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Changing perspectives on investment risk

Conventional Wisdom:

“We have developed business models to assure diversification – such as currency risk, inflation risk, and other economic factors.  Future environmental or resource factors are not financial risks we can or should include in our portfolio allocation strategies

except under general ESG notions.”


Emergent Wisdom:
“Resource and climate risks are likely to have a broad and increasing influence on portfolio outcomes over the next decade.  Current business models largely fail to account for these risks as financial risks, our securities disclosures inadequately address them and insurance is unlikely to cover us for our shortcomings.” 


Fossil energy and utility assets have been considered a relativity safe investment for institutional investors. Most large institutions have 6-8% direct portfolio exposure to coal, gas and oil. Utility holdings add to that total and because a very broad range of other commodities are increasingly correlated to oil, secondary levels of fossil commodity risk exist across a much larger percentage of virtually all portfolios. 


We have already seen evidence of risk in these markets. Pressures in the U.S. coal industry have already caused U.S. coal stocks to decrease 75% in value on a 25% drop in the price of coal in 2011. Those declines have been followed by broader calls for coal divestment. Utility businesses are under increasing pressure, in part driven by the shrinking costs of, and ever-increasing competition from, wind and solar. In Europe, where wind and solar penetration is higher, the top 20 European utilities have lost over $500 billion in value since 2008.


Today, fossil energy sources are being challenged – costs of extraction are going up, capex increasingly exceeds cash flows, and debt levels are ballooning. Nearly half of the oil industry requires $120/barrel prices for positive cash flow while unconventional oil & gas continues to see much higher cash out (capex) vs. cash in (revenue) exerting further stress on business fundamentals. Moreover, in the U.S., notwithstanding low priced natural gas, declining solar PV prices and energy efficiency technologies are threatening the traditional utility profit and business model. 


Perhaps the greatest looming issue is the “carbon bubble.” It is widely agreed that if we are to hold global temperature increases below a critical two-degree Celsius threshold, we must limit further CO2 emissions to 565 Gigatons by 2050. That would mean leaving 2,795 gigatons of carbon in the ground – roughly $20 trillion worth of current fossil reserves. Yet, the industry continues to spend $400 billion a year trying to add to these reserves. How long will investors continue to ascribe full value to these reserves?


Although global attention has largely focused on governmental action/inaction in dealing with climate risk and the carbon bubble, we have focused exclusively on the risk that the changing energy landscape creates for institutional investor portfolios. Most investors are likely to stay the "business as usual" course as long as possible. However, the changes that have already occurred in coal and utilities suggests that when change happens, it happens fast and given the scale of institutional holdings, most investors will be unable to exit before values decline. Dealing with that risk across the percentage of most portfolios that it will affect is the core challenge. We believe there are ways to mitigate these risks and invest proactively in ways that could be highly rewarding as the world moves from business as usual to a new energy paradigm and we are challenging investors to engage with us on how to do so.

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