The reason why we don't invest in fossil fuels

The pursuit of decarbonization has become an indisputable priority for all responsible investors worldwide, whether they are asset owners or asset managers. In this context, we were one of the 30 founders of NZAM (Net Zero Asset Managers), an initiative that currently brings together USD 60 trillion in assets committed to reducing the carbon footprint of their portfolios.

However, it is imperative to recognize that, despite significant efforts in this direction, decarbonizing portfolios may be insufficient to achieve the more ambitious goal of effectively decarbonizing the real economy.

The strategy of portfolio decarbonization largely focuses on the exclusion or reduction of investments in carbon-intensive sectors or engaging with invested companies to reduce their greenhouse gas emissions. While this approach is crucial for mitigating climate risk in investor portfolios, it faces substantial challenges when it comes to effecting tangible changes in the real economy.

One of the central challenges lies in the deep interconnection between sectors of the economy. Many carbon-intensive companies are integrated into complex and interdependent supply chains. Decarbonizing a portfolio can result in mere shifts of investments from sectors considered carbon-intensive to others, without promoting a real reduction in global emissions. This highlights the need for more comprehensive strategies focused on structural transformations.

Another notable challenge is the continued dependence on fossil energy sources in many regions of the world. Portfolio decarbonization, while crucial, does not directly address the need for accelerated transitions to renewable energy sources in the real economy. Encouraging and financing research, development, and implementation of clean technologies and renewable energy solutions are vital for achieving genuine decarbonization.

Furthermore, in the scenario where responsible investors simply divest their assets, it would only result in a shift of ownership, whereby less responsible investors would end up holding these assets, exacerbating the problem.

Does this make portfolio decarbonization an ineffective strategy?

No. The decarbonization of portfolios is a crucial step in the right direction, mainly for two reasons. The first is fiduciary duty: by adopting ESG criteria, investors are not only making an ethical choice but are also recognizing the risks associated with unsustainable practices. Investing in companies committed to environmentally responsible practices is not just a matter of conscience but a smart strategy to mitigate risks and ensure investment sustainability.

The second reason is that massive divestment by such investors ends up raising the cost of capital for these companies and compressing their multiples, making it challenging for them to obtain capital for expanding their activities.

In our portfolio, by design, we do not have exposure to the fossil fuel production sector, as it does not align with our criteria for environmental responsibility. Here, we take the opportunity to reiterate the rationale behind this positioning.

Our understanding of sustainability involves the importance of a healthy balance among companies and all their stakeholders, including society and the environment. We seek companies that ideally operate within dynamically harmonious economic systems or, alternatively, have a strong culture that values this goal and aims to address any imbalances.

In this sense, the fossil fuel sector has always been structurally at odds with this philosophy. Despite its historically robust profitability, we cannot dissociate it from the significant negative externalities linked to its activities. Abundant scientific evidence available on the impact of fossil fuels on increasing greenhouse gas concentrations in the atmosphere leaves no doubt about the size of the challenge the industry faces. Short-term results are clearly inflated by the fact that companies are not held accountable or charged for the impact of pollution generated by their activities on society.

The transition process from an economy based on fossil fuels to one based on renewable energy will not be fast or linear. These are two distinct business chains with their own supply and demand dynamics that need to be effectively coordinated.

In this sense, it is possible that much of the pressure being exerted by society to restrict oil production may not initially be accompanied by a proportional reduction in its demand, punctually boosting the short-term profitability of these businesses. On the other hand, it seems unlikely that this sector will continue to operate without being properly burdened by the damage caused to the environment. In one way or another, society seems to be gearing up to demand compensation more effectively for this negative externality.

As a reference, a recent study by Climate Analytics[1] estimates that the historical partial damages attributed to the 25 largest CO2-emitting oil companies reached USD 20 trillion between 1985 and 2018. Petrobras, which is part of this group, would be responsible for approximately USD 500 billion of the total.

Despite this, the fossil fuel industry continues to rely on government subsidies that reached their historical record in 2022. These subsidies have been widely criticized by the scientific community and civil society, but their maintenance has given a lifeline to the sector.

An effective mechanism to accelerate the energy transition is the creation of a robust global carbon pricing mechanism through an Emissions Trading System (ETS). Just for illustration, assuming a price of USD 75/ton CO2e (indicated in studies by the International Monetary Fund), the impact would be approximately R$ 18 billion/year for a company the size of Petrobras. However, this path may still take time to be effectively implemented given the challenge of coordinating various distinct interests globally, as seen in the dynamics observed annually in the negotiations at COP (Conference of the Parties).

Another, perhaps faster, alternative could be an increase in taxation. Despite the numerous direct and indirect taxes already imposed on the activity, we see this type of initiative for tax increases gaining momentum even in more mature markets outside Brazil. The concentrated nature of companies operating in the sector, along with their high profit base, makes them ideal targets for this type of measure.

These characteristics are also increasingly placing them in the crosshairs of a third way by which society can seek to charge for these externalities, which is climate litigation. We have observed an increase in climate-related litigation cases worldwide, which are likely to grow even more given the ample scientific evidence related to the issue and its impacts, in many cases already quite evident. In industries such as asbestos and tobacco, litigation in international markets played a key role in addressing their damages and externalities. In Brazil, the situation is no different. Currently, we have approximately 70 cases of litigation related to climate aspects, and society's mobilization on the issue should also help boost this process. For more information on the topic, we recommend watching the webinar "Stewardship to decarbonize, create financial value, and prevent climate risks and litigation in companies" here .

Therefore, we view the segment with great caution, as despite its robust profitability, it faces significant challenges related to the proper pricing of its negative externalities and potentially relevant contingencies related to the issue.

This quarter, we became signatories of Nature Action 100, reinforcing our increasingly holistic view of sustainability. We understand that in a few years, the investment world will move beyond talking about "net zero" carbon to discussing "nature positive," firmly incorporating biodiversity into its analyses; a concept that we want to be committed to from now on.

[1] Climate Analytics “Carbon Majors Trillion Dollar Damages”