Report: Assessing the real impact of fossil fuel divestment
Posted on September 4th, 2024
There is a vibrant debate about the appropriate role for asset owners seeking to fulfil their fiduciary duty to clients in the context of sustainability challenges. To help inform the debate in the context of climate change, Border to Coast commissioned a report to provide a perspective on the relative merits of divestment and engagement from fossil fuel companies. The final report, available to read in full here, offers a detailed analysis of the different academic arguments for divestment and ‘myth busts’ a number of preconceptions about divestment and its impact.
The primary sustainability issue being considered by investors is climate change. A key question has been how to deal with fossil fuel companies; some view them as responsible for the climate crisis and want investors to hold them to account. Others say these companies are simply meeting a societal demand and that the best way to tackle climate change is to change demand for fossil fuels. There is also debate about the most appropriate way to hold fossil fuel companies to account: divestment or engagement.
Should investors remain engaged with fossil fuel companies, seeking to use their influence as shareholders to improve the Paris-alignment of these firms? Or should investors instead seek to wash their hands of, or indeed punish, fossil fuel companies by divesting from them, using scarce resources instead to focus on policy advocacy and engagement with heavy users rather than suppliers of fossil fuels? High profile campaigns at various university endowments have led to around two-thirds of university pension plans and endowments in the UK to commit to fossil fuel divestment.
But while divestment is often presented as a high-profile part of a commitment to net zero, there are serious questions as to whether it truly contributes to that goal. Below we present key findings from the report.
Analysing the arguments for divestment
“Fossil fuel companies face stranded assets so should be divested to reduce risk”: Whether fossil fuel companies are risky investments depends on how much of the risk has been factored into prices and whether the market is over- or underestimating the speed of the transition. Financial losses on investments in fossil fuel companies are not inevitable.
“Divesting fossil fuels impacts cost of capital/share prices and so incentivises them to transition”: Divestment does not directly reduce emissions but simply changes their ownership. The act of selling shares could in principle affect share price and cost of capital. However, cost of capital impacts tend to be insignificant and are unlikely to lead to meaningful changes in corporate behaviour; incentives created for executives through share price changes are also unlikely to lead to desired changes, especially if the changes are costly for the company
“Divesting from oil and gas delegitimises the industry”: This argument has some force (based on tobacco experience) but to be successful requires vocal divestment with a clear moral motivation; also, investors need to consider potential negative financial impacts. It is also unclear if delegitimisation could work for an industry as embedded in our way of life as fossil fuels.
“Fossil fuels will never change so we should divest and focus engagement resources elsewhere”: Engagement effort should be focused on where the investor believes it can achieve the greatest impact. But diverting engagement resource elsewhere does not imply fossil fuel assets should be divested; even passive supporters can be helpful to others who do engage.
“…While divestment is often presented as a high-profile part of a commitment to net zero, there are serious questions as to whether it truly contributes to that goal…”
Evidence on engagement
Academic views on engagement: The academic literature provides more support for the impact of engagement than of divestment. Engagement is more likely to be successful if led by a knowledgeable lead investor (in particular, if through a collaborative engagement approach), and if the asks are realistic and aligned with company priorities. There is some evidence that engagement is effective if backed up by a divestment threat (though it must be realistically possible for the company to act to divert this threat).
Impact of engagement on climate outcomes: What constitutes a “success” in academic studies is often extremely modest; it may relate to (potentially undisclosed) milestones set by investors themselves; to disclosure commitments (e.g. TCFD); or to commitments that cannot be tested for some years (e.g. science-based targets). There is little evidence that engagement can achieve major changes in business model that are financially harmful for the engaged company.
Limitations of engagement: These observations suggest the “limitations-aware approach” to engagement is necessary in the climate context, focusing less on cutting fossil fuel production and more on ensuring that the fossil fuels still needed are produced as responsibly as possible, while supporting investment in the transition and the development of over-arching climate policy through work on lobbying and policy engagement.
In summary
The argument that fossil fuel companies inevitably face stranded assets and so should be divested from a risk perspective should instead be viewed as an investment thesis: that the market is underestimating the speed of the energy transition and its effect on fossil fuel demand. Given current valuations of fossil fuel equities, it is not clear that this is the case. Blanket divestment from fossil fuel companies has the potential to create costs for asset owner beneficiaries by reducing the investment opportunity set, especially given the tendency for medium term cyclicality in energy stocks. However, these costs should not be overstated.
Turning to the question of what best helps the transition to net zero, the academic evidence is much more supportive of the impact of engagement than divestment on corporate action, and majority academic opinion would support “voice” over “exit”.
There is very little evidence that divestment can trigger significant change through cost of capital impacts. Instead, the most plausible impact of divestment is through delegitimisation of the divested industries, seeking to undermine political support and create an environment for regulatory change, although by its nature it is hard to find definitive evidence on this. For this channel to be adopted requires divesting institutions to be vocal about the reasons for divestment, often relying on a moral argument.
Multiple studies show engagement has impact and shows respectable success rates, especially for collective engagements. However, overall the evidence suggests that we should be cautious about the extent of that impact. In particular, there is no systematic evidence of investor engagement causing companies to take strong climate action that is against their long-term financial interests. Therefore, to succeed, investors’ engagement asks must be realistic and aligned with long-term value creation pathways.
By remaining engaged investors may be able to help ensure that fossil fuel companies act more responsibly than they otherwise would.
ABOUT DR TOM GOSLING
Tom Gosling is an Executive Fellow at London Business School where he contributes to the evidence-based practice of responsible business by connecting academic research, public policy, and corporate action. He is also an Executive Fellow of the European Corporate Governance Institute, a member of the FCA’s ESG Advisory Committee, and a member of the Advisory Panel and the Stakeholder Insight Group at the Financial Reporting Council. His research interests include responsible investing, corporate governance, and executive pay. He has published on these topics in journals including the Journal of Financial Economics, Human Relations, the Capital Markets Law Journal, and the Journal of Applied Corporate Finance. He has more than 20 years of experience as a board adviser having been a senior Partner at PwC. He has a PhD in mathematics and is a Fellow of the Institute of Actuaries. We would also like to thank Harald Walkate of Route17 for his assistance in writing this report.
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