Investor responses to the stranded assets concept vary substantially and are predicated on several factors such as their mission and investment goals, investment beliefs, existing portfolio construction, stakeholder and beneficiary views, and fund governance. We do not advocate any particular response but here we summarise the four main responses we see, categorised as: •• Engage – use investor influence •• Adjust Risk – reduce downside risk •• Hedge – increase upside potential •• Divest – avoid stranded fossil fuel assets These strategies are not mutually exclusive and a combination could be employed across the portfolio or within asset classes.

1. Fossil Fuels
Exploring the stranded assets debate
Governments around the world agreed in 2010
to limit global warming to below 2°C relative to
pre-industrial1
levels in order to prevent dangerous
climate change. In order to achieve this, only a
limited amount of carbon dioxide can be emitted
globally until 2050. Some argue this means only
one-fifth of proven fossil fuel reserves can be
burnt, rendering those reserves left in the ground
uneconomical to exploit, hence the term ‘stranded
assets’. This disparity does not appear to be fully
factored in by markets and thus current valuations
of fossil fuel companies may be incorrect. Testing
whether the market is fairly priced is never an exact
science but the magnitude of this disparity would
suggest the risk of mispricing of fossil fuel assets
does exist.
In order to assess whether the stranded asset
argument is real and/or material to an investor it
is important to understand the macro factors that
may influence possible future scenarios. Such
factors include policy, science, technology and social
momentum. An informed view of the interaction of
these factors should allow investors to explore the
distribution of risk in a balanced and holistic manner.
In particular an understanding is required of the
unfolding situation regarding the extent and manner
in which carbon constraints will be applied. It follows
to consider the impact of these constraints on the
economics of the fossil fuel industry. We advocate
assessing the potential impacts throughout the
energy supply chain, and across a broad spectrum of
asset classes.
Should we continue to invest in fossil fuels? Are fossil fuel related
investments compatible with our long-term investment horizon? Will fossil
fuels become economically stranded and as such are they mispriced?
These are the questions we hear institutional investors asking. This paper
aims to help investors begin to assess the issues and provides a framework for
developing an appropriate response.

2. 2 towerswatson.com
This issue is complex with multiple layers of knock-
on effects and varied time-frames making the
investment context no easy conclusion. Should a
situation of stranded fossil fuel assets eventuate,
a shift in the supply and demand dynamics of
fossil fuels could negatively impact the valuation
of reserves causing permanent loss of capital for
investors. Alternatively, if the stranded assets
scenario is anticipated prematurely then existing
fossil fuel reserves may in fact be undervalued. In a
similar vein inertia on the part of policy makers to
constrain carbon emissions could result in carbon
reserves having significant economic value.
It is crucial for investors to explore and define their
beliefs to guide any strategic response particularly
given the levels of uncertainty surrounding the
stranded assets argument. Beliefs are unique to
the investor, shaped by a range of factors, and may
include financial and/or moral beliefs. They may also
be influenced by the portfolio’s existing exposure
to fossil fuel assets, measurement of which has
recently improved and is a critical step for investors
that want to actively monitor and reduce investment
risk presented by climate change.
To date we have seen a variety of investor
responses to the stranded assets concept,
predicated on a range of factors such as their
mission and investment goals, investment beliefs,
existing portfolio construction, stakeholder and
beneficiary views, and fund governance. We do not
believe there is a single correct strategy but we
categorise responses into four main groups (which
are not mutually exclusive):
1. Engage – Investors that believe fossil fuel
assets could become stranded may choose to
use their influence to engage with policy makers
and fossil fuel companies, either directly, via
their investment managers or collaboratively with
other investors.
2. Adjust Risk – Some investors are seeking
to reduce downside risk by adjusting
existing portfolios to reduce the exposure
to carbon-related risks. There are numerous
actively managed strategies run on this basis,
as well as a growing number of ‘low carbon’
indexes.
3. Divest – Some investors have chosen to exclude
fossil fuels altogether from their portfolio
or divest according to certain materiality
thresholds, for a variety of reasons including
moral arguments. The divestment movement has
gained considerable traction in recent months,
with a long list of educational and public funds
choosing this route.
4. Hedge – Alternatively some investors have
focused on capturing the upside potential
of climate change, by allocating capital to
investment strategies specifically designed to
perform well in a low-carbon economy such
as companies involved in energy efficiency,
renewable energy and clean technology.
The broader topic of climate change is gaining
traction globally and political impetus is building with
governments around the world starting to work more
cohesively to reduce carbon emissions. We believe
that institutional investors are likely to experience
greater pressure from a range of stakeholders
to have a defined position on their approach
to environmental issues, such as fossil fuel
investments. The heat has been building from the
media and campaign groups, but is likely to increase
from other investors and beneficiaries. Naturally,
greater interest in such topics and evolving societal
norms also elevate the reputational risks associated
with investors’ handling of such issues.
