8 March 2021
Author: Matthew Roberts
During our daily scan of the financial news recently we noticed the clever (or coincidental) juxtaposition of two stories: one profiled an endowment that has recently decided to exclude fossil fuels from their portfolio and the other, which could be considered to lie in opposition, highlighted the increasing risks associated with reflation.
The latter story suggested that traditional energy companies were one of the more effective ways to guard against rising inflation expectations. In the current climate, reflation is a very real scenario yet, running in parallel to this challenge, ESG risks are as prominent in our minds as they have ever been.
How should we deal with this quandary? We propose that the choice should not be quite so stark, and that innovation is the key to solving this puzzle.
The economic linkages between inflation and natural resources such as oil and metals/mining are complex. In the 1970s, after the collapse of Bretton Woods and the ensuing stock market crash, easy money and high oil prices sent inflation spiraling. Here, one might have surmised a clear cause and effect relationship between oil and inflation, but it has been quite variable since. Traditional energy companies are now a smaller proportion of equity market capitalisation and the technology revolution has meant that price discovery works differently (with the service sector and technology companies becoming increasingly dominant in countries like the US and the UK). Furthermore, whilst there may be evidence that some of the long-term secular forces we are all now familiar with (e.g. ageing populations) are plateauing, they are still undoubtedly relevant.
Nonetheless, it is well within the realms of possibility that the gigantic monetary and fiscal stimulus we have all witnessed over the past 12 months, coupled with booming economic activity resulting from ‘the reopening’ will ultimately result in significantly tighter economic conditions in the form of goods and labour. Simply put, the stimulus packages may overwhelm long-term disinflationary secular forces and lead to a world with a very different economic setting.
The below table shows our simplified assessment of the inflation linkage and our Four Key Factors (the bedrock of our investment process for longer-term portfolios) for a collection of different asset classes. We highlight Natural Resource Equities given their “High” expected return and “High” ESG risks. This has caused much deliberation in our team as it is a relatively unusual situation for a Strategy with “High” ESG Risks to score well overall, relative to other possible investments.
At first sight, it might appear that there is a myriad of options for those seeking to guard against inflation risks, but upon closer inspection, we find that:
- Commodity futures also come with High ESG risks (and lower expected returns) compared to Natural Resource Equities
- Inflation Linked Bonds might be a useful defense mechanism, though they may not give you much ‘bang for your buck’ in a growth portfolio
- Floating Rate Credit may be part of a solution, though it does not tick all the boxes as the inflation linkage is only moderate and credit spreads have tightened significantly
- Direct Timber/Agriculture, Renewables and PPI all require use of the illiquidity budget, which may or may not be available
Natural Resource Equities, such as traditional energy and the metals/mining companies, are easy to implement, remain depressed in price terms (despite the recent upsurge) and have modest associated fees. Yet, the category includes some of the highest carbon emitting companies, with elevated ESG risks more generally (particularly climate transition risk).
There are, of course, some arguments that suggest certain Natural Resource investments are essential in the transition to a cleaner world. For example, certain base metals are a requirement in the switch to electric vehicles. However, overall, it is hard to argue that these sectors are at the more controversial end of the ESG spectrum.
To help frame the scale of the challenge we might face, let us contemplate a simple ‘stress test’ for the reflationary scenario. Natural Resource Equities represent 5-10% of the global equity market. With a five year horizon, it is possible these stocks could double or even triple in price to bring them into line with traditional valuations in other sectors. Large swathes of the rest of the equity market are more vulnerable to an increasing discount rate (which is reasonably likely in a reflationary scenario as nominal bond yields are forced higher), including the big tech companies. If we assume for a moment that the rest of the market remains flat, then we would be looking at 1-2% per annum underperformance for an equity portfolio that excludes Natural Resources. This could be significantly higher if we see a general market selloff (as opposed to a plateau).
Is Divestment the answer?
We have examined several possible reasons as to why an investor may elect to divest Natural Resource Equities:
- To lower one’s carbon footprint. This is a truism and a noble act, but it probably does not result in lower absolute carbon emissions overall. The carbon is still being emitted but reflected in other portfolios.
