Rising oil prices exposed dormant risk in decarbonization strategies
The conventional approach to portfolio decarbonization divests from fossil fuel-heavy industries, typically inducing negative active bets on oil prices and energy stocks.
In recent years, such positioning looked benign or even appealing to many investors as the energy sector’s benchmark weight shrank (top chart) as 1) technology stocks surged, and 2) the emergence of shale supply, COVID, and the Saudi-Russia oil price war put downward pressure on crude.
But risks associated with broad exclusions resurfaced as oil prices first rose in late 2021 and then spiked when Russia invaded Ukraine.
Investors have alternatives
For sustainable investors who are concerned about risks of rigid negative oil price exposure, there are alternatives. Instead of broad divestment, constraining the portfolio’s total carbon exposure provides greater flexibility to decarbonize through stock selection or sector reallocation, even allowing for positive energy-related positioning when prospects look favorable.
To illustrate, the bottom chart compares the active oil exposure of an Emerging Market “carbon constrained” strategy, which restricts portfolio carbon exposure1 and only selectively divests high emitters, to a “fossil fuel free” strategy that employs similar carbon exposure restrictions but also broadly divests companies that own fossil fuel reserves. As the energy sector forecast improved in 2021, the carbon constrained strategy’s active oil beta rose and became positive. In contrast, imposing broad divestment meant that the fossil fuel free strategy maintained a negative oil price beta. (Both strategies achieved similar reductions in carbon exposure.)
The example highlights that investors have alternatives in constructing sustainable strategies. Nuanced portfolio construction can help to balance responsible investing and financial objectives.
Shrinkage of the Energy Sector: Weight in MSCI ACWI Index
Oil Price Forecast and Active Oil Exposures
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