Regardless of these external pressures, we believe
it is in the interest of investors with medium to
long-term investment horizons to explore the
stranded assets argument in the context of their
own portfolios. Based on a robust assessment of
exposure and their investment beliefs, investors
can identify a pragmatic and proportionate strategic
response to fossil fuel investment.
Mission and
Investment Goals
Investment Beliefs
Portfolio
Construction
Governance
HedgeEngage
Divest
Adjust
Risk
Investment responses based on
the risk of stranded assets
Influences on responses
Measure portfolio
carbon risk exposure

3. Fossil Fuels – Exploring the stranded assets debate 3
Until relatively recently, the issue of climate change
has largely been the domain of policy makers
and civil society, with much attention focused on
attempts to reach a globally binding treaty to reduce
greenhouse gas emissions. However, stimulated by
new research and fossil fuel divestment campaigns,
the investment industry is now being challenged
on the potential risks to long-term returns from
fossil fuel investments, which some argue could,
in part, become economically ‘stranded assets’.
Indeed, in Towers Watson’s 2013 Secular Outlook
report2
we noted that investors should acknowledge
the potential financial impacts of climate change,
including volatile, non-linear and unpredictable
adjustments to fossil fuel asset valuations, and
seek to position portfolios accordingly.
The UN Framework Convention on Climate Change
reached agreement in 2010 that future global
warming should be limited to below 2°C relative to
pre-industrial levels1
in order to prevent dangerous
anthropogenic interference with the climate system.
To put this in perspective, the Earth warmed
0.85°C between 1880 and 2012, according to the
Intergovernmental Panel on Climate Change (IPCC)3
.
In order to keep below the 2°C target, only a limited
amount of carbon dioxide can be emitted globally
between 2000 and 2050; in effect, there is a fixed
carbon budget. Research from a leading think-tank,
the Carbon Tracker Initiative (CTI)4
, concludes that
only one-fifth of proven fossil fuel reserves can
be burnt by 2050 to keep below the 2°C target. If
a portion of proven reserves cannot be exploited
they may become economically stranded as
carbon emissions continue to be cut and the world
transitions to a low-carbon economy. According to
CTI, there are more fossil fuels listed on the world’s
capital markets than we are able to burn if we are to
prevent dangerous and irreversible climate change.
This is the crux of the stranded assets argument;
this disparity does not appear to be fully priced in
by the markets and thus current valuations of fossil
fuel related companies may be incorrect. Testing
whether the market is priced fairly is never an exact
science but the magnitude of this disparity would
suggest the risk of mispricing of fossil fuel assets
exists.
While natural gas and renewable energies will
undoubtedly play a more significant role in meeting
our future energy needs, we will still rely on coal
and oil as overall energy demand continues to rise.
According to the International Energy Agency (IEA),
world primary energy demand will be 37% higher
in 2040 than now. However, in the IEA’s central
scenario, demand for coal and oil will plateau by
2040, at which point world energy supply will be
divided into four almost equal parts: low-carbon
sources (nuclear and renewables), oil, natural gas
and coal5
.
In parallel to the stranded assets debate, a fossil
fuel divestment campaign built on environmental
concerns has resulted in numerous educational
and public funds selling fossil fuel assets. The
confluence of the stranded assets debate and
the divestment movement has stimulated growing
curiosity within the investment community about
the potential risks associated with fossil fuel
investments, and in particular the risk that they
may be mispriced in light of the stranded assets
argument.
The intention of this paper is not to prove or
disprove the stranded assets argument; rather we
consider the potential investment implications and
suggest a framework to help institutional investors
explore, and potentially respond to, questions
around investments in fossil fuels.
Introduction
Total carbon emmissions if current reserves of
fossil fuels are burned
UN carbon budget
2000 – 2050
Carbon already
emitted between
2000 and 2011

4. 4 towerswatson.com
Institutional investors may question whether the risk of stranded assets is real and/or material to their portfolio, and if so
when and how that risk will manifest. To explore this question it can be useful to consider the various factors which might
influence future scenarios. An informed view of the macro drivers should allow investors to assess the distribution of risk
in a balanced and holistic manner. In particular, an assessment needs to be made regarding the extent to which carbon
constraints will be applied, and the impact of these constraints on the economics of the fossil fuels industry. Below, we show
some illustrative (not exhaustive) influencing factors and possible future scenarios, as a representation of various views
across the industry.
Investment Relevance
• Regulations restricting greenhouse gas
emissions
• Policy to support renewable energy industry
Policy and regulation
• Disruptive technological advances in
energy efficiency or renewables
• Quality of responses from fossil fuel
companies – for example, advances in
carbon capture
Technology
• Further scientific evidence or extreme
weather shifts prompting more immediate
reaction from policy makers, consumers
and/or investors
Science
• Fossil fuel divestment campaigns
• Changes in human behaviours and
demands on their governments
• Politics of higher energy costs
Social momentum
Influencing Factors
Potential scenarios
A shift in the supply and demand dynamics of fossil fuels could render those assets uneconomical and
impact the valuation of reserves. This could cause a permanent loss of capital for investors.
