Why divestment from fossil fuels makes financial sense
As students and faculty at dozens of college campuses call for endowments to divest from fossil fuel companies, this investment manager offers a financial analysis of the divestment decision.
Students at Swarthmore College are in their fourth week of a sit-in to push their college to divest from fossil fuel companies.
Are they right? I recently spent two days with Swarthmore students, faculty, staff and trustees, engaging on the issues of sustainability and divestment. As a longtime investor, including as a former managing director of a fund investing $500 million a year, I offer a perspective from beyond the academic community.
Two years ago, the inclusion of fossil fuel companies in an endowment portfolio was considered a reasonable and prudent position. Today, divestment from fossil fuels — especially coal — appears the more fiscally and morally responsible choice.
The financial rationale for divestment today compared to two years ago includes a greater likelihood that current and future fossil fuel reserves will not be burned. This would drive large valuation reductions of fossil fuel firms. Because fossil fuel companies currently represent a significant percent of most endowment allocations, a large reduction in the value of fossil fuel shares resulting from their stranded assets would result in substantial endowment losses.
In terms of divestment timing and risk, late divesters will experience large losses in capital. From a financial returns perspective, this means that the return upside from fossil fuels is less today than it was two years ago, while the downside risk is larger. This changes the risk return equation for endowment allocations.
The moral arguments for divestment are well articulated by Swarthmore students and faculty — and by students and faculty campaigning for divestment at numerous other colleges — reflecting the accelerating movement toward divestment by higher education institutions. It is clear that Swarthmore students are moral, responsible and engaged — and that these attributes are central to the institution’s excellence.
The moral and responsibility dimensions of the divestment discussion are commonly viewed as more subjective than, and somehow subordinate to, financial prudence questions. In reality, all these aspects of the divestment debate are inextricable.
Let’s start with two points we can all agree on: First, climate change is real and has started to drive large changes in weather, drought and storm frequency and severity. As a result, it is beginning to drive substantial changes in design of cities, emigration patterns as well as in asset allocation towards clean energy, backup power, utility energy mix, shifts in insurance, etc. Second, the reality of climate change on the ground and the greater scientific certainty and consensus on anthropogenic climate change trends strongly indicate that the severity of climate change is even worse than we previously had understood.
I will discuss several arguments against divestment before addressing the case for divestment. These arguments against divestment, increasingly made by organizations — including universities — funded by the fossil fuel industry, are largely wrong.
Fading coal company ROIs
First, it is argued that because the 50-year historical return of fossil fuel stocks has been good, future fossil fuel share returns therefore will continue to be good, and divestment now therefore would lower future returns. However, the last half-century time frame is not relevant to the current climate change divestment and stock price risk.
The relevant stock price return period is the last few years or so, during which time fossil fuel returns — especially coal — generally have underperformed the larger market. Future returns are likely to get even worse. The research arm of Macquarie, a global bank that has heavily financed fossil fuel projects, in a March report describes the future of U.S. coal as “increasingly bleak” and anticipates a wave of future coal bankruptcies.
A related argument is that shifting money from firms that invest in expanding fossil fuel reserves and extraction might reduce financial returns that could fund scholarships and so could hurt the less well-off. The argument that continued investment in coal and other fossil fuel resource firms is today a smart risk-adjusted investment strategy defies common sense — and recent actual stock returns data.
Furthermore, even a minimal review of environmental health impact literature demonstrates that the less well-off disproportionally suffer from air and water pollution and climate change costs resulting from burning fossil fuels. As the Economist noted in its March 28 issue; “coal kills around 800,000 people a year, most of them poor.”
Even a cursory review of the energy labor intensity literature demonstrates that the fossil fuel part of the energy industry is far less labor intensive than renewable energy or energy efficiency, so creates far fewer jobs than a clean energy investment strategy. A realistic assessment is that concern for less well-off should compel rather than restrain a shift away from in coal.
Third, it is argued that re-weighting portfolios to exclude fossil fuels could be expensive both in switching to a new portfolio mix and in terms of ongoing management fees. However, at the scale of a typical university portfolio, and assuming orderly exit over a few years, there is no reason for any increase in fees or costs. A reweighting of investments against fossil fuel-free criteria, especially done in conjunction with other institutions, actually might lower transaction/management fees. This is discussed at more length below.
Fourth, it is asserted that divestment selling off of fossil fuel firms would involve dollar amounts too small to have any material impact and therefore be a pointless gesture. However, divestment decisions by Swarthmore and other leading academic institutions would have a public relations, moral and leadership impact vastly larger than the dollar amount involved, as powerfully demonstrated by the success of the South African divestment movement. The fossil fuel divestment movement increases pressure on energy companies to shift toward cleaner energy.
