Climate change: To divest, or not to divest?

1 Jul 2021

For investors working to combat climate change it could pay to keep your friends close, but your enemies closer. Mark Dunne examines the engagement versus divestment debate.

Getting a place at the University of Oxford is not easy. To maintain its reputation as one of the world’s leading seats of learning, the institution only admits the brightest academic minds into its lecture halls. The university is equally selective in deciding what stocks to hold in its £4.5bn endowment fund.

Yet reputation does not drive the Oxford Endowment Fund’s investment strategy, fighting climate change does.

In April last year, the endowment announced that it would no longer invest in fossil fuels in a bid to assist the transition to a carbon-neutral economy.

Oxford’s endowment is not the only institutional investor that has opted to divest from oil and gas to help save the world from life-threatening extreme weather patterns.

It is one of around 1,200 pension schemes, universities and charities collectively managing $14trn (£9.8trn) of assets that have made a divestment pledge. This includes £17bn workplace pension scheme NEST, which announced last year that it would no longer invest in coal mines, oil from tar sands and arctic drilling.

Their concern is understandable. Parts of the world will be uninhabitable if average temperatures continue to rise. “Science tells us that if we want to mitigate the most severe risks of climate change, we need to limit global warming to 1.5 degrees,” says Margaret Childe, head of ESG, Canada for Manulife Investment Management. “Another way of looking at that is a carbon budget of 1.5-degrees, which means cutting 450 gigatons of CO2 by 2050.

“This means we need to rapidly decarbonise the global economy,” she adds. “A 50% reduction in CO2 emissions by 2030 is needed to stay on track for the net zero goal by 2050.” Denying high greenhouse gas emitters capital could make the global economy net-carbon neutral within the next 30 years.

However, some investors believe that the opposite approach could produce better results. Indeed, by investing in fossil fuel extractors, investors can use their influence as shareholders to reduce a company’s harmful emissions or get them to invest in cleaner technologies. Childe prefers the latter route.

“It is not going to be an easy road for oil and gas companies in the transition to net zero,” she says. “It is going to be a bumpy road, but believe divestment is not the solution.

“Investors need to double down on their engagements with the oil and gas sector to provide the real-world decarbonisation we are looking for,” she adds.

It appears that voice strategies are the preferred route to protecting the planet from extreme weather patterns. “In our experience, investors lean towards engagement as a preference over divestment,” says Ian Burger, head of responsible investment at Newton Investment Management.

“Engagement comes in various forms,” he adds. “As an active investor, in our due diligence conducted prior to investing, we may engage with businesses to understand the long-term viability of their model. With that, we can fundamentally avoid those companies which do not recognise climate change or do not have a transition plan.

“As an active manager, due diligence is crucial to helping us avoid the players we do not believe will benefit from a material change in the industry’s outlook.”

Hot air

For Mark Wade, head of sustainability research and stewardship at Allianz Global Investors, starving fossil fuel companies of capital will not assist the transition to a low-carbon economy. “The industry has cut costs to make them more resilient in a lower oil price environment,” he says. “A lot of companies that were breaking even at $50 a barrel now operate at $30.

“In the wrong hands these assets can be run for cash with limited capex to generate significant returns.” To back this up he points to the percentage of North Sea assets in private hands has risen significantly to 30% from 8% during the past 10 years. “The problem with divestment, especially with the current oil price, is that they can finance themselves easily, they can be run for cash and you are not solving the fossil fuels problem.”

To transition to a low carbon economy, brown companies have to become greener. “You get the best sustainability rate of return if you can get high emitters to cut back,” Wade says, adding that investors need to persuade such companies to invest in new technologies and support them on their way to a transitional path. “If that fails, then the question is, should you divest?” he says.

“A couple of years ago ESG was about identifying idiosyncratic risk, today it is about making an impact,” Wade says. “So more people are asking if divestment as a starting point works.”

Side effects

Solving climate change is not just about banning coal. Creating alternative sources of energy by using the sun, wind and biofuels as well as technologies that remove carbon from the atmosphere are part of the challenge.

For Childe, there is one industry that could use its profits to develop such innovations. “Oil and gas companies can provide the significant capital that is needed for such technologies,” she says.

Such an opportunity to create sufficient capacity to stop using oil and gas to power the world would be lost if investors opt for divestment over an engagement strategy as many governments are unable to foot the bill.