Stranded fossil fuel assets
Above scenario may take longer to be realised or may be mitigated by technological advances in
carbon capture. This could mean that reserves are in fact under valued.
Premature anticipation of a stranded asset scenario
Inertia on the part of policy makers to curtail carbon emissions could result in carbon reserves having
significant economic value.
No co-ordinated carbon constraints
Fossil fuel divestment campaigns could stigmatise fossil fuel companies and failure by certain
industries or companies to respond effectively could be detrimental to corporate reputation and
undermine their social licence to operate.
Licence to operate undermined

5. Fossil Fuels – Exploring the stranded assets debate 5
Equity
Public Equity: The intrinsic value of an equity asset is
determined by the net present value of future cash flows and
as a general rule ongoing uncertainty over those future cash
flows can result in lower net present values.
In the case of fossil fuel stocks in a lower emission
scenario investors should consider the implications of
lower demand and prices for fossil fuels. Reserves, capital
expenditure plans and production costs are key inputs in
forecasting cash flows. The potential scenarios highlighted
previously could affect the operating cash flows of resource
companies. The key is to assess how, when and to what
extent cash flows are likely to be affected and whether
management has the ability to respond to these factors to
protect shareholder value.
As an example, a coal company may be able to adapt to
a certain level of government intervention in the form of a
carbon tax. A combination of cost reductions, an increase in
volumes and passing a portion of the cost on to consumers
may allow a coal company to offset the additional cost
from taxes. Thus analysts might only expect a short-term
adjustment in earnings for that company. However a series
of government interventions that were considered severely
restrictive to a coal company might have more far reaching
effects including:
1. The ability of the company to offset those increased
costs may be limited resulting in reduced earnings, and
2. The reduced cash flow and profitability of the company
might impact the ability of the company to attract equity
or debt financing.
In turn the cost of capital applied to the company by the
market may rise which would lead to a reduced net present
value of future cash flows and could permanently depress
the valuation of the stock.
There is a view that a stranded assets situation would
not necessarily be a bad outcome in the medium term for
investments in certain fossil fuel companies: a company
which is not ploughing returns back into new capital
expenditure projects, as they continuously move up the
production cost curve, will be free to distribute returns back
to shareholders in the form of dividends. While the longevity
of the company’s mining activities may be curtailed, the
return to shareholders while those viable reserve assets
are run down may be attractive. Such was the basis for a
resolution put forward by shareholders at a recent Exxon
AGM6
. Thus, understanding expected future cash flows and
the associated timing is important in this analysis.
Industry analysis is also important. As another example,
understanding the players in the resource industry is
relevant in assessing supply scenarios as national
resource companies may respond quite differently to listed
companies. The former has arguably a wider stakeholder
group and consequently different motivations for continuing
operations.
Many corporates already provide carbon footprint reports
both voluntarily and under various regional regulations.
Some companies employ internal carbon pricing metrics
when pricing new projects even though there may not be an
explicit price on carbon emissions in the region of operation.
Engagement with companies by institutional investors to
understand how management anticipates industry changes
should leave the investor better informed of the potential
risks faced.
Current divestment by institutional investors from fossil
fuels is unlikely to have a material impact on overall equity
valuations because the size of the outflows is not significant
relative to the market capitalisation of the industry. Coal
companies are most likely to suffer the direct effects from
the divestment campaign but pure coal companies represent
a small fraction of the market capitalisation of fossil fuel
The Energy Supply Chain
UsersFacilitatorsProducers
Manufacturing
Farming
Commercial
Property
Residential
housing
Pipeline
Ships
Rail
PlanesTransport
TransformersGenerators
Miners
Asset class considerations
The attractiveness of an investment balances risk, reward and portfolio fit. To date, the practice and ability to incorporate carbon-
related risks into financial models has been relatively limited, but is slowly improving as the issue gains greater traction and more
research becomes available. While the stranded assets debate has understandably focused on listed equities, we believe it also
has broader ramifications on investment portfolios, with potential impacts across a range of asset classes throughout the entire
energy supply chain.

6. 6 towerswatson.com
Credit
Corporate Credit: The majority of research assessing
the risk of stranded assets to equity assets would also
be relevant for corporate credit. Crucially an assessment
of whether the credit spread is a fair reflection of the
risk posed by stranded assets is required. There is an
increasing ability to screen or tilt positions across a bond
portfolio according to certain criteria and an increasing
number of thematic indexes that might fulfil an investor’s
desired response to stranded assets. Time horizon is also
an important consideration for credit given the finite life of
the security. For example, if the maturity of a bond is short
enough so that the bond is repaid in full before the asset
becomes stranded then the risk is effectively mitigated,
although the path to maturity could be volatile if credit
spreads widen. It might be useful to think about dynamically
playing exposure to an entity via different mixes of debt and
equity depending on the unfolding environment. However,
taking credit risk relating to this topic is challenging given it
is a common factor risk which is not always easy to diversify
away so one may argue that taking credit risk makes more
sense in other heterogeneous sectors.
