The Doctor Is In

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The Doctor Is In

Divestment as Abdication

“A man must consider what a rich realm he abdicates when he becomes a conformist.” —Ralph Waldo Emerson

CIO914_Angelo_Story It might surprise some readers but the topic du jour for many asset owners—especially American endowments, foundations, and public plans—is fossil fuels divestment. The mere mention of divestment is probably causing some CIOs to squirm in their seats. It conjures up memories of past divestment movements, with their negative screens and the associated slippery slope, and the equally slippery board discussions. Or maybe it brings to mind the YouTube video of Swarthmore students disrupting the college’s intercultural center meeting with their divestment message.

While previous well-known and now well-studied divestment campaigns (e.g., South Africa, tobacco, firearms, and Sudan) sought to address important issues, they also demonstrated that divestment as an investment activity fails. These divestment movements certainly signaled the need for change, but the academic literature unequivocally demonstrates that as investment activities they failed to either impact the share price or borrowing costs of the target companies. According to a study from the University of Oxford, the results of fossil fuel divestment are likely to be the same.

Yet fossil fuel divestment differs in a primordial way from single-issue divestment campaigns because it deals with a temporally exigent, transphenomenal issue: climate change.

The overarching goal of fossil fuel divestment is to reduce anthropogenic greenhouse gas (GHG) emissions to a level that could limit the increase in average global temperature to two degrees Celsius above pre-industrial levels—the estimated ceiling above which we could face catastrophic and irreversible changes in our climate.

Will an asset owner’s divestment of fossil fuel companies help achieve this goal? Not likely. As Gerrit Heyns, co-founder of Osmosis Investment Management, writes in the Journal of Environmental Investing, “Divestment as an investment strategy is inherently flawed… At best, the complete closure of every listed fossil fuel business on the planet would impact less than 70% of the world’s combustible carbon reserves, most of which are held by state-owned companies in largely single-commodity countries. At worst, even nominal success would result in the ownership of listed fossil fuel businesses by more people and institutions that have less interest in protecting the environment, further gridlocking the ability to make changes within these businesses. There may be a sense of political currency, but there is no win for the planet in an institutional divestment strategy.”

However, the suboptimal nature of fossil fuel divestment does not mean that CIOs should ignore the call for divestment. Instead, they should embrace it as an opportunity to prudently address stakeholders’ concerns and achieve an important investment objective.

The meta goal of divestment is squarely aligned with a CIO’s fiduciary duty of constructing and managing a portfolio over multiple time periods to achieve a target return for a given level of risk (within the constraints of the investment policy).

To start, every portfolio is embedded with exposure to carbon and climate, and these exposures—like those to interest rates and inflation—represent existing and future material risks present in every investment decision. The call for divestment should cause CIOs to address these risks with same rigor as they approach other risks: They should be identified, measured, and managed.

The analytical tools that exist could provide such an assessment. But because of reporting deficiencies and the multi-­dimensional nature of carbon and climate risks, they would provide imperfect assessments. But as Voltaire wrote, the perfect is enemy of the good.

With this knowledge, a CIO could stress test the portfolio to see how it might respond to exogenous events like carbon tax in certain countries, government-imposed carbon emission standards (Americans can laugh at this, but it is going to happen), or weakening demand for fossil fuels (which is already occurring in developed nations). These and other such events could negatively impact carbon-intensive companies (think stranded assets). Let me provide a historical analog: In September 2008, you were certainly asked, “What’s our exposure to Lehman?” In the next few years you will almost certainly be asked, “What’s our exposure to carbon?” Forewarned is forearmed.

This assessment and stress test would allow a CIO to revise his or her investment policy to ensure it accounts for carbon and climate risks and, equally importantly, actively supports allocations to low- or no-carbon investments that provide the desired risk/return attributes and result in a direct reduction in GHG emissions.

A final point: By not divesting, asset owners could directly engage with fossil fuel companies, which according to Jack Ehnes, the CEO of the California State Teachers’ Retirement System, is “an effective strategy to mitigate risks, such as climate change… Engagement through educated dialog will be far more productive in accomplishing our goal that these companies publicly price the risk posed by unburnable fossil fuels.”

In the end, a fossil fuel divestment is a signaling device, not an investment strategy. It’s a sell order that fails to bridge the chasm between intention and change. It is more an abdication than a fulfillment of responsibility, eliminating an asset owner’s transformational powers, masking significant investment risks, and diverting resources from finding and funding market-based solutions.

Angelo Calvello , PhD, is CEO of Impact Investment Partners.