Major asset owners around the world have recently made headlines with their decisions to divest fossil fuel assets from their portfolios. Institutional investors are increasingly considering environmental and social risks when making financial assessments, with more choosing to move away from fossil fuel companies. At the same time, other institutional investors have been engaging with fossil fuel companies to help them become more sustainable.
While both approaches help address the environmental impact of investing, divestment or engagement alone is not enough. Rather, investors need to look for companies whose services provide solutions to sustainability issues.
The Divestment Campaign
Global figures from Arabella Advisors show that in the nine months ending September 2014, the number of divestment commitments by universities, churches, cities, states, pension funds and other institutions more than doubled, from 74 to 181. In total, more than US$50 billion was divested from fossil fuels during that period.
Although the divestment campaign has been remarkably successful in a short period of time, it’s unlikely most investors will completely divest their fossil fuel exposure. When oil, gas and coal prices are strong, for most investors, the resulting cash flows are simply too attractive to ignore. With a US$4.5-trillion market capitalization, the global fossil fuel industry isn’t likely to be capital-constrained apart from periodic price collapses.
What About Engagement?
While many investment industry professionals argue engaging with companies to improve their environmental impact is a more prudent approach, we believe that, while helpful, this approach isn’t enough on its own either.
This is largely due to the inclusion of fossil fuel and energy companies in investment benchmarks, such as those produced by MSCI or Standard & Poor’s, and their prominence in measuring investment performance. Straying too far from these benchmarks causes greater volatility— which, in turn, increases the risk measures of the investment strategy.
For this reason, even responsible investment portfolios will have close to market-weight exposure in fossil fuel companies. The need to align investment strategies with conventional benchmarks limits the extent to which institutional investors can help tackle complex problems such as climate change.
Make an Impact
So what’s the solution? Instead of being too concerned about where a company falls within a particular Global Industry Classification Standard sector (per MSCI and Standard & Poor’s), institutional investors should focus on whether it provides products or services that have a positive environmental or social impact and offers a financial return on investment.
When investors consider companies based on their ability to contribute to and benefit from key sustainability themes—for example, environmental safety or energy efficiency—the investment process becomes futurefocused and long term, unlike benchmark-based investing, which provides a snapshot of today’s economy.
An investment strategy based on this approach is holistic because it tracks multiple environmental objectives. The investment team can then focus on allocating to and engaging with the businesses offering sustainability solutions.
Martin Grosskopf is vice-president and portfolio manager with AGF Investments Inc.
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