Sovereign Credit: Government bonds potentially require
a better understanding of the regulatory environment
within the relevant country with respect to climate change.
Arguably the policy adopted by a country may have a smaller
effect on that country’s bond valuations than the activities
of a company may have on that company’s corporate credit
valuations. However the interaction between domestic public
policy/commitments and global policy is an area investors
who are concerned about this topic may want to monitor
with respect to government bond valuations. It also brings
to the surface an interesting question around who pays –
taxpayers or investors as this could have a material impact
on sovereign debt values depending on the policy response.
Private Credit: The approach to private credit can be similar
to that for public credit markets and equity markets, without
the liquidity. With that said, private credit investments can
include more esoteric investments such as shipping and
aircraft leases, which come with their own challenges but
understanding the business model exposure at the asset
level is the first step in the process. There may also be
opportunities in private credit if we see banks reducing their
willingness to provide financing to certain mining businesses
or pressure on mining businesses leads to non-performing
loans. This in itself could create a supply/demand imbalance
which would see the cost of debt rise for these groups.
In turn such a situation could provide an opportunity for
non-bank lenders to enter the market and fill the void of
banks – not unlike what we have seen with the significant
regulation which has structurally impacted the banking
industry.
companies7
. Indeed even a larger divestment movement
would potentially only have short-term impacts on equity
valuations, as divestment is unlikely to affect the operating
cash flows of the targeted companies and there is likely
to be a neutral or contrarian investor happy to acquire the
divested stock at a temporarily depressed price. Another
consequence of divestment could be an increased cost of
capital at the margin for companies targeted for divestment.
However again there are likely to be other investors willing to
provide funding.
An investor could use the inherent nature of the asset
class (liquidity in the case of equities) to help formulate an
appropriate response to this topic. The liquidity of listed
equities versus private markets would arguably make
it easier in equity allocations to respond to changes in
scenarios and tilt dynamically according to updated risk
assessments.
Private Equity: This can be assessed in a similar fashion
to public equities without the associated short-term noise
of public equity markets. The illiquidity of the asset class
means that more conviction will be required to take a
position designed to exploit the stranded asset theme,
regardless of what the investor believes. For an investor
that believes renewable energy will be a much greater part
of the world’s future energy mix, private equity is ripe for
investment opportunities related to the topic with a plethora
of clean-tech focused private equity funds available for
investment. However private equity investing requires a
greater governance budget as well as potentially high fees
and may not be the most appropriate solution for every
investor. Investors also need to be aware of the potential
risks of being first mover investors in new technologies.

7. Fossil Fuels – Exploring the stranded assets debate 7
Diversifying Strategies
For the purposes of this paper we have focused on the
key diversifying asset classes which form an integral part
of many institutional investment portfolios around the
world, namely real estate, infrastructure and hedge funds.
Diversifying strategies tend to be more concentrated
in terms of asset level exposure – for example, an
infrastructure or real estate fund may only have ten assets
whereas equity portfolios can have many more positions.
Valuation risk needs to be considered for diversifying
strategies in a similar manner to equity and credit.
Infrastructure: Assets such as railways and ports involved
in the transportation of commodities, could potentially
face significant valuation headwinds if certain commodities
become stranded assets. Infrastructure assets are
underpinned by long-term growth assumptions. Given
the current prices being paid for large ‘trophy’ assets,
particularly in countries like Australia, it would appear that
many of these assumptions are quite aggressive. One must
question the longer term use of these assets if a stranded
assets scenario were to play out or further government
intervention were to be implemented (for example, recent
Chinese restrictions on the importation of metallurgical
coal8
). Institutional investors should also question
whether the management teams of these assets have the
appropriate skills to convert assets to alternative uses in a
timely manner should the risk of stranded assets materialise
(for example, converting a coal port to a container port).
There are also opportunities in infrastructure such as
renewable energy which can act as a natural hedge to other
exposures in the portfolio. The viability of renewable energy
projects is predicated on investment and this investment
can be used to further develop the technology supporting
these projects resulting in a rapidly changing environment
in the way in which energy is produced, stored and used.
For example, since the Chinese moved into the market for
solar energy, the price of small scale solar projects has
almost halved9
. This also highlights the early mover risk with
renewables and broader technological advancement – even
if the technology is widely accepted, rapidly falling prices
and technological piggy-backers may result in sub-optimal
returns for first movers.
Hedge Funds: By their very nature hedge funds present
an opportunity to take advantage of the stranded assets
theme. Equity and credit strategies with a particular focus
on momentum and directional trading could target pure play
coal companies should they come under further scrutiny
from the market. Activist equity strategies could also be
used to engage more closely with company management on
the topic, while macro or trend following strategies could be
used to exploit government policy changes. The re-insurance
sector could also be an interesting asset class both from a
risk and opportunity perspective if there is further scientific
evidence linking the impact of weather patterns to climate
change. This could have lasting impacts on the catastrophe
bond market and the broader re-insurance market.