“One of the concerns with a climate-first approach is that divestment could lead to unintended con- sequences, such as losing your voice as a shareholder,” Childe says.

Aside from missing the chance to influence some of the world’s biggest polluters, a divestment strategy could have side effects. “Divestment should be a last port of call as there can be unintended social consequences,” Wade says.

“If you look at certain fossil fuel regions, like certain US states or particular geographies globally, to suddenly kill an industry without a regenerative policy or investment plan could mean achieving climate goals to the significant detriment of social goals in specific communities. So, you need to have a transition programme where you take coal away but develop new technologies to even out the social goals,” Wade says.

The problem with a carbon tax is that it is not always clear how it will be socialised. Who will really absorb that cost?

Margaret Childe, Manulife Investment Management

The price of divestment

Another drawback of divestment is that asset managers might have to work harder. Pension schemes have to regularly generate a certain income to pay member benefits. If not, they may be forced to sell assets.

The issue is that oil and gas companies are typically huge dividend payers. Indeed, BP yields 4.6%. So, does divesting from large oil and gas stocks mean sacrificing return?

“It is a short-term view that investors could miss out on income,” Burger says. “We work to understand the total value of an investment.”

Burger points to the tobacco sector as an example. “For 10 years, the value to the underlying investment has been the dividend, otherwise those stocks’ returns would have been flat.

“History cannot be replicated exactly, but it is a notion we consider when looking at companies from a transition perspective,” he says.

Lower dividends could be positive for longer-term investors. Companies returning less capital to shareholders could be a sign of them investing in their longer-term sustainability, according to Wade. He explains that companies have achieved low-cost structures on the back of ESG efficiencies, but with rising transparency they are having to invest in becoming more sustainable.

“What it comes down to is, that to invest longer term and protect capital investors may have to suffer lower dividends,” Wade says. “You have to ask if a company is paying an attractive dividend from sustainable cash-flows.”

Come together

Engagement works. One widely reported example came in 2018 when the Church of England Pensions Board used its voice as a shareholder to convince Royal Dutch Shell to link emission reductions to how much its executives are paid. But this took more than one meeting to achieve. Patience is needed for those following an engagement strategy as a breakthrough could take years.

One innovation mooted by some economists and climate change campaigners that could speed up the engagement process is the introduction of a carbon tax. So, corporates would pay a financial penalty linked to the level of their harmful gas emissions. However, details of how this will work in practice needs refining.

“The problem with a carbon tax is that it is not always clear how it will be socialised. Who will really absorb that cost?” Childe says. “From an investor’s perspective, it could increase the cost of capital for the oil and gas industry, but you do not know to what extent. You need the carrot and the stick when it comes to the policy side.”

An alternative has been institutional investors coming together to create change by speaking with a larger voice. One such pressure group is Climate Action 100+, which has almost 600 members collectively managing assets worth $54trn (£38.2trn). The group has reported some success.

“Although there is still a long way to go, corporates are making some strong commitments,” Childe says.

However, for Burger, the transition to a low-carbon economy cannot be achieved at the corporate level alone. He points to the variety of key stakeholders within that process, including regulators and investors, who need to come together to ensure that there is an effective transition.

This appears to be a popular view. “Climate change is such a systemic risk that it needs to be tackled by all stakeholders,” Childe says. “It is not something industry can do alone; it needs to work with policymakers and the financial sector.”

Wade calls for a broad-based alignment between sovereigns and corporates. “It is great to have a seven foot forward in basketball, but if no one can pass him the ball he is not going to score. Everything needs to be aligned.

“At the sovereign level there needs to be a favourable regulatory, political or consumer framework that supports companies in what they are trying to achieve,” he adds. “At the corporate level it is about making sure that all key stakeholders are aligned with what you are trying to achieve.”

He highlights executive pay as an area where the chief executive’s rewards should depend on the company achieving certain goals. But there is optimism that it will not just be down to providers of long-term capital to facilitate the transition to a net carbon economy.

“Crucially, with Biden on board in the US, there is an opportunity to achieve a global consensus and manage climate change, and to accelerate that low-carbon energy transition,” Burger says.

Yet the size of the task to achieve carbon neutrality within 30 years should not be underestimated, especially as so many actors need to play their role.

“To achieve these goals, which are pretty challenging, everyone needs to be on the same page,” Wade says.

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