Fossil fuel stocks lead the stock market. How clumsy.

It’s no secret that the stock market has been rocky since the beginning of the year. Tech giants like Apple, Microsoft, Google and Amazon have not helped at all. Their stocks have all fallen by double digits.

In 2022, the S&P 500 has fallen more than 13 percent so far, briefly diving more than 20 percent below its peak, sending stocks into bear market territory. As bleak as the stock market is, the situation looks even worse when you’re concerned about the future of the planet. The fact is that only one broad stock sector has delivered consistent returns in the past year: old-fashioned fossil fuels and the companies that extract, refine, sell and maintain them.

When I looked at a performance table of the top companies in the S&P 500 for 2022, I found that 19 of the top 20 spots belonged to companies that were somehow connected to fossil fuels. The top performer was Occidental Petroleum, with a gain of 142 percent.

This is not just an American phenomenon. Saudi Aramco, Saudi Arabia’s national oil company, vies with Apple for the award as the world’s most valuable publicly traded company. For much of the past year, rising oil prices have outpaced the value of silicon chip companies.

If you pay attention to science, this is extremely inconvenient. To cite just one recent, important report, a group of experts convened by the United Nations and known as the Intergovernmental Panel on Climate Change found in February that the world’s cities, farms and coasts are inadequately protected from the threats posed by climate change. entails already including increasingly severe droughts and rising seas. The incessant burning of fossil fuels, the report says, will make matters much worse.

But for short-term investors, energy looks better than ever.

Russia’s attack on Ukraine and escalating Western sanctions are improving the prospects for fossil fuels, Bank of America noted in a report to customers on Thursday. “Our commodity strategists expect that a sharp contraction in Russian oil exports could lead to a full-blown 1980s-style oil crisis,” the report said. “Not owning energy is getting more expensive,” he said. “With the reopening of China, the peak season and favorable positioning/valuations, we are seeing more upside” for energy prices.

Two conflicting goals

This poses a classic dilemma for investors who want to follow the guidelines of a lot of academic research and be fully diversified. I try to do this by putting my money into cheap index funds that track the entire stock and bond markets. These funds are great in many ways. They reduce the risks of specific stock selection – owning the wrong stocks at the wrong time – and of highlighting the wrong sectors at inopportune times.

There is, however, an important catch. Full diversification means owning all sectors and companies, and in today’s environment that certainly includes traditional fossil fuel companies.

What should you do if you accept the findings of science and, moreover, want to follow the orders of your conscience? Let’s say your main concern is clean hands, which for you means you don’t personally benefit from fossil fuels. One thing you can do is exclude fossil fuel stocks from your portfolio. It’s getting easier to achieve, even in 401(k)s and other retirement plans, assuming your workplace plan has a “sustainable” or “socially responsible” investment option.

But by excluding fossil fuels from your investments, you’re missing out on the best performing part of the market.

An easy way to see these costs is to compare two S&P 500 index funds: the SPDR S&P 500 ETF Trust, a regular vanilla fund that tracks the S&P 500, and the SPDR S&P 500 Fossil Fuel Reserves Free ETF. The second fund excludes the well-performing but climate-warming fossil fuel companies.

The difference this year is reflected in their returns. The regular S&P fund fell 13.5 percent, while the non-fossil fuel fund fell 15.1 percent. Ouch!

These performance differences are not the end of the world, you might say, while unrestrained use of fossil fuels could be. You can add that when energy prices were lower, portfolios without fossil fuels sometimes outperformed the more inclusive index. That inequality could increase at some point in the future — one in which fossil fuels are no longer a central part of the global energy mix. Still, there are undeniable costs associated with avoiding fossil fuels.

But beyond the benefits of diversification, there is an argument for owning the entire market, even if you suffer from investments in fossil fuel companies. It is that through share ownership you can try to use your vote to ensure that the companies you invest in behave in ways that you can accept.

That’s easier said than done. As I’ve pointed out, the vast majority of shareholders—those who hold shares through mutual funds, exchange-traded funds, or their retirement plans—cannot vote directly in the policy and governance battles that take place every year in corporate America. Fund managers vote on their behalf, and until recently those managers didn’t bother to ask what shareholders preferred.

Voice experiments

That started to turn into an experiment with Engine No. 1, the activist hedge fund that acquired Exxon Mobil and won a wildly successful battle.

Last June, a coalition of investors led by Engine No. 1 succeeded in replacing three executives on Exxon’s board of directors in an effort to push the company to intelligently transition to a sustainable energy future.

In an interview on Tuesday, Jennifer Grancio, the chief executive of Engine No. 1, that it had won the Exxon battle in large part because the battle was presented as a battle over money, not ethics or social affiliations.

“Fossil fuels are still needed — we know that,” she said. “But we also know that a good company will allocate capital in the right way, towards a transition to sustainable energy. Exxon Mobil didn’t have the right people on the board to do that.”

Ultimately, a business that doesn’t factor in the costs of properly dealing with climate change will not thrive, Ms Grancio said. Those arguments convinced BlackRock, Vanguard and State Street, the major index fund companies that are the largest shareholders of Exxon Mobil and most other publicly traded companies, to side with Engine No. 1 to choose.

Now, with the help of Betterment, an asset management platform, and Tumelo, a British financial technology company, Engine No. 1 asked investors in his S&P 500 index fund, with the provocative ticker STEM, how they would like their votes to be cast.

A question selected by Tumelo and Betterment asked whether fund shareholders supported a resolution calling on Exxon to complete an audited report on the financial implications of achieving net-zero carbon emissions by 2050.

“We received those poll results from Betterment and have taken them into consideration,” said Ms. Grancio. “And we voted for that proxy,” as did BlackRock and other investors. It was passed, although several other resolutions aimed at reducing carbon emissions from energy companies have been unsuccessful.

Just a start

This is still light years away from the direct vote by mutual fund investors that I believe is needed. Still, with such early steps, progress has been made: shareholders ask for what they want and respect their preferences.

“I think the future is when people will have a real voice on these issues,” said Georgia Stewart, Tumelo chief executive. “This is just a start.”

The Securities and Exchange Commission has introduced regulations that require companies to disclose climate-related risks as a matter of course. Many proxy campaigns have undoubtedly initiated the new rules, which some business groups are opposing. The Department of Labor is also considering regulations that would protect pension plan investors from the risk of climate change, while some Washington lawmakers and Republican-controlled state governments have begun to fight climate change disclosure.

These problems will not go away.

I think they are critical to millions of people for whom diversification by owning the total market through index funds makes financial sense. But it is difficult to recommend stocks in fossil fuel companies if the costs of climate change are not fully reflected in the price of energy.

Getting to grips with corporate contributions to climate change will likely require an active role from investors with the will and ability to control corporations and exercise voting rights in internal corporate battles. But it also takes many citizens to influence these issues in the wider political arena.

Shareholder campaigns to shape corporate behavior can only go so far. There are absolutely no proxy campaigns targeting Saudi Aramco or other state-controlled entities that extract energy abroad. Also, proxy voting is not possible among the private companies that have increasingly entered the energy sector in the United States and Canada.

“Climate change is a huge planetary problem that will require decades of sustained effort,” said Boris Khentov, chief of sustainable investing at Betterment. “These problems are complicated and the solutions will be complicated. Putting all the responsibility for changing the world on your investment portfolio is a fundamentally problematic premise.”

There is no magic bullet here and no easy answer for investors. But at least there are signs of progress, at a time when they are all too few.