Is now the time to reconsider your passive exposure to fossil fuels?

Earnings season has brought some good news for investors in fossil fuels. The Anglo-Dutch oil giant Shell plans to raise its dividend by 4%, despite a slowdown in profits. A day later, Exxon Mobil reported $36bn in earnings for the 2023 financial year. These positive earnings calls suggest there never has been a better time to be invested in oil and gas firms.

Profits for oil and gas firms have put pressure on institutional investors who have introduced carbon tilts to their listed equity portfolios. Over the past two years, indices that under weighed the energy sector have generally underperformed against their benchmarks, according to a comparison of MSCI indices. This has caused some asset owners to question the merits of carbon tilting in passive portfolios.

But over the longer term, the picture looks very different, according to a report on "Passive investing in a warming world" by the Institute of Energy Economics and Financial Analysis (IEEFA). Over a ten year-period, fossil fuel stocks have dragged down overall stock market returns, despite a short-term boost due to Covid and the war in Ukraine.

And the long-term outlook for fossil fuels could be even gloomier as the effects of the energy transition start to kick in, predict the report's authors,  Connor Chung, research Associate and Dan Cohn, energy finance analyst at the IEEFA.

The rise of index investing

Taking a short-term view on fossil fuel productivity might create the impression that the industry is stronger than ever, but the picture looks very different over a ten-year time frame. This is in part due to the rise of index-based investing with many indices being market-cap weighed.

At its peak, in the 1980’s, oil and gas firms accounted for nearly a third of the S&P500. By the late 2010’s their share had shrunk to the low single digits, the IEEFA report points out. The declining market share of the conventional energy sector coincided with the growing launch of ex-fossil fuel indices. 

When matching the risks and returns of the S&P 500, Russell 3000 and MSCI All Country World Index (ACWI) with their ex-fossil variants, Chung and Cohn find that: “excluding fossil fuels has led to modestly superior returns over the past 10 years, in both absolute and risk-adjusted terms.”

For example, a $10,000 investment in the S&P500 ex fossil fuels would have delivered $33,174 over a ten-year period, compared to $31,149 for the standard index. More strikingly, if the money had been invested in the energy sector alone, it would have returned $14,085.

The IEEFA research found that in eight of the 10 years between 2012 and 2021, the energy sector trailed the performance of the S&P 500, and in five of those years, it even placed last.

This should be good news for institutional investors who have adopted carbon tilts in their portfolios. Examples are the $259.9bn New York State Common Retirement Fund, which invests among others in FTSE Russell’s TPI Climate Transition indices. In the UK, institutional investors such as Brunel Pension Partnership or DC master trust Nest have adopted climate tilts to their equity holdings.

Indeed, over the past ten years, Nest’s default 2040 Retirement Fund, which holds almost half of its portfolio invested in a “climate aware” global equities strategy, returned 7.7%, versus 6% for its benchmark. However, this may be affected by other asset allocation factors.

A growing market

Over the past decade, the number of low carbon has skyrocketed, a trend that has been in large part driven by institutional demand. Prominent examples of collaboration between investors and index providers are Oxford Endowment’s contribution to MSCI and BlackRock’s fossil fuel screened indices and Japanese GPIF working with FTSE Russell on ESG indices which are underweight energy.

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Investors have to date committed more than $40.5trn in funds to divestment from fossil fuels, generating a strong incentive for index providers to offer more low carbon products, the IEEFA research points out.

Moreover, the transaction costs associated with switching from a regular to a low-carbon index have now become so low, that divestment meets fiduciary requirements. This has been echoed among others by a review BlackRock conducted last year for the New York Systems.

Comparing different divestment options it concluded that they all were suitable given the “historical outperformance of the representative divested portfolios on a risk-adjusted basis”, BlackRock also said the shift could be implemented with minimal impact on costs and tracking error.

Value thesis eroding

Forward-looking scenarios for the fossil fuels look significantly more drastic, argue Cohn and Chung: "The traditional value thesis underlying the industry—that the fossil fuel industry and economic growth are inextricably linked—is eroding. Facing increased competition between fossil fuel producers and from cheaper alternative technologies, the industry is ill-prepared to manage shareholder value in the coming years."

Indeed, the International Energy Agency predicts that the share of fossil fuels in global energy supply will drop from 80 to 73% by the end of the decade. Worldwide, the number of electric vehicles on the road is expected to increase tenfold by 2030 and solar power is expected to account for half of the global electricity mix.

As fossil fuels are being phased out, the profitability of individual producers will increasingly become dependent on short-term price-spikes driven by circumstances outside their control.

“The fossil fuel sector has shown that large-scale geopolitical destabilization has become a necessary part of its value thesis, and an investment strategy which bets on this is hardly a low-risk endeavour” Chung and Cohn warn.