The limits of divestment

Banks need to recognise that climate risks are bigger and more pressing than the central banks’ stress test scenarios suggest, says Mark Cliffe

By Ed Birkett and Benedict McAleenan

October 31, 2021

At COP26, alongside national commitments to “keep 1.5 degrees alive”,[1] companies will be lining up to announce their own Net Zero commitments.

It is easy to be sceptical about these corporate commitments as their scope and robustness varies wildly, from credible plans based on emissions reductions and permanent carbon sequestration to flimsy plans based on business-as-usual plus carbon offsets of sometimes dubious quality.

The weakness of some plans will justifiably fail to placate activists. In response, activists are likely to step up their campaigns for divestment from fossil fuels. In the financial sector, many plans already include divestment (selling off assets that contribute to climate change, for example polluting energy infrastructure). However, the inconvenient truth is that divestment does little to reduce emissions.

Divestment mainly transfers emissions to companies that are less bothered by pressure from activists, so it is the equivalent of hiding the emissions problem under the carpet. Worse, institutions are often congratulated for divesting of existing assets and even rewarded with higher ESG ratings, despite the fact that the operations and underlying economics of those assets largely remain unchanged. Those who hold onto assets with the intention to manage them down in a Paris-aligned timeframe attract criticism.

So, what will actually deliver? As Policy Exchange has previously argued, mandatory “Net Zero transition plans” can be an important part of the puzzle.[2] By standardising reporting and requiring major companies to explain how they intend to reach Net Zero, these plans will encourage companies to do the hard work of actually reducing their emissions, rather than just outsourcing them. Minimum standards for transition plans will ensure that where offsets are involved, they are audited and proven to be high quality.

Transition plans do have weaknesses, but they demonstrate that the green finance industry is maturing, something that should be welcomed. Part of that maturity is an awareness that divestment is often just a gesture, so more nuanced policies like transition plans are needed.

Surface-level success

The divestment movement has had a number of high-profile successes in recent years, securing commitments from ninety UK universities to partially or fully divest from fossil fuels.[3] These victories include a high-profile commitment from the University of Cambridge, which says it “aims to divest from all direct and indirect investments in fossil fuels by 2030”.[4]

Campaigners are now increasingly focusing on pension funds. For example, the campaign group Divest USS is calling for the Universities Superannuation Scheme (USS) to divest from fossil fuels, tobacco and arms manufacturers.[5]USS is one of the largest pension funds in Europe. The campaigns may prove successful in their goals and they contribute to a more hostile market environment for fossil fuel companies, but the real-world impacts on emissions are limited. Losing investors is one thing, losing customers is what matters far more.

Benefits of divestment

There are two main benefits of divestment. Firstly, divestment from listed companies causes a short-term hit to their share prices, which disincentivises CEOs and other corporate leaders from investing in higher-carbon assets.

Secondly, divestment strangles capital from investing in new fossil fuel infrastructure; research from Oxford Universities’ Smith School suggests that this is already happening. The Smith School finds that, in the last ten years, the cost of financing renewable energy projects has fallen significantly, whereas the cost of financing coal power stations has increased by 56% over the same period.[6] Large asset managers are complaining that divestment is partly to blame for a ‘credit crunch’ in oil and gas that is adding to energy supply woes.[7]

This experience demonstrates that the cost of capital for certain types of projects can be increased, but only if the vast majority of funders demand a higher rate of return. For example, China has now committed not to build any new coal-fired power stations abroad. Along with similar commitments from other traditional funders, this commitment will all-but end global export financing for coal-fired power stations, pushing up cost of capital further.

By contrast, there are still many governments and financial institutions that will fund new investment in oil and gas projects; this is one reason why the cost of capital for oil and gas projects has not changed significantly over the last decade.[8]

The limits of divestment

Despite the best intentions of many in the divestment movement, unfortunately there are a number of downsides to the strategy. Firstly, once assets are divested, the firm divesting loses control, influence and oversight of these assets.

The divested assets may be bought by a company in a different jurisdiction or by private owners who are less susceptible to pressure from activists. The divesting companies would have had a far bigger impact on carbon emissions by remaining as an investor and working with other shareholders to force the company to reduce its emissions.

Secondly, divestment risks penalising companies that are making good-faith attempts to manage down existing assets as part of an ordered transition plan (although some divestment decisions do now retain investments in companies that have committed to reduce their emissions). Conversely, divestment risks rewarding companies who abrogate responsibility for their historical emissions and their development of high-carbon assets.

Thirdly, divesting from publicly traded firms doesn’t reduce emissions or change the economics of existing operations. Divestment may drive down share prices but, perversely, this can increase dividend yields for the new owners. Hedge fund manager Crispin Odey recently argued that divestment was creating good investment opportunities for his company, because big institutional investors “are all so keen to get rid of oil assets, they’re leaving fantastic returns on the table”.[9] In addition, a rush into green assets risks creating a “green asset bubble”, which reduces returns for those investors chasing the limited pool of green assets.

Fourthly, divestment could end up penalising developing countries. Even if we don’t like it, these countries may need new fossil fuel infrastructure to provide basic services to their citizens. For example, Egypt has recently completed construction of four huge gas-fired power plants to alleviate ongoing power cuts.[10]

Whilst these plants burn fossil fuels, they are significantly better than relying on coal and, presuming the contracts were structured correctly, can complement renewables by operating flexibly (turning down when it is sunny and turning up during the evening peak). In addition, these power stations could be retired or retrofitted (with carbon capture or efficiency measures) in the 2030s or 2040s, meaning that they could be part of a Paris-aligned transition to a low-carbon and prosperous Egyptian economy.

