There is now a vigorous debate about fossil fuel divestment as a strategy for addressing climate change. But in this increasingly heated debate about pros and cons, we observe that protagonists on both sides sometimes miss critical questions, fail to consider contradictory factual data and gloss over important connections. We believe that exploring this grey zone will uncover hidden common ground that could become the basis for coordinated action.
In this second article in a series of three, we look at what the impact of the divestment campaign could be.
Will divestment affect share price?
Most experts think that the divestment campaign is unlikely to move the price of any major oil and gas (O&G) company, and even less, the profitability of the sector as a whole. There are three main reasons for this:
- Most institutional investors are heavily invested in a passive manner, i.e. they track a benchmark. There is huge resistance to excluding even a few small companies, as the campaign to divest from landmine manufacturers has found. Thus, one could expect well-organised investment industry opposition to removing the O&G sector as a whole. When investors organise in this manner, as they did against the Financial Transaction Tax, this tends to block government action (0).
- Active investors, i.e. those who pick stocks, must operate with a very close eye to benchmarks that assume a high exposure to the O&G sector (e.g. in the UK, the FTSE 100 has a 30% exposure to O&G). Underweighting one O&G stock might well be corrected by, quietly, overweighting another since to underweight the sector as a whole would cause serious tracking error and high volatility against the benchmark. This is a very serious cause of personal and organisational career risk: asset owners routinely sack investment managers for this. Moreover, there is deep-rooted immunity to change when it comes to challenging dysfunctional benchmarks, even where there are very strong financial reasons for so doing (e.g. underweighting banks that are high risk). (1) This is a major obstacle to the “Divestment 1.0” strategy and there seems little appetite, even in the ESG community, to address dysfunctional benchmarks. (2)* Many of the companies with the biggest fossil fuel reserves today are state-owned, and they are largely immune to divestment pressure. The rest get their income and investment money “by selling oil and related products, not by selling stock”. (Interestingly, a report by Oxford’s Smith School which is anti blanket divestment, does conclude that coal companies could be affected by divestment. (3)
Even if direct impact on stock prices is unlikely, there is a possibility of negative market sentiment if mainstream investors start to think that fossil fuel companies’ assets are overvalued. Imagine there was a huge global effort to attack the reputation of company X, and that this did worry investors (“this could affect its license to operate”) and the share price started to fall. In this situation, the company would likely find “immoral buyers” for whom lower stock prices would be attractive (4). It might also become a takeover target for private equity companies and or other low transparency and politically insulated investors (e.g. sovereign wealth funds from non democratic countries). (5) While divestment campaigners might celebrate this “success”, in reality it will have been achieved at the expense of this company in particular and the sector in general being free to do what it does best: operate quietly behind the scenes.
Some argue that it may not be necessary to affect share prices to make a fossil fuel company change its behaviour, quoting how the boycott of companies trading with South Africa did not influence the share price but still caused those companies to use their influence to push for reform. It should be remembered, however, that South Africa was a (small) part of the turnover of the multinationals targeted. Expecting a fossil fuel company to change its core strategy (which would certainly harm its current business model) because of the possibility of small changes in share price or the kind of engagement that happens today seems highly unlikely.
Others argue that as with tobacco, a widespread divestment campaign can contribute to the process of delegitimisation. Whilst it is possible to debate how much influence investors have had, what we can all agree on is that it took parallel action (for example, government action on product labelling and ease of social smoking) to really worry the tobacco companies.
To balance the above, it is also true that even if investors found clever ways to assess eco-efficient alpha and price this in to their share buying decisions, this too would have limited impact because there are a lot of investors who wouldn’t know or care. This is a challenge to those who assert that finding ESG or environmental alpha will inevitably change the outlook of the managers of corporations; their argument seriously underestimates the need for closely co-ordinated and high-profile stewardship work.
So should we be against divestment?
Just as it is wrong to think of divestment as the only or even a “magic bullet” strategy, it is equally wrong – as some investors suggest – that divestment is always wrong. Rather, it is best to see divestment as one tool amongst others. Using it in the right context and at the right time is the key. The obvious case for divestment is coal and this is for hard financial reasons. Its serious negative environmental and public health impacts have long been known.(6) Indeed, the highly respected climate scientist, James Hansen, has said: “Coal is the single greatest threat to civilisation and all life on our planet.” (7) But what is new is that, as the energy mix which has long been entrenched begins to change (8), so market players are now starting to price in risk faced by coal companies. This is clearest in Europe and South Australia where we are now seeing significant disruption to wholesale energy markets from renewables reaching moderate levels. The merit order effect is hitting incumbent utilities hard, as renewables significantly reduce the marginal wholesale price given their near zero production cost. To put it simply, German utilities are experiencing prices that make operating fossil fuel as base load uneconomic. As one leading ESG investment professional has said: “Coal mining share prices have fallen by two thirds in two years. Several oil majors are also seeing their lowest rating against the market for a decade. A wave of new broker research takes a markedly bearish view of the prospects for these sectors, pointing to serious difficulties with their economics, and even, in some cases, suggesting they could be about to go into ‘terminal decline’. (9)
What should investors do?
