Here’s how money managers can influence what happens to stocks in this hard hit, unloved sector


A long-awaited stock-market rotation back to value stocks might benefit oil and gas companies in the short-term, but long-term there are concerns about the sustainability of the energy industry as it now exists. The sector’s woes are such that at the end of August 2020, energy stocks accounted for just 2.6% of the S&P 500
SPX,
+1.64%

 , down from more than 16% in 2008. 

The systemic risk surrounding energy companies due to climate change underscores the difference in approach between active managers and their index-fund counterparts and large retirement funds, as well as the tools active managers can use to make a persuasive case for meaningful change. While active fund managers increasingly are avoiding the energy sector and its risk of permanent capital impairment, many passive-fund investors recognize that as universal owners of the market and, by default, the economy, they have a stake in encouraging a successful energy-sector transition to renewables.

Eschewing the entire industry is short-sighted and misguided. While some investors have divested from fossil fuels, many continue to hold these investments in the hope of driving change through engagement. Active managers, drawn by seemingly low valuations, are engaging alongside them, with the combined weight of their collective voices leading to better reporting and some shift in strategy towards redirecting capital expenditure to renewables. The challenge will be if the change being supported by engagement will be enough to avoid fossil fuel stocks becoming “value traps.”

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Active managers have distinct advantages when it comes to proxy voting and engagement, the most obvious being that active managers have a far smaller number of securities to cover than a passive manager. Further, through their research processes, active managers can incorporate engagement into their due diligence analysis of stocks before a purchase. Moreover, the continuous feedback loop between management and active managers provides greater insight into the quality of corporate governance; a perspective that makes for better-informed decisions when it comes to proxy voting.

How are investors able to flex their collective muscle if engagement fails to produce desired results? This is a central challenge facing active engagement with the fossil fuel industry, given the role governments play in the ownership, production and national energy strategy — along with significant and real barriers toward making a successful transition to cleaner energy at sufficient speed and scale to compensate for declines in their traditional business.   

Climate risk management promises to lead active managers to put fossil fuel assets in a “why bother?” bucket. For indexed and other broad-market investors, achieving alignment with climate outcomes delivers different conclusions, as they are focused on managing long-term systemic risks associated with owning the market. Without the sanction of divestment, there is a danger that engagement becomes diluted and leads to token action.

In important and visible ways, investors are all activists now. The rapid growth of both active and passive Environmental, Social and Governance (ESG) and sustainable assets has been accompanied by a rise in active engagement and proxy voting. Rather than pliantly voting with management, investors increasingly are voting against management. For example, the increasing adoption of Task Force on Climate-Related Financial Disclosures (TCFD) reporting, the commitment to net-zero targets and to absolute emission reduction targets by a few companies, along with accelerated investment in renewables, is evidence that fossil fuel companies are responding to pressure, both economic and from shareholders. Such newfound, vigorous investor activism only promises to grow as the global economy emerges from the COVID-19 pandemic.

Andrew Parry is head of sustainable investment at Newton Investment Management.

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