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This article first appeared in Personal Wealth, The Edge Malaysia Weekly on August 14, 2017 - August 20, 2017

Fund managers should not remove fossil fuel-based assets from their portfolios altogether. By doing so, they risk overlooking advances in technology and regulation that could re-energise these once overvalued assets, says Mellon Capital.

According to managing director and head of equity portfolio management Karen Wong, managers risk losses if advances in carbon capture technology reach a tipping point that would allow us to “burn more fossil fuel without any accompanying rise in global temperatures”.

These advances could help wring out any trapped value in otherwise “stranded” assets and, crucially, cause investors who had divested to miss out. Stranded assets are those that have become obsolete or non-performing due to some unanticipated or premature write-down, devaluation or conversion to a liability.

To illustrate her point, Wong excluded fossil fuels from the MSCI ACWI — a global index for developed and emerging markets. “Looking at the performance of the fossil fuel-free portfolio, tracking returns since 1995, that portfolio would have performed at 12% below the index. So that is the risk of divestment.

“As for the path to get there, you see the volatility in the returns. For the index, it [the tracking error] was over 1% per annum over the last 20 years,” she said in her presentation at the International Social Security Conference 2017 on Aug 3, organised by the Employees Provident Fund.

In addition, by engaging in wholesale divestment, investors and their managers lose influence over these assets. As a result, the companies are no longer incentivised to reduce their carbon footprint and engage in climate-related financial disclosures.

“If you divest, your shares might be purchased by someone who really does not care about these issues. But by remaining invested, you have a lot of leverage to encourage these companies to do something [about their carbon footprint],” Wong says.

The Taskforce on Climate-Related Financial Disclosure (the influential body set up in the wake of the signing of the Paris Agreement) published a comprehensive report in June, detailing a host of strategies for investors and fund managers to engage with fossil fuel assets in order to be more environment friendly.

Wong says the movement that eventually led to the divestment of fossil fuel assets first started around 2010. It was an activist movement driven by college students across the US.

“They made the argument that in order for global temperature changes to remain under the acceptable 2°C threshold, fossil fuels had to be divested. This is a powerful argument and is easily understood.

“I agree with the motivation of these movements. There is enough scientific evidence on climate change after all, but I don’t completely agree that divestment is the only solution.

“There are other more meaningful measures that could help achieve the same objective. I think we can ‘do well [be profitable] and do good’,” she says on the sidelines of the conference.

For Wong, one of the most immediate and easily executable measures to strike that balance would be for small and mid-cap fossil fuel companies to institute carbon-reporting procedures in their disclosures. However, the California-based Wong said this move has encountered resistance in developing markets.

“A lot of small and mid-cap companies are more resource-constrained compared with the larger-cap companies. Larger companies would have a dedicated team of people working on environmental impact reporting and the disclosures.”

Wong says the smaller companies give a higher priority to the financial outcomes — the returns on investment and capital. However, it is clear that the status quo cannot continue indefinitely.

Studies show that companies that factor sustainability issues into their decision-making do enhance their value, she adds. A seminal Harvard Business School study released this year on this issue — Why and How Investors Use ESG Information: Evidence from a Global Survey — found that more than half of respondents used environmental, social, and governance (ESG) data in the course of their decision-making because it was material to the investment performance.

The study also quoted earlier studies that found correlations between ESG disclosures and “lower capital constraints, cost of capital, analyst forecast errors and stock price movements around mandatory ESG disclosure regulations”.

Wong says, “We’re taking a positive reinforcement approach for now, but at some point, if these companies continue to make only empty promises [on improving their carbon footprint], we would no longer want to hold on to them.”

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