By Michelle de Cordova, Principal and Thea Miles, Associate, ESG Global Advisors
Few aspects of responsible investment are as contentious as fossil fuel free (FFF) investing. Proponents assert that further investment in fossil fuels will prevent us from achieving global climate goals. Detractors claim divestment risks financial returns for the sake of limited real-world climate impact. This raises a big question for fiduciaries: how accurate are these conflicting perspectives, and what are the lessons for developing an effective responsible investment strategy?
Fossil fuel free investing is a form of negative screening in which companies are excluded from the investment universe based on involvement in the fossil fuel industry. (For more information on screening and other responsible investment approaches, see our earlier piece, Reimagining the Responsible Investment Spectrum).
According to the Global Divestment Commitment Database, since the fossil fuel free movement emerged a decade ago 1,594 institutions representing assets of U.S.$40.5 trillion have made commitments to divest fossil fuels. Recently, some investors that have long championed climate engagement with fossil fuel companies have decided to divest. Notably, in June 2023 the Church of England announced the exclusion of all remaining oil and gas majors from its endowment and pension portfolios, citing their failure to align with the Paris Agreement climate goal of limiting global warming to 1.5°C above pre-industrial levels.
Other investors continue to prioritize engagement: for example, 38 institutional investors are collaborating to engage Canadian issuers, including oil and gas companies, through Climate Engagement Canada. Meanwhile, fossil fuels continue to dominate the global energy system, representing almost 82% of total primary energy consumption in 2022, and in its World Energy Investment report, the International Energy Agency (IEA) projects more than double the level of spending on fossil fuel supply in 2023 than is consistent with achieving net zero greenhouse gas (GHG) emissions by 2050.
For investors considering whether to divest fossil fuels, the conflicting perspectives of proponents and detractors can be confusing – not least, because digging into the facts about fossil fuel free produces some counterintuitive results.
Five Things About Fossil Fuel Free (FFF) That May Surprise You
1. There Is No Standard Definition of Fossil Fuel Free
No single agreed set of criteria exists to identify companies to exclude from a fossil fuel free portfolio. Screening methodologies – which are not always clearly disclosed – differ significantly in the types of hydrocarbons and fossil fuel value chain stages targeted for exclusion, as well as the tolerance for revenue derived from the excluded business activities (see Table 1). As a result, company exclusion lists for different fossil fuel free investment products may vary: for example, a screening methodology focused solely on coal, oil and gas reserves ownership might not exclude companies that derive their entire revenue from business activities in the fossil fuel value chain, such as oil and gas services companies or pipeline operators. These types of inconsistencies can contribute to accusations of greenwashing. Negative screening may also have unintended consequences: for example, a blanket exclusion of companies in the Global Industry Classification System (GICS®) Utilities sector would encompass not only coal-fired electricity generation, but also “Independent Power and Renewable Electricity Producers” – companies that a climate-conscious investor might well favour.
Table 1: Examples of Fossil Fuel Free Exclusionary Criteria
Companies with proven and probable coal, oil, or gas reserves.
Asset Manager A
Companies in Energy and Utilitiessectors.
Asset Manager B
Companies directly engaged in the extraction, processing, and transportation of fossil fuels such as coal, oil, and natural gas.
Asset Manager C
Companies whose primary activity involves the extraction and production of fossil fuel or owning fossil fuel reserves.
Asset Manager D
Companies that generate more than 10% of sales from extracting, producing, refining, or transporting fossil fuels, from providing equipment and services to companies involved in these businesses, or from fossil fuel-fired electricity generation.
Asset Manager E
Companies whose primary business is the extraction, production, and distribution of fossil fuels, including oil, gas and coal producers, pipeline companies, natural gas distribution utilities, and liquefied natural gas operations.
2. The “Net Zero by 2050” Climate Scenario Is Not Fully Fossil Fuel Free
According to the Intergovernmental Panel on Climate Change, avoiding the worst impacts of climate change by limiting global warming to 1.5°C above pre-industrial levels requires us to achieve net zero GHG emissions by 2050. However, the pathway to achieving this goal may not require the complete elimination of fossil fuels. The IEA Net Zero Emissions by 2050 Scenario (NZE) is a widely-used source setting out a global economic pathway to net zero. NZE envisages unabated use of fossil fuels (i.e., use without carbon capture, utilization, or storage) making up 5% of total energy supply in 2050, and that hydrocarbons will still be needed for non-energy uses. An investor seeking to design a climate approach consistent with NZE might therefore choose to set fossil fuel investment reduction targets, adopt a “best-in-class” approach directing investment to energy companies taking action on climate change, and practice stewardship to ensure that in 2050 the industry is made up of only the most responsible hydrocarbon producers.
