Scientific Beta

To avoid a climate crisis, the global economy needs to undergo a radical transformation, shifting out of fossil fuels and into renewable and low carbon energies. Drawing capital away from companies that produce fossil fuels can has a dual justification; investors wish to avoid exposure to stranding risk, and by modifying their cost of capital, these companies will be incentivised to transform their business models. However, for both motivations, investors need to make clear distinctions between different types of fossil fuels – natural gas, coal, conventional and unconventional oils – as both the stranding risk they present, and the pace of their net-zero-consistent phase-out, differ widely.

To avoid a climate crisis, the global economy needs to undergo a radical transformation, shifting out of fossil fuels and into renewable and low carbon energies. Drawing capital away from companies that produce fossil fuels can has a dual justification; investors wish to avoid exposure to stranding risk, and by modifying their cost of capital, these companies will be incentivised to transform their business models. However, for both motivations, investors need to make clear distinctions between different types of fossil fuels – natural gas, coal, conventional and unconventional oils – as both the stranding risk they present, and the pace of their net-zero-consistent phase-out, differ widely.

In the first part of this paper, we show a clear hierarchy from coal to natural gas. This ordering is reflected in the fossil fuels divestment policies of many investors, who implement discerning and escalating policies that support an energy transition that is consistent with science-based scenarios. Immediate and indiscriminate divestment from all fossil fuels will not help tackle climate change and could even be counterproductive. Indeed, many fossil fuels companies are also significant players in renewable energies. Pulling the plug on the financing of the electric utilities sector will make essential investments in green electricity harder to achieve, not easier. Our economies are still dependent on fossil fuels, so the dual movement out of fossils and into renewables needs to be implemented in a coordinated, orderly manner. It’s a transition, not a disruption.

In the second part of this paper, we illustrate these pitfalls of fossil fuels divestment by looking at the European Union’s regulated Paris Aligned Benchmarks (PAB). These, perhaps inadvertently, lead to immediate and undiscerning fossil fuels divestment: companies that represent almost 40% of global renewables-based electricity generation are excluded from large and mid-cap equity universes due to the PAB regulation’s fossil fuels exclusion criteria. The regulation also permits even more dramatic underfunding of power companies, as its anti-greenwashing constraints are toothless in avoiding sector-weighting biases. While PAB compliance enables investors to claim an official Paris alignment label, and while their returns looked promising while oil prices were falling, investors should be aware of the explicit and implicit consequences of adopting the PAB-regulated fossil fuels requirements.