Oddly, an argument is made that university abstention from divestment does not imply complicity in supporting global warming. But universities spend a great deal of energy managing their investments and the decision to continue to invest in expanding coal and other fossil fuel reserves while a growing number of academic peers divest is — by definition — a deliberate allocation of critical university resources. Active investment is the opposite of abstention.
Finally, there are the well-funded climate change denier arguments — that divestment is not rational because anthropogenic climate change is not yet proven, that climate change may be beneficial, etc. Higher education, of all place, should stand up for the scientific reality of climate change rather than align themselves with deniers and their various arguments. Higher education also must require full academic transparency on fossil fuel industry funded research and articles, and must include policies to remove clear conflicts of interest.
For example, some higher education institutions include as board members people who are professional third party paid managers of college funds that lack fossil-free investment options — and so have a clear conflict of interest.
What stranded assets could mean for fossil fuel returns
The last few years have seen the emergence of rigorous analysis around the argument that in a carbon constrained world, unburnable fossil fuel reserves are stranded assets that will lose value. For example, a recent Forbes piece notes that a “2013 report commissioned by the Associated Press and performed by the research firm S&P Capital IQ found that a university endowment that pulled out of the 200 fossil fuel companies targeted by the divestment campaign would have avoided substantial losses.”
An important threshold in the recognition of fossil fuel asset value risk was the December decision by the Bank of England to “set a new standard for all central banks and financial regulators on climate risk by agreeing to examine, for the first time, the vulnerability that fossil fuel assets could pose to the stability of the financial system in a carbon constrained world.”
In addition to the financial cost of being a late divester, the moral and brand damage to a higher education institution from being a late divester also can be expected to be large. Many of the best and most moral students applying to college today care deeply about the planet and about climate change. And parents generally welcome a sense of broader responsibility in their children.
Higher education institutions that decide to continue to allocate their funds to companies whose business is to invest in and expand fossil fuel reserves and fossil fuel burning are rapidly becoming less desirable to the many students who care about climate change and the future of their planet. Given the passionate and fast growing engagement of students and faculty on campuses across the country on this issue, the university brand protection case for short term divestment is very strong.
The asset of moral authority
A January letter (PDF) by many of Stanford’s faculty to Stanford's president and board of trustees put the issue this way: “If a university seeks to educate extraordinary youth so they may achieve the brightest possible future, what does it mean for that university simultaneously to invest in the destruction of that future?”
A Swarthmore student leader, Stephen O’Hanlon, argued that “as the school where this movement began, the world is watching us. It is unconscionable for Swarthmore … to invest in and legitimize the fossil fuel companies that are wrecking the climate, poisoning communities, and jeopardizing the very future for which our education is meant to prepare us.”
More than two dozen colleges already have committed to divestment, and this movement is growing far more rapidly than the South Africa apartheid divestment movement, which it otherwise closely resembles. Over 1,000 U.S. cities have committed to carbon reduction targets, and many of these can be expected to shift to low or no carbon investments. There are now low carbon investing conferences, reflecting growing interest on the part of fund managers to service this rapidly growing new market.
Despite rhetoric to the contrary, the cost of shifting to a no or low carbon investment strategy can be low or zero. I served as an advisor to Osmosis Investment Management, which launched the first low carbon exchange traded fund, listed on the London Stock Exchange in 2010.
There is now a growing range of low carbon investment options that impose no or very small additional costs. This is typically done either by adding a fossil free screen to an existing managed fund or by tracking a fossil free index. Parametric Portfolio Associates, a $135 billion asset manager, offers the option of adding a low carbon screen to any of its investment strategies. Adding this fossil free screen — developed by a firm called Fossil Free Indexes — adds only 0.05 percent (one twentieth of one percent) to the existing fund fee, for a total annual cost of 0.4 percent.
Fossil Free Indexes also offers a fossil free index based on the S&P 500 that excludes the 26 firms with fossil fuel reserves, and also has a 0.4 percent annual fee. These are relatively low fee options and are probably lower cost than most funds that higher education institutions currently invest in. And increasingly, higher education institutions are investing in solar PV, energy efficiency and other clean energy projects on their own campuses, typically achieving long term financial returns superior to endowment investments made through third party fund managers — while enhancing university operations and providing valuable practical learning opportunities for students.
Divestment is far more likely to enhance than hurt risk adjusted financial returns, and early divestment is a prudent brand protection choice. Divestment is also the morally responsible choice because climate change costs already are becoming enormous, and especially will hurt those who are less well-off.
The rapidly growing divestment movement, with its morally and logically founded demands, exemplifies the qualities of responsibility that great academic institutions welcome and support in their students. On this issue — the defining issue of their generation and many future generations — student divestment advocates clearly are right.