Wednesday, February 11, 2015

The Feel-Good Folly of Fossil-Fuel Valuation

Mother Nature Says "Divest!"
(So do Black and Scholes.)
If the people who organized Global Divestment Day are looking for a sign that they're getting under the skin of the oil industry, they need look no further than yesterday's Wall Street Journal.

In "The Feel-Good Folly of Fossil-Fuel Divestment," Daniel R. Fischel summarizes a white paper written by his firm and financed by the Independent Petroleum Association of America: “Fossil Fuel Divestment: A Costly and Ineffective Investment Strategy.”

Fischel provides a very interesting argument about why universities, despite their possible wish to appease student activists, shouldn't divest from fossil fuel companies. It goes something like this:

Fossil fuel companies are more like "the market in general" than like any other sector in particular.

As everyone knows, investors are wise to diversify, so that they are not over-exposed to any particular market sector.

The more fossil fuel stocks you have, the wiser you are (because the more your portfolio will resemble a diversified one). Conversely, the less fossil fuel stocks you have . . . well . . . you get the idea . . . .


The readers of the Journal are likely to recognize this as an analysis that has something to do with correlation -- "alpha" and "beta" and the "capital asset pricing model (CAPM)" -- and if this recognition brings back painful memories of business school finance classes it would be hard to fault them for deciding to simply call it a day and just give Mr. Fischel the benefit of the doubt.

Perceptive readers, however, will stop to ask, "What's the real correlation that's at issue here?"

The Wrong Correlation

The premise of the analysis presented by Fischel is that diversifying market risk is the greatest challenge university investment offices face, and that the historic correlation of fossil fuels stocks to possibly risky market sectors is what matters most. (This might be called "avoiding bad alpha.")

But far more important is the future correlation of fossil fuel stocks to generalized, systemic risk in the market, and their negative correlation to the few sectors of the market that stand apart from that risk.  (This might be called "avoiding bad beta.")  Specifically: as the world economy faces a carbon bubble, fossil fuel stocks are likely to go into free fall, and since fossil fuel stocks constitute such a large part of the overall market beta ain't gonna be doing too well, either.  ("Highly correlated," remember?)

Mr. Fischel might assert that I have no way of really knowing if and when fossil fuel valuations are going to go into the toilet. And you know what? I completely agree.  But you see, his is the argument that depends on the proposition that fossil fuel asset valuations are predictable: "load up on lots of fossil fuel stocks, and stay away from instability."  Mine is the argument that is consistent with a high degree of fossil fuel asset valuation uncertainty: "avoid fossil fuel stocks (after all, at best they're little better than a diversified portfolio of other sections."

The reason university (and other) investment offices should divest from fossil fuel stocks is: they provide overly-large exposure to risk. Raising awareness of this is the real point of Global Divestment Day.

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