Ideas Farm: A defence of green investing

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  • Our stock screens like fossil fuels
  • Limits to this analysis
  • Lots of idea-generating content…

Let me make a confession. Since taking over the Ideas section in January, I have felt a bit uneasy about the stock screens I have been tasked with running in these pages.

It’s not that the results for last year’s selections have generally been rough. That’s a function of a bear market, which despite the resilience of major UK share indices is what we have in a raft of sectors. Plus, it’s too late to change last year’s stocks or criteria.

No, the reason for my disquiet is the results the screens keep throwing up. Week after week, heavy polluters and hydrocarbon extractors screen particularly well, and sin stocks have never been too far behind. This week is a particularly egregious example: of the 10 ‘longs’ in our quarterly momentum screen, two are the tobacco giants Imperial (IMB) and British American (BATS) and four – Rio Tinto (RIO), Glencore (GLEN), Shell (SHEL) and BP (BP.) – are among the largest carbon producers in history.

By my rough calculations, of the 333 stocks the past 16 screens have positively selected, around 16 per cent are explorers, producers, or sellers of hydrocarbons.

On a market-weighted basis – which adjusts for company size – that’s not wildly dissimilar to the heft these sectors command in the FTSE All-Share index. Despite efforts to broaden its appeal to innovative ‘new-economy’ companies and entrepreneurs, London’s bourse remains heavily geared to old-economy resources and utility companies.

But on an equally-weighted basis – whereby all equities are treated as one for one, just like our general screening process – stocks listed in the electric utilities, gas distributors, oil and gas producers, oil services and diversified mining sectors make up less than 4 per cent of the total number of companies in the premium market.

Even allowing for our screens’ slight bias towards large-cap and FTSE 100 momentum strategies, our selections are skewing towards oil, gas and coal. For a publication that harps on a lot about long-term sustainable investing, that probably doesn’t sit right for a lot of readers.

The rejoinder to this handwringing is clear: quantitative approaches to investing focus on hard numbers and fundamentals, and generally aren’t very good at factoring ethics into their equations (at least yet).

The long-term success of investors such as Joel Greenblatt can partly be attributed to the way their methodologies cut through ‘irrational’ swings in sentiment. And, windfall taxes notwithstanding, the near-term outlook for non-renewables remains bright. On balance, assumptions that Opec production boosts and Biden’s strong-arming can make up for big looming shortfalls in Russian output – and therefore forestall doomy projections of $175-a-barrel crude – look fragile.

Our screens don’t pretend to have much insight into decade-long trends, or ethical principles. They are, by and large, blunt tools for spotting situations where markets have misidentified near-term prospects and applied too high a discount rate to future cash flows. Right now, oil and gas stocks would seem to meet that criteria.

Green investing, by contrast, is focused on the long term. For all its inconsistencies, incoherence and occasional gimmickry, ESG’s messy promise is to think deeply about what discount rate we should be applying to our collective future. Past a certain point of carbon burning, the wealth of coming generations may not be enough to fix the problems we are creating now.

That might not make it easier for green investors today, staring at rocketing hydrocarbon shares. In 2022, the rubber has well and truly met the road for those hoping to match equity benchmarks while going long on the green economy.

But perhaps markets are waking up after all. According to valuation platform Alpha Spread, investors are applying an 18 per cent discount rate to Glencore shares – roughly double that of AstraZeneca (AZN). When all’s said and done, what is such a high implied level of risk if not recognition that we should stop applying a similarly high discount rate to our children?