On Oct. 8, 2015, California Governor Jerry Brown signed Senate Bill 185 into law, requiring the state’s two public pension funds, CalPERS and CalSTRS, to divest their investments in companies that derived at least 50 percent of revenues from thermal coal.

On Jan. 25, 2016, California’s Insurance Commissioner Dave Jones also urged insurance companies operating in the state to wind down their investments in thermal coal.

Under the proposal, insurers doing business in California with written premiums over $100 million nationwide were asked to divest in any company that generated 30 percent or more of its revenue from the ownership, exploration, mining, or refinement of thermal coal.

Public disclosure

Although this “Climate Risk Carbon Initiative” doesn’t carry a monetary penalty and is strictly voluntary, insurance companies’ choice to comply (or not) will be publicly disclosed.

Given that CalPERS and CalSTRS are the nation’s two largest pension funds managing close to $500 billion in assets, and California insurers collect $259 billion in premiums from the state annually (of which most will be allocated back to investing), the sheer size of this investment pool could foreshadow a bigger trend for incorporating carbon reduction into institutional investing.

For example, in June 2015, Norway’s parliament endorsed the divestment of coal companies from its $900 billion sovereign wealth fund (SWF) — the world’s largest SWF by assets.

2 critical steps

There are two critical steps that insurers must consider before making divestment decisions:

  • Become more aware of companies with exposure to the coal business.
  • Better understand how excluding them historically would have impacted their portfolio performance.

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Mound of coal

Conventional industry classification systems have been widely used to identify coal-exposed companies, but they’re often limited in scope and depth. (Photo: iStock)

Identification of coal-exposed companies

Conventional industry classification systems such as the Global Industry Classification Standard (GICS) or Industry Classification Benchmark (ICB) have been widely used to identify coal-exposed companies, but they’re often limited in scope and depth. In terms of scope, their primary methodology for classifying companies is to assign them to a sector where they generate 50 percent or more of their revenues.

Under this model, companies that generated less than 50 percent of their revenue from thermal coal would be missed, which could prevent insurers from being 100 percent compliant with the “Climate Risk Carbon Initiative” because the divestment requirement starts at 30 percent of revenue.

In terms of depth, both GICS and ICB stop at the general coal level and don’t further differentiate between companies focusing on metallurgical or thermal coal. This means more manual reviews and higher potential costs for insurers to achieve compliance.

Analytical tool available

One can perhaps address both of these shortcomings by using an analytical tool such as FactSet RBICS (Revere Business and Industry Classification System), a multi-dimensional and highly granular industry classification that maps companies to all of their business operations along with their respective percentage revenues.

For example, if a company generates 70 percent of its revenues from oil production and 30 percent from thermal coal mining, GICS or ICB would simply classify it as “Oil Exploration and Production,” leaving out the fact that it also has a significant thermal coal exposure. Hence, investors using this conventional coal exposure identification approach could have mistakenly kept this company from divestment.

RBICS makes both of these revenue streams visible to investors, clearly identifying organizations that should be divested under initiatives like California’s.

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Chart 1 from FactSet

Figure 1. Returns of various coal exclusion portfolios based on Russell 3000. (Source: FactSet)

Looking back five years

As Commissioner Dave Jones explained in his press announcement, a main reason for urging thermal coal divestment is to prevent the “[discovery] in the near future that insurance companies’ books are filled with stranded assets that have lost their value because of a shift away from the carbon-based economy, jeopardizing their financial stability and ability to meet their obligations, including paying claims to policyholders.” But has this been true in the recent past? What would the performance impact to a U.S. stock portfolio look like if coal companies had been excluded in the past five years?

Using the Russell 3000 (R3K) as the base portfolio universe, several coal exclusionary filters were applied via RBICS to test their historical five-year performances. The results are based on returns from Oct. 15, 2010, through Oct. 15, 2015. Returns are based on total returns, including dividends reinvested.

Shown in Figure 1 are the results for four hypothetical insurance company investment portfolios in which we excluded:

  1. All coal-exposed companies in the Russell 3000 (R3K excluding Coal) regardless of the percentage of revenues they received from coal;
  2. Coal-focused companies that received 50 percent or more of their revenues from coal;
  3. All thermal coal-exposed companies; and
  4. Only “focus” coal companies that received 50 percent or more of their revenues from thermal coal.

The back-tested results suggested that excluding all coal-exposed companies in the Russell 3000 for the past five years yielded the best cumulative return at 83.07 percent, followed by excluding only coal companies that received 50 percent or more of their revenues from coal.

The lowest return came from the portfolio that excluded coal companies that received 50 percent or more of their revenues from thermal coal.

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Chart 2 from FactSet

Figure 2. Returns of excluding focus coal and focus thermal coal vs. Russell 3000 from 2010 to 2015. (Source: FactSet)

Doing better without coal

In addition, all four exclusionary portfolios outperformed the Russell 3000 (equal-weighted and rebalanced annually) in the past five years.

Excluding coal companies in the Russell 3000 for the past five years appeared to be improve portfolio performance, even when a more restrictive thermal coal exclusionary filter was applied.

As carbon reduction and environmental, social and governance (ESG) investing become more widely adopted and encouraged by the general public and regulators, the California Climate Risk Carbon Initiative offers a model for the way similar ESG divestment requests could impact insurers in the future.

These initiatives also illustrate why it’s critical for insurers and other institutional investors to access the proper data and analytics to achieve and ensure compliance.

Lauren Kline is vice president and product strategist, Content and Technology Solutions for FactSet. She can be reached at Lkline@factset.com.

Jeremy Zhou is a senior product manager for FactSet and heads the development of FactSet’s proprietary index business. He can be reached at jezhou@factset.com.