Divesting from fossil fuel holdings has significant implications for a portfolio’s structure and risk profile so institutions should implement a bespoke strategy to do it, according to Cambridge Associates.
The last 18 months have been crucial to the divestment campaign, the consulting firm said, as endowments and foundations have increasingly committed to dumping fossil fuel holdings. According to the firm’s data, 11 US colleges and universities—with an average $30 million in assets—have agreed to fully divest as of May 2014. Stanford University also recently announced that it would divest its $18.7 billion endowment from publicly traded coal companies.
“Proponents make both ethical and economic arguments for divestments, seeing the act as a means for an institution to express its view on climate change as well as to reduce financial risks in investment portfolios,” the paper said. “But each institution’s approach will inevitably depend on its particular policies, values, and circumstances. Developing a bespoke strategy gives an institution greater authorship and ownership, which is more conducive to effective implementation and oversight.”
The first step to establishing a custom divestment strategy is to establish a firm social investing policy ensuring appropriate governance and engaging in a dialogue with the institution’s stakeholders, the study found.
The fiduciaries then should analyze the portfolio’s fossil fuel exposure, “both at the manager and total portfolio levels as a mechanism for determining the potential structural magnitude of divestment,” according to Cambridge Associates. The firm found an average of 5% to 10% exposure to fossil fuels.
Most importantly, investors should carefully address portfolio construction challenges they may face, even if divestment is conducted gradually.
Measuring potential portfolio performance impact is crucial, the report found, especially as global energy equities, which are largely made up of fossil fuel companies, represent 10% of the global equity market today.
“Developing a bespoke strategy gives an institution greater authorship and ownership, which is more conducive to effective implementation and oversight,” the report said.
Institutions should also carefully manage transitions for commingled funds, which may require a large move of assets and managers, and are usually accompanied with high transaction costs. There could be potential write-downs, the paper said, if the shift involves dumping of illiquid investments in secondary markets.
Divesting could have significant implications on a portfolio’s diversification, Cambridge Associates said, as it may “inhibit an institution’s ability to diversify risks and opportunities by constraining investments in strategies with distinct portfolio roles such as global equities, diversified hedge funds, and real assets.”
Notable challenges were found in emerging market equities, where fossil-free strategies are severely limited, and energy commodities with investments primarily in fossil fuel companies.
However, alternatives to merely dropping whole sectors exist, the paper said, for institutions unable to execute any level of divesting.
Institutions could try a more nuanced approach by narrowing the scope of divestment, focusing on “excluding the ‘dirtiest’ companies” engaged in coal production. Investors could also reinvest capital from fossil fuel companies into alternative energy sources. According to the paper, the S&P Global Water Index returned 13.4% annualized over 10 years, “outperforming traditional natural resources as well as the broad global equity index.”
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