Investors have a love–hate relationship with crude oil. When prices are rising, the quest for alternative, renewable sources of energy gathers steam, driven by proponents of climate change. When prices are falling, investors seek out opportunities to profit from the low cost of energy and its spillover effects on other industries. In all cases, everyone tends to have a view on how high or low prices will go, and energy analysts remain divided in their predictions of crude oil prices.

The divergence in views is accompanied by volatility in prices, which inevitably makes its way to investors’ portfolios. Crude oil, in many cases, now serves as the benchmark for other fossil fuels. Managing the impact of these non-renewable sources of energy continues to be the focus for both institutional and individual investors, especially in countries such as Canada where these commodities are an important part of the economy. This focus becomes newsworthy as climate change and geopolitics come into play.

Focus on Sustainability

Shielding portfolios from the negative impacts of fossil fuels remains a challenge for investors. How can investors practically manage the various trajectories of such a core commodity? For those with long-term time horizons in particular, how can fossil fuels be strategically incorporated into portfolios for generating sustainable returns?

There may not be any direct answers to these questions, but there were plenty of actionable insights at the recent Annual Pension Conference hosted by CFA Society Toronto. Focusing on long-term sustainability of portfolios, topics covered included ESG (environmental, social, and governance) investing, fossil fuels, and geopolitics, to name a few.

While topics presented at the conference were primarily directed at institutions with long time horizons such as pension funds and insurance companies, they could prove quite relevant for Millennials, younger investors born between 1980 and the early 2000s. This generation is just starting to build their portfolios and has a significantly long time horizon. They also exemplify the ideals of impact investing, an approach that links financial profit to societal benefits. According to the Harvard Business Review, Millennials, compared to all other generations, are the most likely to make investment decisions based on social, political, or environmental values. With fossil fuels and climate change on the agenda, some of the ideas presented would certainly prove quite beneficial for the Millennial investor.

Presenting on this topic was Jane Goodland, Senior Investment Consultant, from Towers Watson, who explained how to invest strategically in fossil fuels with a long-term focus. As background for her thesis, she cited the United Nations Framework Convention on Climate Change agreement reached in 2010, which established that future global warming should be limited to less than two degrees Celsius relative to pre-industrial levels. This mandated a fixed amount of carbon dioxide emissions between 2000 and 2050, which would most likely have a real impact on the demand and supply of fossil fuels and have further implications for investors’ portfolios.

According to estimates from the Carbon Tracker Initiative think tank, only one-fifth of proven fossil fuel reserves can be burnt by 2050 to meet the UN target. Goodland termed this disparity as the “stranded asset debate,” whereby some sources of energy may become inaccessible, despite their availability. She then presented four strategies for investors to incorporate this theme into their portfolios. These strategies can be summarized as follows:

Engage – Investors can collectively influence public policy and collaborate with policy makers to work on the financial risks posed by climate change to investment practices and corporate behaviour. There are several efforts that both institutional and individual investors can join to impact policy.

Adjust Risk – Limit downside risk by adjusting portfolios to reduce the exposure to carbon-related risks. There are numerous actively managed strategies available to investors, along with a growing number of low-carbon indices.

Hedge – Allocate capital to investment strategies specifically designed to perform well in a low-carbon economy such as companies involved in energy efficiency, renewable energy, and clean technology.

Divest – Investors can exclude fossil fuels altogether from their portfolios or divest according to certain materiality thresholds. This could be for moral reasons or simply to avoid negative publicity. Not surprisingly, several educational and public funds have chosen this route.

Goodland emphasized that these strategies need not be mutually exclusive, and a combination of them could be employed across a portfolio or within an asset class. She also laid out some practical advice for those looking to systemically adopt these strategies. The first step investors should take to move in this direction is to define their investment beliefs, particularly with respect to climate risks. In essence, investors should determine whether this is a moral argument or purely an economic decision. The second step is to measure the carbon exposure of their existing portfolios.

Investors’ beliefs and current carbon exposure are then used as inputs to select and implement a strategy. This has to be followed by clear communication and transparency about the strategy for it to work. Finally, continuous monitoring and review of the investment portfolios relative to expectations is the final step that will ensure alignment with the strategy.

Regardless of the specific strategy investors may choose, they can do so objectively, based on their own views about climate change and the future of fossil fuels. Such a framework can also help investors gradually adjust their portfolios to the new fuel consumption regime as it evolves. More importantly, investors’ need for generating returns does not have to be at odds with their desire to protect the environment. In essence, it is now possible to infuse more love of the planet into the traditional paradigm.