Coal phase out: The investment case
- Sustainability rationale: Coal, the highest carbon emitting source of energy in the global fuel mix, has no meaningful role to play when it comes achieving the goals of the 2015 Paris Agreement. The share of coal in electric power generation will decrease by 2040 in any climate scenario. The Intergovernmental Panel on Climate Change’s (IPCC) consensus of scientists expect that the share of coal to electricity generation needs to fall to almost zero by 2050, if we are to achieve a 1.5°C scenario.
- Economic Rationale: There is also a clear economic rationale in moving away from coal. First, as carbon regulation will strengthen, stranded asset risks will materialize. Second, demand from fast growing Asian markets remains strong but the use of coal is on a downward trend in most countries. Growth of demand for renewable energy is supported by both government policies and the rapidly declining relative cost associated with these alternatives. Finally, there is also a growing trend where financial institutions are more restrictive, when it comes to providing financing to coal companies.
- AXA Investment Managers is further strengthening its climate risks policy and tightening the threshold for companies involved in coal. We have identified three measures of coal exposure which a business can be assessed by. This analysis also forms the basis of our engagement initiatives with the extractives and electric utilities companies. This is one of the pillars of our approach to mitigating the impact of climate change risks and aligning our investments to the Paris agreement.
Coal has no meaningful role to play when it comes achieving the goals of the 2015 Paris Agreement. Right now, it remains an important part of the energy mix, fuelling base-load power stations across the globe. But despite this, it is very much a commodity of the past. As a result, we do not see a long-term future for it.1
Today coal accounts for almost one third of the energy supply mix and nearly half of the carbon emissions produced by energy combustion.2
But like lead pipes and asbestos insulation before it, the societal cost of its use is no longer justifiable, if the world is to succeed in its efforts to limit the effects of climate change.
The 2015 Paris Agreement, has been signed by 195 members of the United Nations Framework Convention on Climate Change – and only 10 are yet to act on it. Under its terms, countries have agreed to limit the rise in global temperatures this century to “well below 2°C above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5°C.” 3
And given that coal is the highest emitting source of CO2 within the global fuel mix, it has no real role to play if countries are to succeed in this goal.
Figure 1: Total Primary Energy Supply by fuels and CO2 emissions (2016)
Source: International Energy Agency – emissions from fuel combustion Highlights 2018
The sustainability rationale: Hitting targets
According to October 2018’s Intergovernmental Panel on Climate Change report, if the world is to succeed in its aim of tackling climate change, the share of coal in the primary energy supply mix must decrease from 27% today, to less than 5% by 2050.
In its 2018 World Energy Outlook, the International Energy Agency (IEA), also points to the likelihood of a significant reduction in coal-generated power, even if commercial realities mean it is probably too soon to entirely eject coal out of the global power mix.
In its New Policies scenario, which outlines what the future of the energy market could be - if only announced policies and targets are accounted for - the IEA says that a rising tide of electricity, renewables and efficiency improvements, should together stem growth in coal consumption.
In the IEA’s Sustainable Development scenario, however, which outlines accelerated clean energy transitions, that will put the world on track to meet goals related to climate change, universal access and clean air, global demand for coal should fall by more than 50% by 2040 from now. As a result, the share of fossil fuels in electricity generation should go from nearly 40% today to less than 10% in 2040.
Figure 2: Power generation mix in various Climate scenarios
Sources: AXA IM, BP Plc, International Energy Agency (IEA), Intergovernmental Panel on Climate Change (IPCC), International Renewal Energy Agency (IRENA) 2018
The economic rationale: The transition to a low-carbon world is materialising
While there is a clear rationale for less coal use from a sustainability perspective, the economic rationale is also becoming increasingly powerful.
“Transition” risks or Stranded Assets threat
The Paris Agreement aims to limit global warming to well below 2°C. Reaching this goal requires that a large part of oil, gas and coal reserves be kept in the ground. Current moves by governments to reduce carbon emissions, strengthen climate regulation and develop alternative technologies is resulting in broad shifts in demand for sources of electricity. Over time, there is a risk of fossil fuel asset values becoming impaired or stranded. Coal and unconventional oil (such as tar sands) are the most highly emitting sources of energy. As such, these forms of fossils fuels are the most exposed to so-called transition risks.