Real Estate: Property is also exposed to the financial
risks associated with carbon exposure although it tends
to be through energy consumption within buildings rather
than direct emissions. Buildings are the single largest
contributor to the world’s greenhouse gas emissions,
using 40% of global energy and generating up to 40% of
carbon emissions10
. The advantages of reduced energy
consumption and greener policies are well recognised
for property assets. There are widely accepted reporting
standards for energy and water efficiency ratings in the
real estate industry (for example, GRESB, NABERS, ABGR
and Green ratings) and in some regions incentives exist to
promote energy efficient buildings. The benefit of greater
energy efficiency is lower operating costs which can make
the building more attractive to potential tenants. Additionally
future rental growth, lower depreciation and the green
policies in place by many corporates contribute to the
attractiveness of energy efficient buildings. Older property
assets, which continue to be large consumers of energy, are
potentially at risk if higher energy prices emerge as a result
of carbon taxes or a reduced availability of economically
cheap sources of energy such as fossil fuels.

8. 8 towerswatson.com
Investor responses to the stranded assets concept
vary substantially and are predicated on several
factors such as their mission and investment goals,
investment beliefs, existing portfolio construction,
stakeholder and beneficiary views, and fund
governance. We do not advocate any particular
response but here we summarise the four main
responses we see, categorised as:
•• Engage – use investor influence
•• Adjust Risk – reduce downside risk
•• Hedge – increase upside potential
•• Divest – avoid stranded fossil fuel assets
These strategies are not mutually exclusive and a
combination could be employed across the portfolio
or within asset classes.
Engage – ‘use investor influence’
Investors that believe fossil fuel assets could
become stranded may choose to use their influence
to engage with policy makers and fossil fuel
companies, either directly, via their investment
managers or collaboratively with other investors.
There is a great deal of collaborative engagement
activity already occurring within the investor
community related to climate change. Therefore
investors adopting this approach may be best
served by joining existing efforts. For example, there
are three key collaborative investor groups (IGCC,
IIGCC, INCR11
), each with a regional bias which bring
investors together to work on the financial risks
posed by climate change and influence public policy,
investment practices and corporate behaviour.
Another example of collaborative engagement
was the Global Investor Statement on Climate
Change which was presented to the United Nations
Secretary General’s Climate Change Summit in
September 2014. More than 360 institutional
investors representing over US$24 trillion in assets
called on government leaders to provide stable,
reliable and economically meaningful carbon pricing
that helps redirect investment commensurate
with the scale of the climate change challenge,
as well as develop plans to phase out subsidies
for fossil fuels. Investors including Blackrock,
CalPERS, PensionDanmark, Deutsche Asset &
Wealth Management, South African GEPF, Australian
CFSGAM and Cathay Financial Holdings have signed
the statement among many others12
.
Adjust Risk – ‘reduce downside risk’
Another strategy being adopted by some investors is
to adjust existing portfolios to reduce the exposure
to carbon-related risks. There are numerous actively
managed strategies run on this basis, as well as a
growing number of ‘low carbon’ indexes.
The Swedish pension fund, AP4, is decarbonising its
portfolio in this way. In partnership with European
asset manager, Amundi, it is reducing the weights
of carbon intensive companies in its passive equity
portfolios while maintaining low tracking error to
the reference benchmark. AP4 has implemented
this approach on approximately US$2 billion of
its assets, and is aiming to decarbonise its entire
portfolio (US$20 billion). Another example of this
approach is by Legal and General Investment
Management which developed a pooled fund
seeded by the BT Pension Scheme. The fund alters
the weights of companies in the FTSE 350 Index
according to their carbon footprint, tilted in favour
of lower carbon companies, but maintaining overall
Investor Responses
Mission and
Investment Goals
Investment Beliefs
Portfolio
Construction
Governance
HedgeEngage
Divest
Adjust
Risk
Investment responses based on
the risk of stranded assets
Influences on responses
Measure portfolio
carbon risk exposure

9. Fossil Fuels – Exploring the stranded assets debate 9
sector weightings as for the FTSE 350 Index13
.
In a similar vein the MSCI Global Low Carbon
Target Indexes overweight companies with low
carbon emissions (relative to revenues) and low
potential carbon emissions (per dollar of market
capitalisation). The indexes are designed to achieve
a 30 basis point per annum ex ante tracking error
target while minimising the carbon exposure relative
to their parent indexes14
.
Hedge – ‘increase upside potential’
Alternatively some investors have placed more
emphasis on positioning portfolios to capture the
upside potential of climate change, as opposed
to managing for downside risks. These investors
have allocated capital to investment strategies
specifically designed to perform well in a low-carbon
economy such as companies involved in energy
efficiency, renewable energy and clean technology. If
such companies thrive in a low carbon environment
they could provide some degree of offset, or hedge,
against climate-related risk on more conventional
portfolios which are exposed to fossil fuels. There
are a numerous such investment strategies, across
a range of asset classes, including both active and
passive approaches.