3. Fossil Fuel Free Investing Does Not Necessarily Sacrifice Financial Returns
A significant barrier for many institutional investors is the belief that divestment conflicts with the fiduciary duty to act in the best financial interests of the beneficiaries they serve – even if some beneficiaries are asking for fossil fuel free investment, to align with their values.
In theory, screening approaches that limit the investment universe might be expected to negatively impact financial returns. However, in practice this risk may be exaggerated. Notably, when New York City asked BlackRock and Meketa Investment Group to explore the implications of its pension funds divesting fossil fuels in 2020, both found that, based on historical analysis, divestment did no harm and might indeed have boosted returns. Research focusing on a global group of almost 7,000 companies over the period 1973-2016 found no significant risk and return performance difference between fossil fuel free and unrestricted portfolios, while a 2023 study found that the cumulative value of the public equity portfolios of a group of U.S. pension funds would have been boosted over the period 2013-2022 by divesting fossil fuels, despite rising oil prices at the latter end of the period.
All in all, impact on returns may not be the killer argument against divestment that some investors believe: a more important question may be whether fossil fuel free delivers real world climate impact.
4. Fossil Fuel Free Portfolios Are Not Necessarily Low Carbon Portfolios
It might be assumed that fossil fuel free portfolios are also by definition low-carbon portfolios, but this is not necessarily the case. The current reality is that many investors measuring portfolio carbon – the GHG emissions associated with their investments – are only accounting for the Scope 1 and 2 GHG emissions of investee companies, because of the limited availability and reliability of data on Scope 3 value chain GHG emissions (see callout – Understanding GHG Emissions Scopes). While the Energy sector has the highest average emissions when all three GHG scopes are considered, other sectors and industry groups – Utilities, Materials and Transportation – have higher average Scope 1 and 2 emissions (see Figure 1).
Investors seeking to reduce portfolio carbon should focus specifically on that goal, monitoring and addressing their exposure to all high-carbon sectors, and considering the scope of GHG emissions that are being measured.
Figure 1: Which Sectors Have the Highest Scope 1 and 2 GHG Emissions Intensity?
5. The Impact of Divestment on Real World GHG Emissions Is Uncertain
Investors divesting fossil fuels want to take positive action on climate change. However, there is conflicting evidence as to how divestment impacts GHG emissions in the real world. For example, a recent study of U.S. and European equity mutual fund holdings found the stock price declined at divested firms, and that these firms subsequently reduced carbon emissions compared to non-divested firms, where emissions actually increased over time. Another study found that increasing divestment pledges within a country were associated with lower capital flows to domestic oil and gas companies. On the other hand, the same study found capital flows were redirected to oil and gas companies outside the home jurisdiction, while a further study highlights a trend toward transfer of oil and gas assets from environmental leaders to laggards and from public markets to private hands subject to less scrutiny. A further challenge is that the majority of global oil reserves are controlled by state-owned companies that are not easily influenced by divestment campaigns.
Conclusion: Identify Real-World Climate Outcomes, Then Decide
Before deciding whether to adopt fossil fuel free investing, investors should consider what climate outcomes they are seeking to achieve in the real world. Some outcomes can be effectively pursued through divestment, while others may be better pursued using different approaches within the responsible investment spectrum. For those considering fossil fuel free, we recommend three initial steps:
Build capacity among decision makers to reach a common understanding of the spectrum of responsible investment approaches and the financial and climate outcomes they can deliver.
Agree on the financial and climate outcomes that should be pursued before determining the responsible investment policy.
Choose the responsible investment approaches and tools best suited to produce the desired financial and climate outcomes. This may – or may not – include fossil fuel free.
Some investors will be surprised where these steps lead them: but, whether or not they lead to divestment, they will produce a responsible investment policy that can be explained to stakeholders.
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