Financial institutions fight against climate change
The coal mining and power generation sector is finding it increasingly difficult to access funding, as financial institutions are moving to restrict the financing of coal. Almost 1,000 institutional investors with more than $6 trillion in assets have made public commitments while many banks and insurers have also limited the funding and underwriting business they do with these companies. AXA group has been a pioneer in this movement.
The Aiming for A – which later became Climate Action 100+ in 2017 – is an initiative with more than 320 investors, with $33 trillion in assets under management collectively. The group engages with major global companies which are large contributors to greenhouse gas emissions. It also engages with other firms that face significant opportunities in clean energy to improve governance, curb emissions and strengthen climate-related financial disclosures.
The impact of this shareholder engagement led to Swiss-based commodities giant Glencore announcing that it will cap its annual coal output. It said it would instead focus on commodities such as copper, cobalt and nickel as part of a response "to the increasing risks posed by climate change".5
Demand for coal is slowing
Coal production may have already peaked. Global coal production has recently bounced back, but there are signs that investments in new coal-fired power capacity might have peaked in 2017. Coal plant additions have declined significantly in China in particular. Most countries’ demand is on a downward trend. This downward pressure on demand is being driven by governments striving to meet emission reduction targets and price competition from other sources of energy e.g. the cost of solar power has fallen rapidly in the past decade.
Figure 3: Falling costs have made renewables more competitive
Sources: Bloomberg New Energy Finance, 2016
Figure 4: Levelised Cost of Energy
Sources: Lazard estimates
According to the Carbon Tracker Initiative7, a UK not-for-profit think tank, 42% of global coal capacity could be loss-making today. This proportion could increase to more than 50% by 2030 due to rising carbon prices, renewable energy falling costs, strict air quality rules and greater climate-related regulation.
The situation is different in some developing markets where coal remains a significant, and growing source of power. Most of the growth in global coal production is supplying Asia Pacific economies where there has been five to six-fold expansion over the past 30 years. Asia Pacific now produces more than 70% of coal, up from around 25% in early 1980’s. The average age of a coal-fired plant in Asia is less than 15 years compared with around 40 years in advanced economies. This means that overall industrial coal use could continue to increase slightly into 2040. Power stations using coal are more reliable sources of constant electricity than solar or wind. Advancements in energy technology, such as smart grids, storage/batteries and big data, should allow for integration of renewables which would hasten coal’s demise.
Figure 5: Coal production and consumption by region since 1992
Source: BP statistical review of World Energy 2018
Brown companies financial returns: Academic findings
In academic literature, the effect of environmental performance on a company's financial performance has been studied from two main angles - the financial valuation or realized performance on the one hand, and the cost of capital on the other. Although the empirical results are not unanimous, the consensus is that a positive environmental impact performance influences financial performance.
The effect on the cost of capital was first theoretically established by Heinkel and al. (2001)7 - the cost of capital on companies excluded by green investors increases, compared to the most environmentally sound companies. This result has been empirically supported by several papers, notably by Sharfman and Fernando (2008)8 and Chava (2014).9
More recently, Trinks and al (2018)10 investigated whether Fossil fuel divestment campaigns would have had a material impact on equity portfolio performance. The study found that divested (fossil-free) portfolios would not have significantly underperformed the unconstrained market portfolio. Fossil fuel company stocks have not outperformed other stocks on a risk-adjusted basis and only provide relatively limited diversification benefits.
How we assess coal exposure
Because of the economic and sustainability rationales, we believe our investment portfolios need to be positioned to deal with the anticipated decline of coal use over time. AXA IM’s Climate Risks Policy uses a process with coal companies that adopts a combination of exclusion and engagement. We are a responsible steward of capital and we are committed to utilising our investor rights in a proactive fashion. We engage investee company management in discussions and by voting at shareholder meetings in a way that supports a move to a cleaner energy mix. We consider investor engagement as key tool to help support and accelerate a companies’ transition process.
Companies have a wide range of exposure to coal. Below, we have listed three measures of coal exposure which a company can be assessed by. This proprietary framework combines various criteria. This includes relative and absolute measures, backward-looking performance data and forward-looking assessments. We adopt quantitative data sets and qualitative analysis. This methodology will highlight well-known companies for engagement.
Our investment portfolios exclude electric power generating utilities and mining companies, that are not credibly demonstrating a commitment to energy transition - and which are also:
- Strongly dependent on coal for revenues and/or electric power generation mix (revenue/power mix of more than 30% to thermal coal)
- Largely contributing to coal output (especially coal mining production of more than 20MT)
- Significantly expanding their coal output capacity (coal capacity expansion of more than 3000MW)
The principles of the AXA IM Climate risks policy are available here.
