of Ox-

ford and the Smith School of Enterprise and

the Environment (SSEE) found that tradi-

tionally divestment campaigns seem to fol-

low a path of three waves. The first wave of

divesters have historically been religious and

publically related organizations in the Unit-

ed States, followed in the second wave by US

universities and cities. The third wave is

where past divestment movements have

reached international asset owners.149

SSEE

and University of Oxford have concluded

that the fossil fuel divestment campaign is

already in the second wave of divestment.150

Contrary to some beliefs, the campaign isn’t

likely to effect the share prices of fossil fuel

companies, or the debt financing they re-

ceive from banks. Compared to total global

investment, university endowments and

public pension funds hold a relatively small

concentration of fossil fuel company shares.

It will most likely effect the reputations of

fossil fuel companies. Fossil fuel companies

could become stigmatised as ‘bad’ or ‘risky’

companies, discouraging business from po-

tential employers, employees, suppliers and

clients. Past divestment campaigns have also

been very successful in lobbying for new leg-

islation, so it is likely the fossil fuel campaign

could as well.151

37

149 Atif Ansar, Ben Caldecott, James Tilbury. (October 8, 2013). Stranded Assets Programme: Stranded Assets and the Fossil Fuel Divestment Campaign. Smith School of Enterprise and the Environment and University of Oxford. 150 Ibid. 151 Ibid. 152 (2014). Risk & Performance. Fossil Free. 153 Patrick Geddes. (2013). Do the Investment Math: Building a Carbon-Free Portfolio. Aperio Group, LLC. 154 Ibid.

Private Pension Funds



Norwegian insurance, pension, banking, and asset management company, Storebrand ASA an-

nounced in July 2013, that it would be divesting assets worth $74 billion USD from fossil fuel

companies.155

Storebrand planned to divest from 24 oil sands and coal mining companies, in-

cluding US coal giant, Peabody Energy Corporation.156

Storebrand doesn’t offer an ethical invest-

ment option to its clients, but sees these companies as financial risks.157

Scottish Widows, an asset manager responsible for $233 billion USD divested for pure coal com-

panies last year, after demand for coal has tapered.158

Government Pension Fund (GPF) stated its intention to divest its coal assets in November

2013.159

The government owned fund, managed by Norges Bank Investment Management

(NBIM), is worth $800 billion USD, the largest pension fund in the world.160

GPF owns about

1.25% of the world’s stocks and is invested in 147 of the top 200 largest fossil fuel companies.161

It

is also a large shareholder in both Glencore Xstrata and BHP Billiton, holding more than $2 bil-

lion USD worth of BHP shares.162

Local Government Super (LGS), an Australian superfund worth $7 billion AUD, is investigating

its investment in the fossil fuel industry.163

LGS is considering a ban on investing in coal mining

and other companies with a high exposure to fossil fuels. LGS’s CIO, Craig Turnball, worries that

increasing risks from international carbon legislation and a large concentration of high emitters

on the Australia Securities Exchange (ASX), could decrease returns in the future.164

155 (November 21, 2013). Is Coal the New Tobacco for Investors? The Sydney Morning Herald. 156 Ibid. 157 (August 02, 2013). Storebrand Reduces carbon Exposure in Investments—19 Companies Excluded. Storebrand. 158 Jesse Riseborough and Thomas Biesheuvel. (November 21, 2013). Coal See As New Tobacco Investor Backlash: Commodi-ties. Bloomberg. 159 Tom Revell. (November 06, 2013). $800bn Norwegian Oil Fund Under Pressure to Divest From Coal. Blue & Green Tomor-row. 160 Ibid. 161 Ibid. 162 Jesse Riseborough and Thomas Biesheuvel. (November 21, 2013). Coal See As New Tobacco Investor Backlash: Commodi-ties. Bloomberg. 163 Sally Rose. (December 10, 2013). Local Government Super Considering Coal Ban. Financial Review. 164 Ibid.

38

Public Pension Funds



21 cities in the United States have committed

to pursue divestment over the past two

years, with cities Seattle, WA, Ithaca, NY,

and San Francisco, CA leading the way.