Examples of funds taking this approach include
Local Government Super (Australia), which invests
approximately 8% of its assets in low carbon
investments. These include equities with low carbon
activities, property, private equity and green bonds.
Meanwhile the UK Environment Agency Pension
Fund is aiming to have 25% of its portfolio invested
in companies and assets that make a positive
contribution to a low carbon and climate resilient
economy by 201513
.
For passive investors there are a number of
indexes which provide exposure to specific market
segments. The FTSE Environmental Markets
Index series measures the performance of
global companies whose core business is in the
development and deployment of environmental
technologies, including renewable and alternative
energy, energy efficiency, water technology and
waste and pollution control15
. Other examples
include S&P’s Global Eco Index which comprises
40 of the largest publicly traded companies in clean
energy, environmental services and water16
and
the MSCI Global Climate Index which is an equal
weighted index of 100 developed market companies
that are leaders in renewable energy, future fuels,
clean technology and efficiency14
.
Divest – ‘avoid fossil fuel assets’
Some investors have chosen to exclude fossil
fuels altogether from their portfolio, for a variety
of reasons including moral arguments. Regardless
of the motivation, the divestment movement has
gained considerable traction in recent months, in
part stimulated by the 350.org campaign focused
on educational and public institutional investors.
In practice divestment may be confined to the
avoidance of coal companies, or may involve a
broader interpretation which excludes all fossil fuel
companies.
The list of institutional investors that have
committed to divest fossil fuel assets is growing;
some examples include Stanford University
(US), the University of Glasgow (UK), Oxford City
Council (UK), City of Moreland (Australia)17
and
the Rockefeller Foundation. The latter announced
in September 2014 that it is working to exclude
coal and tar sands from its portfolio immediately
and will then determine an appropriate strategy for
further divestment of other fossil fuels over the next
few years18
. By contrast, in 2014 the Norwegian
Government Pension Fund reviewed its approach
to fossil fuel investments and concluded that a
blanket exclusion of fossil fuels was not appropriate
but that its guidelines should be amended to allow
companies to be removed from the investment
universe on a case-by-case basis where there is
‘unacceptable’ risk that a company’s actions are
‘severely harmful’ to the climate19
.
To facilitate divestment, index providers have
created fossil-fuel-free indexes. Examples include
the MSCI ACWI ex Fossil Fuels Index which
eliminates 100% of carbon reserves exposure by
excluding companies that own oil, gas and coal
reserves, while the MSCI ACWI ex Coal Index
excludes companies that own coal reserves14
.
Meanwhile the FTSE Developed ex Fossil Fuels Index
Series is a market capitalisation-weighted index
which excludes companies that explore, own, and
directly extract carbon reserves20
.
Investors considering a divestment approach
should be mindful of several issues. For example,
is divestment in the best interests of the Fund’s
stakeholders? Have fiduciaries sought to understand
the views of members? If divestment is pursued,
what exactly will be excluded; coal only or all fossil
fuels? By its very nature, a portfolio which excludes
fossil fuels will differ from its conventional reference
benchmark and as such is likely to possess different
risk-return characteristics. Investors should also
consider the costs associated with excluding fossil
fuels which may include transition costs, or higher
manager fees.

10. 10 towerswatson.com
We believe that institutional investors will
experience greater pressure in the future from a
range of stakeholders to set out their approach
to environmental issues, such as climate change.
These demands are likely to come from the media
and campaign groups, but also increasingly from
beneficiaries as social interest in the topic builds.
Naturally, greater interest in such topics also
elevates the reputational risks associated
with investors’ handling of such issues. This is
particularly so where investors are required to be
more transparent; in Australia for example there are
moves towards disclosure of underlying holdings by
superannuation funds which would enable greater
scrutiny from stakeholders.
We consider that it is appropriate for investors to
have a well-defined position on climate change,
including fossil fuels. Below we suggest a pathway
for establishing this, with which Towers Watson can
assist. The key steps include:
1. Define investment beliefs
Investment beliefs can help guide decision making
when there is a high degree of uncertainty. Investors
could explore and define their beliefs with respect
to climate risks and stranded assets to help identify
the most appropriate response. For example, does
the investor view this as a moral argument, or
are they purely interested from an economic
perspective? Consider the existing investment and
or ESG policy, if one is in place, and how this topic
fits within that framework.
2. Measure carbon exposure
Investors are being encouraged to measure their
carbon exposure across their portfolio. New tools
and methodologies are emerging to assess the
carbon risk embedded in portfolios, particularly in
equity and credit allocations. Institutional investors
may choose to conduct this exercise in-house;
however there are a number of research providers
that have developed proprietary tools for such
analysis that may provide a good alternative.
