Investors are sitting on a time bomb of fossil fuel assets

The world is in the grip of a climate emergency, with the UN Environment Programme saying global carbon emissions reductions must hit 7.6% annually until 2030 to meet the 1.5°C stabilisation target.

SA is warming twice as fast as the global average, with widespread drought hurting farmers and the rural poor. Day Zero — no water in the taps — has already hit several SA municipalities. The developmental gains SA has made over the past decades are all at risk because of climate change.

The crisis is real and the threat imminent. Yet our government speaks with two tongues. It pays public lip service to the Paris climate agreement while also wedging new coal into the latest Integrated Resource Plan (IRP) and making a deal with China for another huge new coal power station in Limpopo.

The failure of the government to lead SA into a sustainable future puts the burden, as usual, on private citizens and our other institutions. Chief among these are SA’s institutional investors, including our universities, which, as centres of climate change research should have the foresight to lead divestment from fossil fuels.

Analysts and the Bank of England have dubbed the risk hiding in fossil fuels the “carbon bubble”. Much of the world’s fossil fuels will have to remain in the ground if we want to mitigate climate change to manageable levels. There is growing evidence that today’s prices do not internalise this risk.

Our universities are sitting on the financial equivalent of a ticking time bomb. And it is not only universities, but all collective investment schemes, pension funds and the Public Investment Corporation (PIC); all have huge exposure to fossil fuels and expose their investors to this mispriced risk.

How do we quantify that risk? Let’s look at two different scenarios for investments: someone saving R50,000 every year for retirement, and an institution managing an already large fund of R1m. In our sample calculation we assume the portfolio will grow in normal times at 6% per year. We compare three scenarios in which a carbon bubble bursts. In the first the bubble bursts after three years, in the second after 15 years. In each case the bursting of the carbon bubble leads to an abnormal return of -10% year on year.

This is large, but in line with losses during the last global financial crisis, when a sizeable bubble in the housing market burst. In the third scenario, this single year of losses is followed by a short and mild recession of -2% growth in the year after the bubble bursts, and +1% growth the year after. After that, we are back to our normal 6% annual growth rate.

In the case of someone who saves R50,000 every year for their retirement, after 25 years their savings alone would be R1.25m. But now the miracle of compound interest kicks in: because they get interest on both the savings and the interest that accrues, the total value of the portfolio after 25 years will be almost R2.9m. So, because of compound interest the portfolio value will more than double. For this reason when asked what he wished he had done differently in his investments, legendary investor Warren Buffett answered: “I wish I had started earlier.”

But what happens when there is a carbon bubble that eventually bursts? If the bubble bursts early, for example three years after you have started saving, you will earn less compound interest. But as it turns out, the overall loss is quite small at 3.26%.

If the bubble bursts late, say 15 years into the saving period, you lose almost four times as much, close to 13% of the portfolio value compared with a scenario without a carbon bubble bursting. If the bursting of the carbon bubble is followed even by a mild recession — as is quite likely — the losses would be even bigger, at almost 25% relative to the scenario without a carbon bubble. These numbers are significant, and can make the difference between a comfortable or precarious retirement.

Now compare this to the case where a collective investment scheme is managing the assets of, for example, the University of Cape Town (UCT). For simplicity, we assume UCT has R1m in assets to invest at a fixed horizon of 25 years. After 25 years this portfolio will have grown more than fourfold thanks to compound interest.

Interestingly, in this case the university doesn’t care when the carbon bubble bursts. The loss is the same, at about 18% relative to a scenario where the bubble doesn’t burst. And again this has only to do with the way compound interest works. What is notable, though, is that the loss in the scenario where the bursting of the carbon bubble is followed by a short recession is almost 33%. This is huge from a portfolio management perspective.

So the trade-off UCT now faces is to assess the probability of a carbon bubble bursting, with the potential losses. A back-of-the-envelope calculation, yes, but one that makes a powerful point: the potential losses due to a carbon bubble can be huge, so investors cannot afford to be lackadaisical about this risk.

But the problem for SA investors who want to divest is that SA asset managers have not yet created a fossil-fuel-free fund. That means consumers are limited in their choices and institutions remain exposed to unacceptable levels of risk.

So what can be done about it? One way to bootstrap a fossil-fuel-free fund in SA is for UCT and other universities to come together and commit a small percentage of their current assets to such a fund. SA’s top universities combined have more than R20bn in their endowments. Just 4% of the total — R800m — could easily seed-fund two or three competing fossil-fuel-free funds and unlock a new era of responsible investment in SA.

Our house is on fire, and there is no excuse for universities to be complacent about the risks that slumber in their portfolios.

• Georg is an associate professor in the School of Economics at the University of Cape Town and holds the SA Reserve Bank research chair in financial stability studies. Le Page is co-ordinator of Fossil Free SA.