Prudent investors should be taking action now on companies that have a business model that is manifestly inadequate for the economics of the future markets, since this could affect pricing in the very short term. More medium term, but arguably sooner than the herd currently thinks, investors should be taking action on assets that may become stranded as a result of carbon price or loss of license to operate as a result of social/environmental concerns. As with other behavioural anomalies, once understood they can pretty quickly disappear. It is entirely plausible that as fear of catastrophic outcomes increases, so markets will even lead politicians to price in emissions and this may be much sooner than is built into the mainstream assumptions.Carbon Tracker, the main research group behind the carbon bubble hypothesis, also does not support blanket divestment but rather recommends assertive engagement with fossil fuel companies to stop them from spending capital on new fossil fuel projects and to get them to return it to shareholders via higher dividends or share buybacks. This allows companies to shrink while increasing returns to shareholders. This is becoming known as “Divestment 2.0”. Whilst this strategy is intellectually appealing, it suffers from a major execution challenge: investors today have little incentive to do this kind of detailed stewardship work. Even where it is barn-door-obvious that the incrementalism of “business-as-usual” stewardship is failing – eg the “too-big-to-fail” banks who still pay their staff in ways that offload risk onto society – the investment community largely turns a blind eye to what end beneficiaries really need. For example, not one US bank has faced an investor “no” vote on its say-on-pay resolution. Shifting the same kind of inertia to stranded assets in a portfolio will require considerable campaigner pressure and serious sell side/credit rating analyst attention to the details of this debate.
Another possible use for divestment is to focus on a company that is particularly obstructionist and unresponsive to investor engagement. Big investors have found they have needed to do this on other sensitive issues (e.g. Israeli companies involved in the West Bank) (10) and it may be needed on this agenda too as a signal that stewardship efforts are now much more serious than they used to be. However, thinking that divestment from one major O&G company would, by itself, change the debate is unrealistic. The company would simply acquire an investor base that is either disinterested or even actively supportive of its current strategy. Other O&G companies might also see this as arguably a preferable outcome. As Apple has told its climate change denying investors, and Unilever its short-term investors, if you don’t like what we do, please go elsewhere. Such a divestment campaign would work only if it were combined with high profile investor actions (c.f. hedge fund activism) (11) plus widespread social mobilisation to target that company. Finally it should be remembered that there are financial products, swaps, which have a divestment like impact, at least in terms of hedging risk.(12) Swaps creates the equivalent economic benefit of selling stranded assets at current valuations and investing those proceeds in the
broad equity market. When considering these products it is also useful to remember a warning from McKenzie Funk, the author of “Windfall”: “We are always wowed by the smartest guys in the room…. some of our smartest are developing staggeringly complex plans to deal with what is essentially a problem of basic physics: add carbon, get heat. We should also remember that there is also a genius in simplicity. We should remember that we rarely recognise hubris until it is too late.” (13)
If investors were to divest from fossil fuels, where would they put their money?
Clearly, there is an urgent need for less capital to go to dirty energy and more to clean energy. Some well-intentioned colleagues believe that “there is plenty of money to be made investing in the transition from fossil fuels. While government spending and regulation would undoubtedly make more climate change solutions profitable, many of these investments are viable right now.” (14) And even long-standing sceptics are beginning to change their mind on the economics of wind and solar. (15) But the inconvenient truth is that investing in clean energy has often not proven a successful investment strategy, at least in the way that investment professionalsare measured and rewarded (i.e. risk adjusted returns) and over the usual time periods. Furthermore, the subsidies available to dirty energy remain high, and their political power is strong. On the other side, the price of carbon is low to non-existent. Therefore it is arguably “rational” for investment professionals to ‘act for now’, especially when short-term performance relative to peers is such a dominant part of their remuneration. Good evidence of this uncomfortable reality is that “the biggest and best-known mutual funds that call themselves environmentally and socially responsible also invest in fossil fuel companies.” (16)
Investment in clean energy is critically important. And even more so if, as national security specialists are starting to say, that the peak oil/gas scenario is much closer than we may think. But we need a mobilisation scenario of the kind we had with World War 2 or the Marshall Plan for Europe or the American “Man on the Moon” project. In the current context, there are not enough good assets to invest in if there were widespread divestment. Just because climate change deniers engage in “magical thinking”, this is no excuse for us to do so too. We cover this and related issues in our third article.
Raj Thamotheram is an independent strategic adviser, CEO of Preventable Surprises and a visiting fellow at the Smith School, Oxford University. Antoine Thalmann provided research support for this article.
Tomorrow’s third and final article in our fossil fuel divestment series looks at what should be expected – right now – of investors who have a forward looking definition of fiduciary duty, and how the various stakeholders (advisors, NGOs and governments) could feed into this change.
The Network for Sustainable Markets is supporting an active, positive dialogue on responses to the divestment campaign: to join this dialogue, feel free to contact: Cary Krosinsky
Footnotes for this article can be found on the next page
0. Financial Transaction Tax
1. Personal communication, Paul Woolley, Centre for Market Dysfunctionality, LSE, (March 2014)
2. Smith School
3. Smith School
4. Premier oil case study
5. The author has been unable to find data on what percentage of the O&G is owned by private equity firms and sovereign wealth funds. If readers have such informations, please contact the author direct.
6. Coal not clean
7. James Hansen
9. Craig Mackenzie
10. Israel divestment
11. Hedge fund activism
12. Bob Litterman
13. McKenzie Funk, Windfall: the booming business of global warming, The Penguin Press (2014) p 287
14. Dan Apfel
15. Paul Krugman
16. Marc Gunther