Is Fossil Fuel Divestment A Bad Idea?

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Despite objections to the contrary from those beholden to fossil fuels, the financial benefit and ethical motivation behind the divestment of fossil fuel investments is not likely to slow any time soon — if ever.

A Global Initiative

The fossil fuel divestment movement has exploded in popularity over the last several years, thanks in parts to the massive efforts of groups like 350.org, the group behind Fossil Free, the organizers of Global Divestment Day. In addition, the sweeping divestment movement is particularly attractive to tertiary education institutions around the world, and each month closes with more universities and colleges around the world announcing their divestment from fossil fuel investments.

Beyond the education world, a number of cities are making independent announcements of their own intention to divest from fossil fuels — the most recent being the city of Oslo, capital of Norway, which announced at the beginning of March that it would divest $7 million worth of coal investments from its pension fund. Oslo joins more than 40 cities around the world to have made similar divestment announcements, and two counties — San Francisco county in California, US, and Dane County in Wisconsin, US. In fact, Fossil Free has a regularly-updated page dedicated to listing the number of divestments, including religious institutions, foundations, and other institutions around the world.

Possibly one of the biggest announcements was Norway’s, made in December of 2014, to begin excluding companies from its sovereign wealth fund deemed harmful to the climate on a “case-by-case basis.” “We believe active ownership and engagement are appropriate primary tools for the [fund] to use to address climate-related issues,” the Ministry of Finance wrote in a press release. Fast forward to February, 2015, and the bank charged with managing the country’s sovereign wealth fund announced that it had divested 49 companies from its investments.

In total (PDF), for 2014, 181 institutions or local governments and 656 individuals divested, representing over $50 billion.

Backed by the UN

Beyond individual announcements, the case for fossil fuel divestment has received praise worldwide — most recently from the UN Framework Convention on Climate Change (UNFCCC). Speaking to the Guardian earlier this month, Nick Nuttall, spokesman for the UNFCCC, said that the UN is supporting the current global divestment campaign:

“We support divestment as it sends a signal to companies, especially coal companies, that the age of ‘burn what you like, when you like’ cannot continue,” said Nuttall.

“Everything we do is based on science and the science is pretty clear that we need a world with a lot less fossil fuels,” Nuttall continued. “We have lent our own moral authority as the UN to those groups or organisations who are divesting. We are saying ‘we support your aims and ambitions because they are fairly and squarely our ambition,’ which is to get a good deal in Paris.”

And Opposed by the Fossil Fuel Industry

Nevertheless, the fossil fuel energy industry has retaliated to the UNFCCC’s decision to back fossil fuel divestment, with the Guardian writing that “the World Coal Association has criticised the UNFCCC’s decision to back divestment, saying it threatened investment in cleaner coal technologies.”

In a statement published in February, the World Coal Association (WCA) wrote that “coal plays a vital role in society by providing 40% of global electricity and as an indispensable ingredient in modern infrastructure.” Benjamin Sporton, WCA’s acting chief executive, commented at the time:

“Calls for divestment ignore the global role played by coal and the potential offered by HELE and CCUS technologies. It is essential that responsible investors actively engage with the coal industry. All low emission technologies are needed to meet climate targets. We cannot meet our energy needs, tackle energy poverty and reduce global emissions without utilising all options available to us, including low emissions coal.”

Continuing the calls for a cessation to fossil fuel divestment, a paper commissioned by the Independent Petroleum Association of America (IPAA) and produced by Professor Daniel Fischel’s consultancy company, Compass Lexecon, argued that “fossil fuel divestment is a bad idea” economically.

The paper’s existence was brought to my attention earlier this month by Jessica Shankleman over at BusinessGreen, who raises a good question: “the release of the paper also begs the question as to why the IPPA is so concerned about the divestment campaign if, according to the research, it won’t affect the group’s share prices?”

