Fossil Fuel Divestment: Portfolio Consequences and Strategies

The wide variations in performance may be easier for an institution to weather than an individual investor. 

Given the minimal exposure of the full divestment portfolio to energy stocks, the study compared performance of the full divestment portfolio to the trend in oil prices during the simulation. Chart 3 illustrates that the doubling of oil prices from 2002 to 2004 coincides with the performance deterioration of the full divestment portfolio relative to the S&P 500 index. The subsequent doubling of oil prices in 2007 had a similar impact to performance.

Evaluating the risk of divestment

In addition to simulating performance retrospectively, the study examined prospective risk of the divestment portfolio relative to the S&P 500 Index.  The study used standard deviation to measure projected risk in absolute terms, determining the projected variability of each portfolio. As shown in Table 1, the divestment portfolio has a slightly higher simulated (backward-looking) and projected standard deviation, but the differences are small.

Examining risk in relative terms, the study also examined predicted tracking error, which is a statistic that measures deviation from a target benchmark. The divestment portfolio has a predicted tracking error of 1.07%. In statistical terms, a portfolio with predicted tracking error of 1.07% is expected to have annual returns within plus or minus 1.07% of S&P 500 returns, two-thirds of the time.

Risk models and optimizers have inherent limitations; past performance and simulated results are no guarantee of future results. The study doesn’t account for potential changes in company behavior resulting from engagement efforts, nor does it consider potential regulatory changes that could restrict the ability of companies to extract carbon.

Reinvestment Implications

Energy stocks were poor performers in 2014, suffering through an unexpected collapse of oil prices during the second half of the year.   Many observers expected declining oil prices to be a positive development for portfolios that divested their energy stocks, but some investors experienced unexpected consequences. 

A key consideration influencing investment results is the decision about how to reinvest the proceeds from divesting fossil fuels. There are a few distinct approaches that carry different advantages and disadvantages. The approaches we see most frequently include:

• Pro-rata reallocation: The approach we used for the study used the proceeds from divestment to increase the weights of the remaining index constituents on a pro rata basis. This is the easiest approach to implement, though it may not be the optimal approach from a risk perspective.
• Risk-based reallocation: The approach we often recommend for clients, in which divestment proceeds are redeployed into companies that may be statistically correlated but are not directly involved with energy activities. For example, industry groups such as construction and engineering, aerospace and defense, and machinery have high historic correlations with oil companies.   Another option for investors with a global perspective is investing in the currencies or non-energy equities of countries that are major energy producers, such as Canada, Norway and Russia. The broader economy in these countries tends to do well when oil prices rise, so investing in them could be a way to benefit from rising oil prices without providing direct funding to fossil fuel companies.
• Reinvest in clean energy-related stocks: The approach that is likely to be the most satisfying from a social value-driven perspective, but which carries risks that aren’t always apparent to clients. Last year provides a good illustration, as oil industry leaders Exxon and Chevron experienced stock market declines of about 6% for the year. As a comparison, the Powershares Clean Energy ETF declined about 16%, First Solar about 18% and Yingli Green Energy more than 50%.  The other side of the spectrum is represented by Vestas Wind Systems, which gained more than 20% in 2014 after being up more than 400% in 2013. The booming stock price of Vestas, however came after a three-year period in which it lost about 48% in 2010, 66% in 2011 and 46% in 2012!

  Consequences of the rapid fall in oil prices included reduced demand for alternative sources of energy and a period of heightened risk aversion for investors, creating the dramatic performance results discussed anecdotally above. As a result, “old” energy companies such as Exxon and Chevron delivered better stock market performance than many “new” energy companies. Clean energy companies often have more volatile business models than the established companies targeted in divestment campaigns, featuring steeper adoption curves, a higher degree of technological and regulatory uncertainty, and less financial cushion.  Clean energy companies may offer attractive long-term prospects, but it’s important to recognize the higher near-term volatility they exhibit. 

Closing Thoughts

Our investment analysis suggests that removing energy stocks from a well-diversified portfolio may have a small to moderate impact on investment risk; however, the magnitude of the impact is very much a function of the investor’s time horizon. Endowments with a multi-decade time horizon are likely to be much better equipped to weather near-term volatility than an individual investor nearing retirement.  

The question of reinvestment is equally important, and risk and reward associated with divestment are intricately linked to the decision about how to reinvest.  As with the original divestment question, time horizon plays a critical role influencing the success or failure of a given strategy.