Mayor Mike McGinn requested that Seattle

divest its deferred compensation plan and

state pension fund, worth a combined $2.8

billion.165

McGinn also planned to freeze all

new fossil fuel investments and look into

moving existing investments.166

San Francisco, another prominent leader,

requested the San Francisco Employee Re-

tirement System (SFERS) divest from fossil

fuels in April 2013. The SFERS board was

asked to divest $532 million (3.1%) from the

city’s $16 billion retirement fund.167

The

SFERS board announced in October 2013,

that it would not be divesting its fossil fuel

holdings, but instead engaging with busi-

nesses deemed riskier assets.168

Although

San Francisco chose not to divest, it brought

investors attention to one the problems fac-

ing investment institutions currently. San

Francisco is a good example of an alternative

way to approach unburnable carbon,

through the use of engagement.

Endowments The Stranded Assets Programme, published by

the Smith School or Enterprise and the Envi-

ronment and the University of Oxford found

that 2-3% of American university endowments

are invested in fossil fuels, compared to 5% of

United Kingdom university endowments.169

This is due to the nature of the stock indices

that American and British universities follow.

The FTSE, a British index following the top

companies listed on the London Stock Ex-

change (LSE), has a higher affinity towards fos-

sil fuels than the Standard and Poor index

(S&P), which follows the top companies listed

on the New York Stock Exchange (NYSE).170

Eight colleges and universities have committed

to pursue divestment of their endowments.

The eight colleges and universities have a small

stake in the investing world compared to other

asset owners like pension funds and insurance

companies, but are exposed to the same risk

none the less. The largest university commit-

ted to divestment is San Francisco State Uni-

versity, with an endowment of $51.2 million.171

The eight US schools that have committed to

divestment will not have any impact on the

value of stocks they are divesting from, but will

likely add to the stigmatization of fossil fuel

companies that is already occurring.

39

165 Mike McGinn. (December 21, 2012). An update of fossil fuel divestment. Seattle.gov.

166 Ibid.

167 Jamie Henn. (April 31, 2013). San Francisco board of Supervisors Unanimously Pass Resolution Urging Fossil Fuel Divest-

ment!. 350.org

168 Ilaria Bertini. (October 13, 2013). San Francisco pension fund ops against fossil fuel divestment. Blue & Green tomorrow.

169Atif Ansar, Ben Caldecott, James Tilbury. (October 8, 2013). Stranded Assets Programme: Stranded assets and the fossil

fuel divestment campaign: what does divestment mean for the valuation of fossil fuel assets? Smith School of Enterprise and

the Environment and University of Oxford.

170 Ibid.

171 Jamie Henn. (June 11, 2013). San Francisco State University Divests From Coal and Tar Sands. Fossil Free.

Conclusion

The supply of resources like coal, oil, and gas will eventually run out. The question that remains

is, will we let them? Or will we phase fossil fuels out before the earth increases by 4° to 6°C, the

trajectory we are currently on?

Due to current market forces some fossil fuels are already struggling. This should make inves-

tors question how they will fair as renewables become more competitive and carbon legislation

starts to have a larger impact. Fossil fuel companies are still investing CAPEX into exploration

and development, but yielding lower quality fuels at a greater expense to the environment.

The significance of unburnable carbon is that many fossil fuel companies may be currently over-

valued, creating risk for investors. Investors also risk loss of capital through the exploration and

development of resources that may never be able to reach the market. Allocation of capital into

the fossil fuel industry also leaves renewable and energy efficiency markets underinvested.

These industries need investment to be competitive in a market dominated by highly subsidized

fossil fuels.

Lenders like banks, also must consider the systemic risk that unburnable carbon poses. Private

banks are notoriously invested in the fossil fuel industry, despite social and environmental poli-

cies against practices like MTR. Coal mines and coal-fired plants are long-term investments, and

are often not fully paid off for 30-50 years, which creates risk for banks and their clients. As evi-

denced by the last global financial crisis, banks don’t always make smart lending choices and fail

to see systemic risks.

Investors should identify fossil fuel exposure within own investments, and engage with their as-

set owners and managers to decrease their risk. The Asset Owners Disclosure Project (AODP)

estimated that 55% of pensions and supers are exposed to sectors that will be impacted by cli-

mate change.171

Through strategies such as engagement, diversification, tilting, and divestment,

investors can prepare their portfolios for the future.

The time to act is now. What will your portfolio look like in the future?

Conclusion

40

171 (December 11, 2013). Climate Smart Super: Understanding Superannuation & Climate Risk. The Asset Owners Disclosure

Project.

Documents

Fossil Fuel Risk Through Economic and Financial Markets