Can divestment save us?

Climate activists at the University of Sydney and around the world have frequently argued that investors should refuse to invest in morally compromised or environmentally damaging industries. But is that really effective? What other options do we have?

In recent years, the climate movement has adopted a strategy of pressuring institutions to divest from their holdings of fossil fuel related shares. Divestment is certainly an enticing proposition for otherwise powerless activists – the idea that such a simple financial decision could benefit the climate provides a tangible goal that activist movements can fight for. Contrary to this received wisdom, divestment may at best be an ineffective method of delivering positive climate outcomes and at worst may actively conflict with optimal paths of decarbonisation. The alternative is not to be averse to theories of change that involve finance, but to pursue more effective alternatives like pressuring universities and superannuation funds to engage in shareholder activism. Before commencing the substance of the article, I make one caveat. This discussion of divestment is limited to the questions of institutional investors divesting their shareholdings. Banks (or other debt investors) “divesting” in the sense of refusing to roll over debt commitments, hugely increasing lending premia or otherwise denying credit is a far more effective financial strategy to achieve climate outcomes. Equally, the decisions of ordinary retail investors are irrelevant enough to not matter. 

The divestment movement has been deeply influential on the political culture at the University of Sydney. Recent controversies about the USU’s unwillingness to divest its own fossil fuel holdings cap off a long history of student activists calling on it and the University to go “fossil free”. In the wider world of Australian climate politics, the Environmental Defender’s Office has recently commenced litigation against UniSuper over its failure to divest from Santos, arguing that UniSuper may be in breach of its statutory trustee obligations by holding shares in Santos. Equally, there has been an explosion in the popularity of “ethical” superfunds that do not hold shares in fossil fuel and other “sin” stocks.

Starting from the premise that the holders of these shares are “funding” fossil fuel companies, the divestment movement has argued that the moral obligation of investors is to divest their holdings, stopping the extent to which they finance the likes of Santos, Woodside, Exxon and BHP. But it’s hard to say that these shareholders are “funding” these companies in any meaningful sense. Unless these shareholders are subscribing to new share issues, no money is flowing to the companies that they are supposedly funding. In the event of divestment, the divesting investor (like a university or super fund) sells its shares to someone else. Money passes between the investors (and brokers) that are buying and selling these shares on the secondary market, but the company itself is ambivalent to this transaction.

A better version of this argument for divestment can be constructed if we understand the purpose of divestment as trying to increase the cost of capital for fossil fuel companies. The cost of capital describes how much it costs, on average, for a company to borrow money, and crucially for our purposes, the cost of equity (or return on equity). This latter concept refers to the returns that the company expects to pay to its shareholders. It’s sufficient here to say that a reduction in the company’s share price should also negatively affect its equity cost of capital. New investments should earn more than a company’s cost of capital – if Santos’ cost of capital is 8 per cent, a new gas project that it commissions should earn at least 8 per cent before it is worth investing in. 

If divestment of a particular company’s shares could substantially increase the equity cost of capital, fossil fuel companies should, at the margins, be less likely to invest in new fossil fuel projects. Indeed, the cost of capital for fossil fuels has certainly risen in recent years. Coal is entirely on its way out, and is essentially uneconomical. Publicly listed oil and gas companies have been reporting that the rise of socially conscious investing has created “capital discipline” that impedes their proposed expansion plans. However, it’s dubious whether the divestment actions of individual institutional investors could ever really meaningfully affect the cost of capital of fossil fuel companies. Most holdings of fossil fuels, particularly those targeted by divestment activists, are usually too small for their divestment to matter. In their study of divestment proposals targeted at UK university endowments and public pension funds, Atif Ansar, Ben Caldecott and James Tilbury find that the even if the maximum possible capital was divested by university endowments and public pension funds from fossil fuel companies, their shares prices would be unlikely to suffer precipitous declines. On the other hand, the small group of investors with huge ownership of public equities (namely asset managers like Blackrock and Vanguard) are passive owners, meaning they cannot and will not exit individual firms at will. Jonathan Berk and Jules van Binsbergen have found that under optimistic assumptions, to effect a more than 1 per cent change in the cost of capital, the divesting agents would need to make up more than 80% of all investable wealth in the market. 

In many cases, divestment may be actively bad for the environment. From the point of view of financial theory, purchasing divested stock that may be exposed to climate-related financial risk is not an issue if the purchaser is diversified enough to absorb the risk. The crucial aspect of being a shareholder is that you have rights of control over a company. When an institutional investor divests from a fossil fuel company, these rights of control are transferred to whoever buys the divested shares. This means that the control rights transferred to those on the other end of the divestment transaction, who are presumably less climate conscious than the initial owners. These shareholders can pick up the divested stocks at a short-term discount, exercising their control rights in ways that are actively harmful for the environment. In many cases, the purchasers of these dirty stocks are private owners with very little public or regulatory oversight, creating a problem of “transferred emissions”. These owners rarely have environmental commitments and are simply interested in maximising profits, meaning that they facilitate dirtier practices in oil and gas such as increased methane pollution

The alternative to divestment then appears to be relatively straightforward: shareholder activism. Instead of pressuring climate-conscious investors to give up their seat at the table, activists should focus on getting them to exercise their control rights. Given that almost all existing fossil fuel assets will need to be prematurely retired (or stranded) as part of the climate transition, it is far preferable for the stewardship of this asset stranding to be undertaken by the most climate-conscious investors. Similarly, these investors can push oil and gas companies to return cash to shareholders instead of investing it in new fossil fuel capacity expansion. Activist investors can scrutinise and punish corporate managers who do not adhere to their climate transition plans. I noted earlier that the holdings of institutional investors are usually too small for their divestment efforts to be effective. While this may also be a constraint on shareholder activism, minority shareholders can be a serious thorn in the side of climate-negative managers by moving shareholder resolutions that draw attention to poor conduct and working with other activist investors. This kind of shareholder activism has been successful in the recent past in Australia. AGL’s efforts to spin off its fossil fuel assets into a separate company was defeated by the votes of Mike Cannon-Brookes and industry super fund HESTA, preventing AGL from giving its coal assets a substantially longer life than they otherwise would have. 

Despite the myriad of reasons to be sceptical of divestment as a climate strategy, it does have one obvious upside: publicity. Large divestment campaigns have and will continue to have negative reputational impacts on their targets, and this may sometimes be a reason to persist with them. In those instances where shareholder activism is impossible or continually frustrated, divestment might be a useful reputational threat for climate conscious investors. Regardless, substantial state stewardship will be required for an orderly and successful transition. Even accepting the logic of this article so far, a large public asset manager that could hold shares in fossil fuel companies and manage the stranding of assets and the winding down of these companies. But in our time, it seems unlikely that such an intelligent and straightforward solution would ever happen.