University students across the US have been moving with increasing vigor to press their investment offices to divest from fossil fuel companies whose activities are leading contributors to climate change. Energized by Bill McKibben and an article he wrote this summer entitled Global Warming s Terrifying New Math, they cite the foreboding mathematical analysis around greenhouse gas emissions levels, the rise in global temperatures and the implications of the frightening statistics if we do not significantly reduce carbon emissions. The endowments' responses have largely been polite, but unfaltering in their perception that they need to invest in fossil fuels to generate returns. The implied underlying argument is that endowments need exposure to growth driven by resource scarcity and emerging markets, both of which are provided by traditional energy stocks. We too have done some math and believe this to be short sighted not only from a global climate perspective, but from an investment perspective as well.
Investors can access the secular drivers of resource scarcity and emerging market growth in other ways. While the demand for energy is one key example of resource scarcity, water and food are even more essential resources, and their demand is expected to accelerate through mid century. Most of this growth in demand is being driven by population growth and changing demographics in emerging market countries as they industrialize, and per capita incomes increase. To date, most institutional portfolios have been underinvested in stocks providing solutions to the global need for food and water. Instead of investing in energy companies driven by fossil fuels, could not water and agribusiness stocks be viewed as part of the replacement for the drivers of growth from traditional energy stocks?
Sources: Kleinwort Benson Investors and Datastream.
Note: in the table above, Global Equities refers to the MSCI World equity index, Energy refers to the MSCI AC Energy index, Agribusiness refers to the DAX Agribusiness index, Water to the S-Network Water index, and the Water/Agribusiness blend to a portfolio comprised of 50% S-Network Water index and 50% Dax Agribusiness index (rebalanced annually). All returns are in USD, annualized, for the 10 year period to end November 2012.
A look at the last ten years' performance shows that water and agribusiness stocks could have been strong alternatives. Agribusiness would have outperformed energy by more than 6% per annum. Water would have delivered returns in line with Energy, but at significantly less risk. An equal-weighted combination of water and agribusiness would be the most risk efficient replacement for Energy, outperforming by more than 4%, and with significantly lower risk.
As the noted disclaimer proclaims, past performance is not necessarily an indicator of future performance, but looking forward, we would argue that the long term trends that drove returns over the last ten years remain very much in place, and in fact are arguably stronger today. We also believe that over the next ten years the opportunity for water and agribusiness stocks is stronger than investment in conventional energy stocks.
Water is a finite resource for which there is no substitute. Less than 1% of the world's water is available for use and this limited supply is increasingly threatened by pollution, particularly in emerging market countries as they grow and industrialize. Historically, water demand has grown at twice the rate of population and is expected to grow by 41% by 2030. Consultant Booz, Allen, Hamilton, estimates $22 trillion investment will be required to meet the need for water through 2030 which is expected to be the largest component of global infrastructure spending in the next 20 years. This extensive capital commitment will be deployed through companies working to provide solutions.
Similarly, the supply of arable land for farming is relatively fixed, with approximately 38% of the earth's land currently used for farming. Demand for food is expected to expand by at least 70% by mid century , largely driven by economic growth in emerging markets. In order to meet the demand for food, we will have to find ways to dramatically increase crop yields and distribute produce more efficiently, which will require massive investment in companies providing machinery, precision agricultural technology and infrastructure.
Demand for energy will also increase significantly, but there are more significant risks to conventional energy stocks over the next ten years. Unlike water and agriculture, there are substitutes for traditional energy sources like oil and coal. While renewable energy stocks have suffered since the onset of the global credit crisis, the costs of wind and solar have continued to decline and it's reasonable to expect they will reduce the reliance on fossil fuels over the next ten years. There likely will be a renewal of societal pressure on policy makers to accelerate the path to a low carbon economy as more people comprehend the implications of not reducing carbon emissions and continue to experience first hand the consequences of rising global temperatures through extreme weather. Any policy movement in this direction would support renewable and energy efficiency stocks relative to conventional energy stocks. Additionally, as John Fullerton of the Capital Institute reports, limiting the rise in global temperatures to two degrees Celsius will require stranding of fossil fuel reserves with an economic value of approximately $20 trillion, creating a potentially devastating shock to the global economy and a huge liability for the entire conventional energy sector.
The problem is current investment horizons are not taking these risks into account. But given the actual long time horizons of most endowments, should not these risks be given some probability? And once this is done, will not accessing the drivers of resource scarcity through water and agribusiness (and other long term growth alternatives) prove compelling on a forward looking risk/reward basis? Even moving a portion of their assets from conventional energy stocks to water and agribusiness could be a win/win for the endowment and the planet.
Investors need to incorporate the longer term risks embedded in fossil fuel stocks as they develop their equity strategy for the next ten years. While an immediate wholesale move out of traditional energy stocks may not be practical, investors need to develop a plan for managing exposure to the risks of fossil fuel stocks and identifying alternative investments like water and agribusiness with more favorable risk/reward profiles. This could involve a carefully constructed plan for divestment that manages costs of divestment and weighs the opportunity to influence change at big oil companies through active engagement. It would also involve exploring stocks with alternative exposures to the drivers of growth from resource scarcity, which in addition to water and agribusiness, could include renewable energy stocks and clean tech companies providing energy efficiency solutions.
Bill McKibben has used the tag line "Do the Math" for his campaign. Well, we've done the math and we believe an alternative to fossil fuel stocks can do better, and we're not just talking about returns.
Disclaimer: The views expressed in this document are expressions of opinion only and should not be construed as investment advice. Kleinwort Benson Investors International Ltd is registered with the SEC as an Investment Adviser and is also regulated by the Central Bank of Ireland.