• Paul Stuart-Smith

Climate change could put your portfolio in check, mate

Updated: Nov 24, 2020

“It’s an entire world of just 64 squares … I feel safe in it. I can control it. … And it’s predictable …” Beth Harmon, the fictional protagonist of Netflix’s must-see drama series The Queen's Gambit, explaining what it is she loves about chess.

Investing has much in common with chess. Both rely on strategies and frameworks aimed at creating a safe psychological space, controlling risk, and maximising opportunity in order to achieve predictable, or at least positive, outcomes.

Strategies and frameworks may change over time based on fashion or new ways of thinking. The Queen’s Gambit, though one of the oldest known chess openings dating back at least to the 15th Century, “did not become common until the 1873 tournament in Vienna,” according to Wikipedia. Similarly, in the world of investing, ESG has been around in one form or another as a strategy for as long as there have been investors, but it is only recently, and now heightened by the pandemic, that ESG has entered the mainstream.

Even so, as anyone involved in the asset management industry knows, there remains considerable uncertainty about how to define, prioritise, measure and use ESG criteria. Every day, financial firms, analysts, academics, regulators, investor groups and journalists churn out papers and articles about ESG with titles like: “ESG Investing Takes Off, But Classification Confusion Remains” and “An Alternative to ESG ratings”. There are also fundamental disagreements about whether ESG portfolios are out-performing the broader equity market, and, if so, why?

Valuable though these discussions can be, from an investment performance perspective they risk obscuring the fact that not all ESG criteria are created equal. Like the pieces on a chess board, they may all play a role in the outcome of the game but it is likely to be your opponent’s Queen that helps put you in check mate. The Queen in this analogy is, of course, climate change.

If a picture paints a thousand words, then the following chart (courtesy of Bigcharts) surely captures the point. It shows the percentage change in price over the past 3 years of one of the world’s leading coal producers, Peabody Energy (BTU), plotted against the index of oil & gas shares (XOI) and the I-Shares Clean Energy Exchange Traded Fund (ICLN).

Since December 2017, Peabody’s share price has declined from around $40 to just $1 today; the value of the XOI index has been cut in half, while shares of ICLN have risen from around $9 to almost $22: little room for disagreement here about which has performed best.

While many factors can influence share prices, it is the risks & opportunities associated with climate change and the energy transition that have driven the dramatically divergent investment returns of coal, oil & gas, and clean energy companies.

Faced with competition from cheap natural gas and rapidly falling renewable energy prices, Peabody warned only last week, in a Form 10 Q filing with the Securities & Exchange Commission (SEC), that it “may need to voluntarily pursue an in-court restructuring” (i.e. file for bankruptcy) if “the Company is not able to improve its liquidity and financial position, or otherwise meet its liquidity needs”. This would be the second time in less than 5 years that Peabody has filed for bankruptcy. It previously did so in April 2016.

If Peabody is a metaphorical canary in one of its own coal mines, oil & gas companies risk suffering a similar fate if they do not adapt. Some – BP, for example – now aim to play a major role in the energy transition and are diversifying into solar, wind, hydrogen and other forms of renewable energy. But it is not just fossil fuel companies that need to think about and act on the risks & opportunities they face from climate change. All companies are exposed to a greater or lesser extent.

This is why governments, regulators, investors and other stakeholders are ramping up demands for companies to report information about how they are managing and mitigating these risks using the global disclosure framework known as the TCFD recommendations. The UK government announced last week that this will become a mandatory requirement across the economy by 2025 though most larger companies are likely to need to produce TCFD-aligned disclosures in their annual report (or explain why they are not doing so) from next January.

Zero Carbon Finance offers a TCFD & ESG advisory service in partnership with sustainability specialist JS Global and also works with other leading consulting firms including Wood Mackenzie.

NB: Nothing in the above is intended as investment advice nor should it be taken as such. However, in the interest of full-disclosure, I do own shares of ICLN and recently bought shares of BP.