Why Everyone's Talking About… Divestment

Divestment’, so the theory goes, reflects the asset owners’ desires to curtail exposure to contentious activities in line with their beliefs, or avoid profiting from specific industries, and it is often seen as the simplest response to stakeholder or public pressure.

For fund managers under pressure to decarbonize their holdings, it offers a quick way to lower one’s portfolio’s carbon intensity. By divesting, you are sending a signal – you are removing your financial stake on the grounds that the company is falling short on its climate commitments, for instance, or is heading irrevocably in the wrong direction in the transition to green energy.

Yet such actions merely shift the carbon from one balance sheet to another – you might simply be handing over your position to a less scrupulous investor.

It’s been argued, for example, that oil giant BP’s sale of its Prudhoe Bay oil field in Alaska oil to the rather more obscure unlisted company Hilcorp may reduce the group’s carbon footprint². But overall, it has increased emissions because the new owners do not have the same incentives to keep their operations clean.

The impact of divesting might not be quite as impactful as intended, either. Research last year from Stanford Graduate School of Business³ demonstrates that divesting from “dirty companies” that fail to meet sustainable investing criteria is not nearly as impactful as its practitioners might like to believe. What’s more, by divesting, you could also be removing the finance that the company needs to make the transition to a greener future – making divestment a lose-lose in the fight against climate change.

If you remain at the table, on the other hand, and continue to engage the board and use your voice, you’ll retain your power to influence and can demand that the company does better. Asset managers call this ‘active ownership’. Indeed, research published by Harvard in 2020⁴ concluded that “exit is less effective than voice in pushing firms to act in a socially responsible manner”

Of all the recent high-profile engagement efforts, the example made of oil giant ExxonMobil might yet prove to be the most pivotal. Activist hedge fund Engine No. 1 managed to get three climate-friendly directors on ExxonMobil’s board after a proxy fight, which many saw as not just as a victory of ‘Sustainable investing over Big Oil’, but a clear-cut demonstration of the power of active ownership.

The company had performed poorly for a decade because it had consistently ignored sustainability issues and was famous for brushing off shareholder concerns about the energy transition⁵, its critics claimed. Engine No. 1 presented the economic argument, using the available ESG data showing that ExxonMobil could improve its long-term returns by reducing emissions and, through their appointments, the new directors imposed green energy experience on the board.

And the event sent shockwaves through the oil and gas industry. If an activist investor could do this to America’s largest oil company, it showed that no company was safe – even beyond the energy sector. Any carbon intensive company understood that what happened to ExxonMobil could happen to them.

Similarly, a climate ruling against oil giant Shell in 2021 was seen by some as a crucial signal that would change the dialogue on a companies’ responsibilities for climate change. Shell lost a landmark ruling in the Netherlands, in which a Dutch court ordered the company to reduce its emissions – a case brought to bear by seven groups including Greenpeace and Friends of the Earth Netherlands.

Although Shell has since filed an appeal against the Dutch court’s ruling, its investors were riled enough at the end of last year to back its plans to relocate its headquarters to the UK from the Netherlands. Moreover, environmental law firm ClientEarth has started legal action against the entire board of Shell.⁶

If nothing else, it shows perseverance and patience is required when it comes to active ownership: Shell’s shareholders tabled a resolution back in 2017 asking the company to establish carbon emission reduction targets. But the case also shows that engagement breeds accountability for company action – or inaction – and that boards with inadequate climate strategies may increasingly find themselves under fire.

One theory goes that as long as there is demand for oil gas and coal, there will be a business in producing it – even if it becomes less profitable because the cost of capital is high. Yet, as Bill Gates put it in a Financial Times comment in 2019⁷: "Divestment, to date, probably has reduced about zero tons of emissions. It’s not like you’ve capital-starved [the companies] making steel and gasoline."

For some investors, however, there comes a point when engagement runs its course – particularly on fossil fuels. Europe’s largest public pension fund, ABP, announced in October 2021 that it will divest from all fossil fuel producers as it sees “insufficient opportunity for us as a shareholder to push for the necessary, significant acceleration of the energy transition at these companies”⁸.

Likewise, the world’s second-largest reinsurer, Swiss Re, said in March 2022 that it would no longer re/insure or directly invest in new oil and gas field projects after this year as part of a strengthening of its fossil fuel policy. It also said that from July 2023 it would halt individual insurance coverage for the world’s top 10% most carbon-intensive oil and gas companies, having banned coverage of the top 5% most carbon-intensive firms since 2021⁹.

Yes, investors need to give companies time to adjust as they transition their business onto a more sustainable path. But at the same time, there should be little compromise with those that don’t take climate change seriously.

Certainly, a tougher approach might be needed with those companies not transitioning fast enough – particular when you consider the landmark report by the UN’s Intergovernmental Panel on Climate Change (IPCC) last year¹⁰, which said “immediate, rapid and large-scale reductions” in emissions were needed to avert a calamitous effect on the planet. ESG investors can ill-afford to drag their feet.

Perhaps it’s more useful to think of engagement and divestment together – two sides of the same coin – rather than an either-or problem. You can have engagement for a while, sure, but unless you are committed to divest, your engagement isn’t credible. Investors should therefore keep the threat of divestment in the back pocket to be used as a last resort.