There are various methods to determine carbon
exposure which makes like for like comparisons
between funds employing different methods
difficult. An understanding of the limitations of
each method is recommended. Some of the more
common practices include an assessment of
carbon emissions. The Greenhouse Gas Protocol
(GHGP) has emerged as the most widely used
framework internationally. The GHGP effectively
categorises emissions as either direct or indirect.
Other techniques measure fossil fuel reserves or the
exposure of a business to fossil fuel production and
Next Steps
1. Beliefs
Facilitate definition of
Fund’s beliefs/position
2. Assess
carbon exposure
Analyse portfolios to
identify exposure
3. Strategy
Evaluate cost
benefit of each
strategy
4. Transparency
Facilitate communication
of approach to stakeholders
5. Monitoring
Periodic review
of beliefs and
impact of strategy
How Towers Watson can help

11. Fossil Fuels – Exploring the stranded assets debate 11
attempt to make a judgement on the materiality of
those exposures according to revenues/market cap
measures or other.
Aggregating exposures at an individual allocation
level can give a view of the total portfolio exposure.
This could be based on greenhouse gas emissions
or another measurement. Another approach from a
total portfolio view would be to depict the spectrum
of exposures represented across the portfolio
varying according to the intensity of the exposure.
The aim should be for the investor to find a
comfortable balance across that spectrum that they
feel reflects the organisation’s beliefs. The spread
should mirror the assessment of the risks to the
portfolio. The ability to handle those investments
from a governance perspective should also be taken
into consideration in this exercise.
The Portfolio Decarbonisation Coalition (PDC) is a
multi-stakeholder initiative encouraging institutional
investors to assess and subsequently decarbonise
their portfolios. One of their main goals is to make
‘carbon exposure footprinting’ common practice.
PDC was co-founded by the UN Environment
Programme Finance Initiative (UNEP FI), the fourth
national pension fund of Sweden (AP4), Amundi
Asset Management and CDP (formerly known as the
Carbon Disclosure Project). The initiative aims to
drive down carbon emissions by mobilising a critical
mass of institutional investors to measure and
publicly disclose their carbon exposure and gradually
decarbonise their portfolios.
We have seen financial regulators apply stress tests
to the banking sector in order to understand the
resilience of the banks. It is important to note that
these tests are not determined by how likely the
regulators consider the scenarios to be but rather to
understand the areas of vulnerability. Institutional
investors could take the same approach. Using a
variety of scenarios an asset owner could consider
how the portfolio would be positioned from a risk
perspective in those situations. Using managers to
explain how companies in the portfolio are set up to
deal with the internalisation of environmental costs
for example could be helpful.
A number of frameworks have been developed to
allow fossil fuel companies to report their carbon
emissions using quantitative and qualitative
information21
. Quantitative information includes
emissions by value chain stage, assumed emissions
based on current production and reserves,
and contribution of clean energy technologies.
Qualitative information includes the analysis of
climate change policies, the demand outlook and
requires the consideration of the physical effects
of climate change on the business’ operations. The
information provided can help investors understand
the underlying risks involved in investee companies.
3. Implement appropriate strategy
Based on an investor’s climate related beliefs and
their current portfolio exposure, an appropriate
strategy can be selected and implemented. In the
table below we map some possible responses
according to various beliefs.
Illustrative Beliefs
Divest Adjust Risk Engage Hedge
Conviction Example
Very strong
There is an
unacceptable level of
risk to asset values and/
or desire to avoid fossil
fuel investments for
non-financial reasons
Divest fossil fuel assets
to the greatest possible
extent
–
Engage with policy
makers to accelerate
the transition to a low
carbon economy
Invest in assets
expected to perform well
in a low carbon economy
Strong
There is a high chance
of re-pricing of fossil
fuel assets over the
short/medium term
–
Re-weight portfolios
significantly away from
fossil fuels
Engage with companies/
policy makers relating
to remaining fossil fuel
assets
Possibly invest in assets
expected to perform well
in a low carbon economy
Medium
There is a chance of
re-pricing of fossil fuel
assets but unsure of
timing
–
Re-weight portfolios
moderately away from
fossil fuels but maintain
some exposure to
benefit from potential
upside in medium term
Possibly engage with
companies/policy
makers relating to
remaining fossil fuel
assets
Possibly invest in assets
expected to perform well
in a low carbon economy
Weak
There is no significant
risk of re-pricing of fossil
fuel assets at any time
– – – –

12. 12 towerswatson.com
4. Be transparent
We see increasing levels of transparency relating
to investors’ position on fossil fuels, which in part
is stimulated by engagement initiatives such as
the Asset Owners Disclosure Project (AODP)22
. The
AODP focuses on improving disclosure and conducts
a survey of the world’s largest 1,000 asset owners
(pension, superannuation, insurance and sovereign
wealth funds) with respect to their management of
climate risks, the results of which are published in
the AODP Global Climate Index. The UK Environment
Agency Pension Fund currently occupies first place
in the index; it has been conducting annual carbon
footprints for several years and its overall footprint
has reduced by 39% since 200823
. Recently it
commissioned Trucost to assess the embedded
carbon emissions in the fossil fuel assets held
in the equity portfolio to identify the potential for
stranded assets24
.
