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Tackling the fossil fuel risk

The news this week that President Obama is about to ramp up regulation surrounding the fossil fuel burning US power industry is a stark reminder of the growing regulatory, legislative and legal risks facing the energy sector. The new rules planned by the Environmental Protection Agency would, for example, prevent the construction of new coal-fired power plants unless they have some capacity to capture and store their CO2 emissions. Overall, the government’s plans seem likely to have a significant impact on both consumers and energy producers.

This kind of government action is why a growing number of investors accept the argument that the likelihood of greater regulation for the fossil fuels sector represents a significant business risk that could have a major impact on future performance of their portfolios. To ignore such risks, they believe, could be very unwise. No longer can the notion of screening fossil fuel companies out of an investment portfolio be regarded merely as the financial equivalent of tree-hugging.

Take the question of stranded assets. This is the technical term for fossil fuel deposits such as coal, gas and oil, that may never be mined, extracted or drilled because legislation, regulation or legal challenges may prevent it. As governments around the world become more concerned about carbon emissions driving climate change, the risk of these assets being “stranded” underground increases. The perceived imperative of keeping the global temperature rise to below 2% in order to avoid potentially very significant climate change would necessitate a wholesale shift to a low-carbon economy. This would likely result in write-offs or downward revaluations of the stranded fossil fuels.

A number of benchmarks have been developed to help investors identify companies likely to benefit from the shift to a low-carbon economy, such as renewable energy and water management groups. But any investor wanting to take account of the stranded asset risk has had a harder time identifying which fossil fuel companies are most at risk. FTSE has recently sought to help in this area by launching a new tool: the FTSE Developed ex-Fossil Fuel Index Series, a set of global benchmarks that exclude companies linked to exploration, ownership or extraction of fossil fuels. The excluded companies – there are 76 of them worldwide – can be removed entirely from these indexes.

Companies that are excluded must be oil, gas or coal exploration or production companies, and either have revenues arising from these sources or have proved or probable reserves of these fuels. In other words, they are the companies directly involved in extracting potential “stranded assets”. Companies that service them are not excluded from the new index.

But perhaps the most interesting part of this is how these indexes have performed. When the historic performance of the ex-Fossil Fuels Index between June 2006 and January 2014 is plotted against its benchmark, FTSE All-World Developed Index, the performance of the two indexes is extremely close. Like any index, of course, the ex-Fossil Fuel Index is not without some risk. But excluding the fossil fuel companies does not produce the underperformance that many critics might have expected. So much for impractical tree-hugging. 


FTSE Developed ex Fossil Fuel Index against the FTSE Developed Index

Source: FTSE Group, 31 March 2014.


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