The paper, Fossil Fuel Divestment: A Costly and Ineffective Investment Strategy (PDF), is published directly by Professor Fischel, and therefore has not been peer-reviewed, despite being picked up by the Wall Street Journal and headlining a new website set up by the IPAA called Divestment Facts. The paper has similarly been well received by those within the industry.

Fischel, wisely, opens by stating that “before divesting, investors and institutional fund managers should consider the costs of divestiture and the likelihood that divestiture will contribute meaningfully to desirable environmental goals.” However, unsurprisingly, his conclusion is that “the costs to investors of fossil fuel divestiture are highly likely and substantial, while the potential benefits — to the extent that there are any — are ill-defined and uncertain at best.”

“Fossil fuel divestiture is therefore unlikely to pass a cost-benefit test, particularly compared with alternative ways investors who so desire can promote environmental goals.”

However, Professor Fischel makes several unnecessary (yet convenient) assumptions right at the beginning of his analysis, which go a long way to undermining the legitimacy of his findings. Fischel describes “three key types of costs” those looking to divest from fossil fuels are likely to incur:

• Trading costs. Divestiture involves selling certain securities and presumably buying others, both of which involve payment of broker commissions and bid-ask spreads.
• Diversification costs. By restricting the securities that can be included in a portfolio, it is widely recognized that an investor loses the benefits of diversification, suffering lower investment returns for a given level of portfolio risk.
• Compliance costs. Investors must identify the specific securities to be divested from an existing portfolio. Moreover, because firms evolve over time and new investment opportunities arise, there will be ongoing compliance costs to ensure that the portfolio continues to meet the desired standards.

Fischel immediately dives into a vivid and financially-horrifying vision of what can happen to a university endowment if it sees negative returns on its investments. However, the assumption behind the numerous statistics that follow is that there will be a negative return, not that there might be.

In regards to the first two “costs” Professor Fischel highlights, there are several unnecessary assumptions being made: The first is that trading costs have not already been taken into account when an institution or company divests — or that they are not in some way covered by another investment, donation, or that the institution is simply willing to take the financial hit in an effort to make an ethical investment. Secondly, and more long-term than the one-off divestment trading costs, Professor Fischel makes the assumption that fossil fuel investments are inextricably linked with diversification; a more accurate statement is that “an investor decreases the benefits of diversification,” rather than immediately “losing” the benefits. Furthermore, the decrease in benefits resulting from divesting will vary widely depending on a number of varying factors, including investment preferences, the market, etc. To assume that fossil fuel divestment inherently precludes diversification is simply erroneous.

Professor Fischel’s “compliance costs” are a legitimate concern, but one, in the grand scheme of things, an ethical investor is likely to be willing to submit to — especially if alternative investments provide a similar or better return, a likely proposition in a world where the lifespan of fossil fuel-dependent companies is diminishing with each year that passes by.

Other concerns with Fischel’s work have been raised. Quoting Jessica Shankleman’s BusinessGreen article, “critics say Fischel was wrong to base his analysis on the performance of fossil-fuel companies over the past 30 to 40 years when the future value could be very different as a result of the falling costs of renewables and the growing costs of extracting oil.”

Mark Campanale, founder of the Carbon Tracker Initiative, spoke to BusinessGreen, saying that past performance in this case should not be taken as a guide to the future. “That’s the key mistake of this article,” he told BusinessGreen. “It’s a bit like saying locomotives and railroads that made up a huge part of the stock market in the 19th century therefore would have made up a huge part of the stock market in the 20th century, and unless you carried on investing in steam locomotives you would have missed out on all the returns. That’s completely implausible.”

Professor Fischel’s concerns are not likely to go away any time soon, and they are even more likely to be heralded by those within the fossil fuel industry, and those investors intent on remaining involved in the fossil fuel industry, for years to come.

However, conversely, concerns by those such as Mark Campanale are similarly not likely to disappear any time soon, especially as renewable energy continues to grow in size, and fossil fuel divestment campaigns continue to make compelling environmental and financial sense.