Another example of an investor promoting greater
disclosure is The Pensions Trust in the UK which
requires its hedge fund managers to report quarterly
on the Fund’s underlying exposure to companies
in six of the most carbon intensive sectors.
This information helps the Trust to monitor its
exposure to climate risk and participate in relevant
engagement activity13
.
While we welcome greater transparency the timing
of communications and the extent of transparency
should be considered carefully. Any communication
of a commitment should reflect the ability of the
asset owner to implement the policy in practice. The
reputational risk associated with failing to adhere
to one’s own policy on fossil fuels should not be
underestimated.
5. Monitor and review
Any response adopted should incorporate a regular
review process to monitor the progress and status
of the chosen strategy. We would suggest:
1. Reviewing the thesis for the response adopted
and ensuring that conviction in that belief
remains;
2. Comparing the performance of the portfolio
against expectations and objectives; and
3. Considering valuation metrics relevant to assets
in the portfolio that are particularly exposed to
the stranded assets theme to assess whether
particular opportunities have become attractive/
unattractive over time.
Further Information
If you would like to discuss any of the areas
covered in more detail, please contact your
usual Towers Watson consultant.

13. Fossil Fuels – Exploring the stranded assets debate 13
References
1 UN Framework Convention on Climate Change
(UNFCCC), The Cancun Agreement 2010.
2 Global Investment Committee, Secular Outlook 2013,
Assimilating Thematic Thinking, Towers Watson.
3 Observations: Atmosphere and Surface, 2013.
Available at: http://www.climatechange2013.org/
report/full-report/
4 Carbon Tracker Initiative (CTI) is a not for profit
financial think-tank aimed at enabling a climate secure
global energy market by aligning capital market actions
with climate reality. The CTI team comprises financial,
energy and legal experts with a ground breaking
approach to limiting future greenhouse gas emissions.
CTI provides information, research and events to
educate and empower all the key decision makers and
groups.
5 World Energy Outlook 2014, International
Energy Agency, 2014. http://www.iea.org/
newsroomandevents/pressreleases/2014/november/
signs-of-stress-must-not-be-ignored-iea-warns-in-its-
new-world-energy-outlook.html/
6 2015 Shareholder Resolution Exxon Mobil, Arjuna
Capital and As you Sow at the request of Capital
Distribution/Carbon Asset Risk, 2014. Available at:
http://www.asyousow.org/companies/exxon-mobil/
7 Stranded assets and the fossil fuel divestment
campaign: what does divestment mean for the valuation
of fossil fuel assets?, University of Oxford Smith School
of Enterprise and the Environment Stranded Assets
Programme, 2014.
8 “Coking coal - also known as metallurgical coal -
is mainly used in steel production”, http://www.
worldcoal.org/coal/uses-of-coal/
9 “China-US deal is a tipping point for carbon policy”,
The Australian Financial Review, Friday 12 November
2014.
10 The Business Case for Green Building, Green Building
Council of Australia, 2013. Available at: http://www.
gbca.org.au/resources/gbca-publications/green-
building-evolution-2013/
11 The Investor Group on Climate Change (IGCC) brings
together investors from Australia and New Zealand;
the Institutional Investors Group on Climate Change
(IIGCC) is a forum of predominantly European investors
with over 90 members with €7.5trillion in assets; and
the Investor Network on Climate Risk (INCR) is mainly
a North American focused network of institutional
investors with over 100 members with over $13 trillion
in assets.
12 http://investorsonclimatechange.org/
13 Financial Institutions Taking Action on Climate
Change, IIGCC, INCR, IGCC, AIGCC, UNEP FI
and PRI, 2014. Available at:
http://www.investorsonclimatechange.org/
14 http://www.msci.com/products/indexes/esg/
environmental/
15 http://www.ftse.com/products/indices/env-markets
16 http://eu.spindices.com/index-family/environmental-
social-governance/green-investing/
17 http://gofossilfree.org/commitments/
18 http://www.rbf.org/content/divestment-statement/
19 http://www.ipe.com/10005429.article?utm_
source=Newsletter&utm_medium=Email&utm_
campaign=IPE_Daily/
20 FTSE Developed ex Fossil Fuel Index Series, FTSE,
2014. Available at: http://www.ftse.com/products/
indices/dev-ex-fossil-fuels/
21 Global Climate Disclosure Framework for Oil & Gas
Companies, IIGC, Ceres and IGCC, 2010.
Available at: http://www.igcc.org.au/page-1357360/
22 http://aodproject.net/
23 Strategy to address climate risk, The Environment
Agency Pension Fund, 2014.
Available at: http://www.eapf.org.uk/
24 Stranded Assets: fossil fuels, Trucost, 2014. Available
at: http://www.trucost.com/published-research/128/
strandedassets/environmentagency/

14. towerswatson.com
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