However, we will hold businesses in our portfolios which have coal exposure but are showing an ability to evolve their energy mix - and move towards a strategy, which can support global goals for a cleaner, low-carbon future. This includes engagement with diversified players with low coal dependency, a minimal contribution to global capacity or limited expansion plans.
Investing without coal – impact assessment
We have measured what impact our exclusion list has on various corporate indices, for both equities and bonds. Presently our policy excludes about 2% to 3% of these universes, whatever the asset class, the region and the credit quality.
Table 1: Percentage of index value not impacted by AXA IM Climate risks divestment policy
Barclays Global Corporate Aggregate
ICE BofAML Global High Yield
JP Morgan CEMBI Broad Diversified
MSCI AC WORLD FREE
Sources: MSCI, JP Morgan, BofAM, AXA IM calculations 2019
Looking at investment opportunities cost, we focused our analysis on equity markets. AXA IM’s Climate Risks list is a small portion of the companies, in the global mining, utilities and coal resource sectors. In listed global equity markets, our list represents 11% of these industries, in terms of the number of companies. As highlighted above, the overlap between the Climate Risks list names, and the MSCI All Country World Index, is less than 3% by index weighting.
As shown in the graph below, AXA IM Rosenberg Equities’ analysis highlighted that the predicted returns of the Climate Risks names (as observed on 28 February 2019) were wide-ranging. Some exhibited extremely poor return prospects, while others appeared to have strong potential upside. This range of predicted outcomes mirrors the larger opportunity set and ultimately reflects the fundamental characteristics of each individual stock on a given date.
The key point is that AXA IM’s investment teams still have a wealth of stocks to choose from, even after restricting investment in the inhabitants of the Climate Risks list.
And vitally, our investment universe does not meaningfully change when we omit the the AXA IM Climate Risks list from consideration. This fact, coupled with the sustainability and economic arguments behind coal divestment, suggests to us that the fossil fuel’s days are burning out fast.
Figure 6: AXA IM Climate Risks List as a Proportion of the Global Listed Equity Opportunity Set
Source: AXA IM Rosenberg. All data observed at 28 February 2019. Opportunity set determinations based on Rosenberg industry classifications. While the stock scores (so-called ‘Predicted Alpha’) displayed above may inform investment decisions, they constitute only one of several inputs to our investment process and do not necessarily equate to actual portfolio holdings or realised performance. Please see section entitled Important Information at the end of this document.
Looking to the future
In most climate scenarios, fossil fuels are about to decrease in the energy mix - and coal has no role to play in a low carbon world. Scaling up renewables is an inevitable measure to achieve the -2°C target.
Currently technologies which allow large-scale renewables integration while addressing intermittency issues, including among others, energy storage, distributed generation and upgrading grid infrastructure, are not yet mature, but they are developing rapidly.
The development of new energy technologies such as smart grids, big data and batteries, will in the future allow deeper and wider renewables integration. Some countries are already very ambitious. For example, Denmark plans to have 70% of its energy generation sourced from variable renewables by 2022.
In the meantime, both low carbon and reliable sources of energy can help secure the energy supply during the transition away from highly emitting resources like coal. Notably, the use of nuclear power and a shift to natural gas are also strategies we can, at least temporarily, encourage.
Figure 7: Capacity Factor by Technology (base load factor)
Source: EIA 2015
6 https://www.carbontracker.org/wp-content/uploads/2018/12/CTI_Powering_Down_Coal_Report_Nov_2018_4-4.pdf hts:/www.glencore.com/media-and-insights/news/Furthering-our-commitment-to-the-transition-to-a-low-carbon-economy
7 R. Heinkel, A. Kraus, and J. Zechner. The effect of green investment on corporate behavior. Journal of Financial and Quantitative Analysis, 36(4):431–449, 2001.
8 M.P. Sharfman and C.S. Fernando. Environmental risk management and the cost of capital. Strategic Management Journal, 29:569–592, 2008.
9 S. Chava. Environmental externalities and cost of capital. Management Science, 60(9):2223–2247, 2014.
10 A. Trinks, B. Scholtens, M. Mulder, L. Dam. Ecological Economics 146: 740-748, 2018.
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