Taken together, these drawbacks of divestment suggest that a more nuanced approach is required, which is where transition plans come in.

Transition plans

Looking beyond divestment, policymakers are taking a two-stage approach to implementing green finance rules. Policymakers have already agreed to implement disclosure rules such as those recommended by the Task Force on Climate-related Financial Disclosures (TCFD). In June this year, the Finance Ministers of the G7 countries agreed to support a move to TCFD-aligned climate disclosures.[11]

TCFD disclosures will encourage companies to pursue a combination of mitigation and adaptation. However, these disclosures alone are unlikely to be enough to drive Paris-aligned decarbonisation; TCFD is about companies managing their own exposure to risk rather than managing down their existing assets. For example, companies could choose to divest from their more polluting assets, rather than retiring them over time.

Policymakers are now moving beyond disclosures, by requiring companies to implement mandatory transition plans. In March this year, Policy Exchange argued for mandatory transition plans for the most systemically-important companies, [12] an approach that the UK Treasury department is now proposing as part of its “Roadmap to Sustainable Investing”, published earlier this month.[13]

However, transition plans aren’t a panacea.

One weakness of transition plans is that they don’t fully address the risk of companies offloading assets to others (i.e. divestment). Ideally, transition plans should be “asset based”, with companies taking responsibility to manage down and retire their high-carbon assets over time, or at least create stewardship plans to account for retirement.

Secondly, transition plans may require companies to reduce the supply of high-carbon products more quickly than demand reduces. Even when demand for oil and gas falls, underinvestment in new production could contribute to significant price rises, which would hurt energy consumers.

Thirdly, transition plans encourage companies to diversify their operations; for example, transition plans encourage traditional energy companies to develop new businesses in low-carbon industries such as renewable energy. However, this may not be what investors want.

Investors often prefer companies to focus on their core business; investors can then clearly decide how exposed their own investment portfolio is to various risks including climate risks. Responding to this demand from investors, some European energy companies have been split into renewable and non-renewables entities. For example, Uniper was formed when E.ON split off its fossil fuel assets into a new company.[14] In some ways, Uniper is acting a “bad bank” for E.ON’s climate liabilities.

In addition, when companies have tried to diversify, some investors have tried to break them up. For example, Shell claims that hedge funds are trying to split the company into multiple companies, with the oil, chemicals and refining business split from the company’s renewable energy division.[15]

It is a fair challenge from investors when they argue that they should be allowed to choose the exposure of their own portfolio to climate and other risks by investing in a range of specialised companies, rather than Governments forcing all companies to operate in both higher-carbon and lower-carbon industries.

Transition plans must be supported by economy-wide decarbonisation policies.

Despite the good intentions behind divestment, it is clear that it risks concentrating higher-carbon assets in private markets, where investors are under less pressure from activists. Far from harnessing the financial sector to reduce emissions, this risks driving carbon-intensive activity into shadows. Mandatory transition plans are a step in the right direction; however, there are valid questions that are being asked about whether it is right to force companies to hold both higher-carbon and lower-carbon assets within a single portfolio. There is almost certainly more that governments can do to mitigate this risk, for example by supporting the creation of “bad banks”, which would allow and even incentivise companies to spin off higher-carbon assets into specialist vehicles designed to run down polluting assets in a Paris-aligned timeframe.

In any case, it is clear that these “green finance” policies work best when they are supported by economy-wide actions from governments, whether that is regulation on car manufacturers to sell more zero-emission vehicles, or carbon pricing and carbon border adjustments. With a combination of transition plans and decarbonisation policies in place, the financial sector would inevitably play its part in creating the Net Zero economy.

Notes

[1] Cabinet Office (September 2021). Speech by Alok Sharma: Cutting global emissions is essential to keeping 1.5 degrees alive. Link

[2] Policy Exchange (March 2021). Capital Shift. Link

[3] People & Planet (undated). Universities committed to pursuing fossil fuel divestment. Link

[4] University of Cambridge (October 2021). Cambridge to divest from fossil fuels with ‘net zero’ plan. Link

[5] Divestuss.org (undated). Divest USS! Link

[6] Oxford University Smith School (April 2021). Significant fall in cost of financing renewable energy projects. Link

[7] Matt Levine (October 2021). Nobody is Drilling the Oil. Link.

[8] Ibid

[9] Fletcher, L. and Brower, D. Financial Times (October 2021). Hedge funds cash in as green investors dump energy stocks. Link

[10] The Glboal Power & Energy Elites (November 2019). The Global Power & Energy Elites 2020: Projects. Link

[11] Reuters (June 2021). G7 backs making climate risk disclosure mandatory. Link

[12] Policy Exchange (March 2021). Capital Shift. Link

[13] HM Treasury (October 2021). Greening Finance: A Roadmap to Sustainable Investing. Link

[14] E.ON (January 2016). Separation of E.ON business operations completed on January 1: Uniper launched on schedule. Link

[15] Wilson, T. Financial Times (October 2021). Shell warns hedge funds risk derailing energy transition. Link