Institutional investors should consider replacing fossil fuels with energy-efficient and renewable energy stocks to avoid the pitfalls of increasing regulations around carbon dioxide emissions, according to Impax Asset Management.
Grassroots campaigns calling for fossil fuel divestment and falling demand for fossil fuels could also make reserves less valuable or even render them "stranded" and worthless, it said.
However, some investors worried about the impact of divesting fossil fuel stocks.
Impax modelled a number of alternative portfolio constructions to test the theory that reducing exposure to fossil fuels would increase some risks, particularly tracking error, and have potentially negative impacts on performance.
It found that replacing the fossil fuel energy sector with energy efficiency, renewable energy and other alternative energy stocks, whether passively or actively managed, would improve returns, with limited tracking error over five- and seven-year periods.
Over the last seven years to the end of April 2013, replacing fossil fuels with FTSE's Environmental Opportunities Energy stocks would have made no change to performance, with a minimal tracking error increase of 1.6 per cent.
Replacing fossil fuels with more actively managed and diversified energy stocks had an even greater effect, it found.
Replacement of fossil fuels with an actively managed allocation of stocks selected from a wider range of resource optimisation and environmental investment opportunities such as water, waste management and recycling delivered the highest annualised returns at 2.3 per cent, the highest information ratio at 0.31, with 1.6 per cent tracking error.
Impax said it was logical to conclude that a number of pressures would increase the cost of carbon and reduce the value of fossil fuel stocks.
As atmospheric concentrations of carbon dioxide passed 400 parts per million for the first time in human history in May 2013, even institutions such as the World Bank, the International Energy Agency and the International Monetary Fund expressed concern about the risks of climate change, Impax said.
It cited calculations by Carbon Tracker to show there may be a carbon bubble inflating over the world's stock exchange, as the market value of the largest 200 listed fossil fuel companies does not account for the devaluation of stocks in the event of credible action to address climate change.
The European Union, Australia, California, South Korea and Quebec have all introduced emissions trading schemes (ETS), while China is piloting a number of regional ETS.