Why fossil fuels still have a future

A growing number of investors are responding to climate concerns by selling shares in fossil fuel producers. At $5.4 trillion, the value of portfolios that exclude fossil fuels has doubled in two years1, and even voices in the EU Parliament recommend divestment2.

However, we believe divestment is too simple an investment strategy. It’s clear that oil, gas and coal producers will face challenges as demand for their products fade, but the impact on profitability and value is less obvious.

The fortunes of energy producers will be determined more by their discipline (or lack of it) in adjusting to lower demand, than the impact of falling sales itself. That’s why we emphasize dialogue over disinvestment.

Meeting international climate change targets will involve more disruption than we have seen so far. Our recently launched Climate Progress Dashboard implies that changes currently underway will result in a rise of over 4°C in global temperatures3, well above the two degree commitment global leaders made in Paris in 2015. Hitting those targets will have implications across industries, but fossil fuel producers are in the cross hairs.

The reason is simple: essentially all of the blame for climate change lies with man-made greenhouse gas emissions (GHG), around 80% of which are from fossil fuels4. Limiting temperature rises to acceptable levels means cutting those emissions by two-thirds over the next three decades, which is a clear threat to producers. It implies that the world will need to cut fossil fuel production by 1% annually up to 20505, a sharp reversal from the 2% annual growth of the last thirty years. But shrinking demand need not be fatal for producers. The investment case is more complex than the black and white picture that is often painted. Our analysis implies that a disciplined response to production cuts could leave the industry twice as valuable as it would be in an investment free-for-all, even as demand falls.

While the industry’s aggregate response will dictate overall profitability, retreating growth will reveal differences in the business models and exposures of individual producers. Some will have much more robust earnings buffers against falling demand than others. Gas producers will benefit from the lower carbon content of their fuel, relative to coal miners. Companies with lower cost operations will be better able to withstand falling consumption.

1 https://gofossilfree.org/commitments
2 https://www.responsible-investor.com/home/article/ep_fossil
3 The temperature rises described here represent long-term (typically 2100 or beyond) increases stemming from each course of action.
4 https://www.eia.gov/energyexplained/index.cfm?page=environment_where_ghg_come_from
5 Based on IEA scenario analysis, combining different fuels on a contained energy basis.

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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.