- All facets of engagement have been explored and exhausted and there is no evidence of or commitment to change from the underlying companies. We are sympathetic to this position, but we find that new engagement methods are developing rapidly (see later).
- ‘Fossil fuels are going to become redundant anyway’. It is possible this is true over the long term, though we do not see it as a justification for divestment; it would seem to us to be part of an investment view. We can imagine that for some investors with a very long time horizon, the gradual eradication of fossil fuels from our daily lives may render them a less compelling investment, but again we find it hard to see how this should lead to an exclusion in and of itself.
- To increase the cost of capital for the underlying companies. In some sense, divestment can be viewed as the ultimate method of engagement. If there is divestment ‘en masse’, there may well be an impact on the cost of capital, which could prompt further company action or have broader impact (such as political stigma). However, the ultimate effectiveness of this approach is not guaranteed given the prevalence of marginal buyers. For example, the tobacco sector, which is often excluded from portfolios (including ours) remains profitable and has an investor base with critical mass.
We respect and sympathise with the difficult divestment decision. Climate goals have to be a team game. By ‘team’, we mean our entire industry. You may be thinking ‘if the status quo persists then we aren’t going to meet climate goals!’ This is almost certainly correct and so, we would like to propose a few ideas that highlight how innovation can help.
A bit of elbow grease will go a long way. As you consider whether Natural Resource Equities should be a part of your portfolio, we have three suggestions that might aid the discussion (all of which have been implemented at Fulcrum):
1. Engage, engage, engage
We imagine the most suitable method of engagement will vary from one investor to another. One such example is engaging with traditional energy companies on the transition to clean energy and we have seen some early indicators of success in the way these companies now report on their business activities and the setting of long-term goals. Another is a policy we have developed at Fulcrum which is to discuss the Science Based Targets initiative in our company and external manager meetings (whether we own the company/invest with the external manager or not). Part of this discussion promotes the consideration of the temperature-based methodology (Implied Temperature Rise), which helps us assess alignment with long-term climate goals.
Importantly, we recognise there are data issues faced by investors wishing to be better informed on ESG. For example, temperature-based metrics are prone to certain assumptions. However, our view is that data is unlikely to improve if users do not request it, interrogate it and engage on it. It is one of the many hard truths about climate change; none of this is easy! However, hard work will pay off and the more of us that engage thoughtfully, the better.
We would very much like to hear about your ideas on engagement in this area.
Given the well documented ESG risks associated with traditional energy, one approach could be to filter the universe to focus on the most forward-thinking (and acting) companies, which requires a thorough understanding of the business models. Several of the major fossil fuel companies are playing a substantial role in the clean energy transition and we have seen very concrete (no pun intended) action from certain companies both in terms of future carbon emissions commitments as well as change on the ground. As a live example, we have developed a theme in our portfolios entitled ‘Energy Transition’, distinct from our ‘Clean Energy’ theme (which is more of a pure play). We feel these companies are likely to be rewarded for their innovation over the long term relative to others. We also feel that taking this stance will encourage laggards to up their game (please refer back to idea 1. above). The important nuance here is that we are not saying ‘we will never own you’; we are saying, ‘up your game, and the responsible investment case might improve to the point that we can own you’. This is quite different to the idea we often hear that ‘everything has a price’, it should contribute to creation of the (necessary) political stigma and it is a strategy that can evolve.
We wonder if this might be more effective compared to a blanket ban?
Whether you choose to divest or not, other asset classes that might not ordinarily be part of the discourse when it comes to inflation could provide hard-to-find diversifying return streams. We have included several ideas of this nature in our portfolios (e.g. Asian Convertible Bonds). Separately, there may be more esoteric investments with a clearer relationship with inflation that are worthy of consideration, such as emissions futures.
The likelihood of a reflationary scenario has increased. With such an outcome, there is a hard-to-ignore chance that Natural Resource Equities perform very strongly, which in turn poses a major challenge for ‘ESG integrators’ as they seek to meet their investment objectives. It strikes us that innovation is the key and one of the hard truths about climate change is that this will not be easy, though we believe that being innovative through engagement, selectivity and originality will help us all along the way.