Tackling climate change is a whole of society endeavour. Governments may set targets, taxes and regulations, but a complex mix of decisions by businesses, households and charities will put them into effect. Achievement requires an intersection of economics and ethics, finance and politics.
Investors have an important role to play. In their collective actions, they help shape the relative cost of capital, thereby allocating resources across companies and the economy. Apart from the financial returns they seek, they must increasingly ask, which companies will make most progress fastest towards the goal of carbon neutrality? Does it make sense to invest in new technologies, including unproven ones such as carbon capture? Should we divest from old-fashioned fossil fuel companies? Such questions are at the top of the agenda for many charities, endowments and foundations.
A combination of moral, economic and financial arguments is often put forward for immediate divestment. Moral considerations may preclude investing in fossil fuel producing companies, such as big oil. Comparisons are made with investing in ‘sin sectors’, such as cigarette, gambling, firearms or pornography producers; the businesses may be legal but seen by some as unethical.
The economic arguments are obvious. Fossil fuel production is a classic example of an industry where there are significant externalities. Private profits are made at the expense of public costs. To quote Andrew Hauser at the Bank of England, “there are increasingly persuasive reasons to believe that financial markets are materially under-pricing the cost of emissions, and hence climate risks”.
Financial arguments are also evident. To begin, there is the risk of stranded assets leading to considerable portfolio losses. Studies suggest that 66-80% of fossil fuel reserves need to stay in the ground if a 2 °C climate change target by 2050 is to be achieved. An argument is also made that if enough investors divest, the cost of capital will increase, encouraging companies and their stakeholders to shift production to cleaner sources of revenue.
Yet divestment is not a panacea and other options must be on the table. In many cases, it may be better for investors to engage with company executives to accelerate moves to lower carbon emissions. Asset managers have established Environmental, Social and Governance (ESG) departments with the aim of encouraging higher standards, not just on climate change but across an array of United Nations Sustainable Development Goals. The recent success of activist shareholders at the annual general meetings of ExxonMobil and Chevron, alongside the court case brought against Shell in the Netherlands, may spur companies to transition much more quickly.
It is also worth underscoring that, even under a fast transition scenario, the world economy will continue to use fossil fuels for years to come. Electric cars may soon replace petrol, but heat pumps will more slowly replace gas central heating and the airline industry is years away from sustainable jet fuel. Natural gas will long be the transition fuel to replace coal until renewables reach critical mass. It becomes a rather confused logic if investors boycott swathes of companies, yet at the same time continue to rely on their products and services in everyday life.
A dangerous fallacy of composition also exists. If one investor sells, another buys. Selling bonds or shares does not destroy them. Ownership merely changes hands. Sarah Breeden, executive director at the Bank of England, has noted that “while individual investors can divest, the financial system as a whole cannot.” She went on to highlight that “seemingly rational individual actions” could make the problem much larger.
Indeed, there is a real risk that divestment switches ownership to individuals with ‘lower’ ethical standards compared to those of committed climate change investors. In the case of fossil fuel producers, the problem is even more acute. The 13 largest energy companies globally are owned and operated by governments, while state-owned companies control more than 75% of all crude oil production. Government policy in China and India is leading to a surge of new coal mine projects and power stations. The threat is that divestment will transfer market power to less transparent producers in China, Russia, Venezuela or OPEC members.
How do we balance these moral, economic and financial arguments? In some areas, outcomes are becoming clear. Tar sands and old-line coal fired power stations are at great risk of becoming stranded assets and they are being sensibly excluded from many portfolios. Big oil companies such as BP, Shell or Total are on a path towards becoming renewable energy companies, even if the debate is warranted about the speed of their adjustments.
But the concept of stranded assets needs to go beyond oil and gas and incorporate demand, not just supply. Agriculture accounts for nearly a fifth of greenhouse gas emissions. Major industries, such as aluminium, cement, chemicals and steel production are big emitters that need to accelerate carbon capture or embrace alternative energy sources. Investors focus on fossil fuel producers risks overlooking necessary adjustments required by fossil fuel users.
Investors must grapple with many complex issues as they manage assets. How should they balance social responsibility with their fiduciary responsibility to deliver financial returns? What are the ethical considerations of solar power investing when China is a major producer? How should they balance the small carbon footprint of social media with its dubious social and political footprints? Where should investors draw ethical boundaries?
A major and vital energy transition is taking place. Much rides on the scale and speed of adjustment. Investors have a critical role to play. But it is too simplistic to suggest that divestment is the only answer. To quote Andrew Hauser again, “divestment is a powerful tool and should remain squarely in the toolkit. But it should be used as a credible threat to reinforce incentives, not an indiscriminate quick fix”.
Other tools are needed to ensure a successful transition, such as responsible investment policies directed at reforestation and restoring biodiversity, corporate engagement to lower fossil fuel demand, the development of robust data to measure and reduce portfolios’ carbon footprints, and investor engagement with governments to adopt effective carbon pricing policies.
It is simply not possible for investors to disengage from industries that serve legitimate needs. Energy is crucial to life. To accelerate the switch to energy sources and consumption that pose the smallest risks to humankind, the solution resides in engagement, selective divestment and the curbing of demand through a mixture of taxes and subsidies.
Mitigating climate change demands hard work and clear heads. Well intentioned slogans are not enough.
