Over the last few years institutional investors and those who advise them have had to confront the question of disinvestment or engagement. As regular readers will be aware, we sit firmly in the camp which says that engagement is more likely to produce meaningful results. It gives better alignment with fiduciary duty and is also more likely to make a real difference to the planet. Recent events at Exxon and Shell encourage me.
We have not changed that fundamental view one whit, but it is also clear that there is a broad spectrum of actions which investors are choosing to take. As the new Task Force on Climate-related Financial Disclosure (TCFD) legislation starts to loom large, we discuss the risks and benefits of disinvestment as a response.
The fiduciary contract an investing institution has with its stakeholders is a matter of considerable importance in this respect. An investor managing their own assets, or even an endowment, has some defence for taking any action, whatever the result in financial terms, so long as they are investing in accordance with their stated objectives. However, a pension fund’s fiduciary responsibilities are greater, and boards have to be confident that stakeholders share their views before taking any decision with the potential to increase risk. Generally, the default position has to be to tread conservatively and in a considered way.
Secondly, one of the fault-lines in the debate is how urgent an issue climate change is seen to be. For activists, the benefits of taking more aggressive action may be considered to outweigh the risks involved. However, while agreeing on the ultimate objective, investors with fiduciary duties will want to deliberate carefully in order to avoid hasty action which may turn out to cause financial detriment.
One argument for a faster move today is the requirement for major investors to make greater disclosures as part of the TCFD’s recommendations. These include disclosure, not just on the metrics used, but also on how climate-related risks will be managed, what the longer-term strategy is, and the overall governance surrounding this.
This greater level of disclosure is welcome (even with the caveats on the data scoring mentioned below) but will lead to some serious questions. Many institutions, when they do the work, will find that their carbon emissions are higher than expected. We would not be surprised if some respond by choosing to disinvest. However, we also question whether this is an appropriate response. It may make the metrics look better, and possibly reduce a fund’s exposure to climate-changed financial risk in the short-term. But it has some significant negatives too.
First, we need to be clear what is meant by disinvestment. Is it a formal decision to exclude, or an active decision not to invest? Forever, or simply for now? There will be a few companies whose activities are so far beyond the pale that it is not controversial to consider them outside a responsible investor’s universe. But for many, such as the oil majors, their current activities may be considered undesirable, but they have scope for change. The classic example here is the Danish company Orsted, originally Danish Oil and Natural Gas, but now a renewable energy darling – even if it still produces natural gas. Total's rebranding may be a step on the same path.
We would argue that a blanket decision to disinvest from oil companies ‘forever’ simply cuts off a potential option. Academic theory teaches that an option can never have a value of below zero, so the holder is better off with it than without it. Not all oil companies will make the transition, but those who do represent an option with real value, as Orsted did 15 years ago. Investors may not wish to invest in them today, but to avoid losing the value of these options blanket exclusions should be avoided.
The converse of this is that decisions whether to disinvest need to be made at the company level. For active managers, this will be part of their normal process of screening their universe, unless of course the underlying owner has made exclusions when agreeing the investment mandate. They will be able both to disinvest from individual companies, and also reinvest if and when there has been a shift in their behaviour. In our view, allowing analysts to make these decisions is likely to lead to the best results, and active management is in principle well placed to invest in a responsible way. We should be clear that we am not suggesting all active managers are perfect in practice.
If, however, the governance structure is such that exclusions are driven by the underlying asset owner, whether via choice of index in a passive mandate or by virtue of the agreed mandate, they or the index-provider will have to take the responsibility for monitoring the list of exclusions at the company level on a regular basis, or alternatively paying somebody else to do that.
This is where we begin to disagree with the disinvestment thesis. There is plenty of academic literature to point to the arbitrary nature of ESG scoring, even for metrics which might be considered reasonably objective, such as greenhouse gas emissions.
The randomness comes from a host of factors: the data is historic; it is neither verified nor in many cases standardised; it can be influenced by the company paying for the data; in the case of carbon emissions any attempt to measure Scope 3 is bound to be based on heroic assumptions (how far are you going to drive your brand new car?); and when we move on to the S and the G it becomes even more subjective. Witness the different views on what is socially acceptable in China, the U.S. and Europe, for example.
The science of ESG scoring is undoubtedly developing, and there are passive (in the sense that their allocations are driven by algorithms rather than humans) funds with innovative approaches to the problem. But the upshot is that for almost all companies the answer is too complex to be encapsulated in a simple decision to or not to disinvest. That is even before assessing how to weight conflicting signals from different metrics.
That is why there is a clear risk of financial detriment when index funds or asset owners use ESG scoring to make exclusions. The randomness of the scoring means that they will inevitably throw some babies out with the bathwater. If investors choose to take this route, they should at least do so with the input of a knowledgeable company analyst to add context.
We next question what an investor achieves from a policy of disinvestment. Their portfolio’s carbon metrics will look better, but by definition another investor’s will look worse, so it will not help the planet. In practice, the point is often made that it will do the opposite because the new holder is less likely by definition to have the same ESG focus.
Disinvestment may help mitigate a portfolio’s financial risks in the short-term, but as argued above by cutting off options and using backward-looking and often subjective data will increase portfolio risk in the longer term. In my view the strongest argument for excluding, whether formally or as an active investment decision, a company is to send a signal that its activities or behaviour is unacceptable. This may have a positive effect (Deliveroo?), or it may not (Sports Direct).
On the other hand, the case studies for engagement are considerably stronger. The election of two (and possibly more) directors from activist hedge fund Engine No.1 to Exxon last week was driven by institutional investors. The hedge fund itself has a stake of less than 0.1% of the company. Most oil majors have now set carbon-free targets. One can argue about their sincerity in achieving them, and that the job is far from finished, but there is no doubt that engagement is having an effect in changing their business models.
In summary, we would argue that while some investors may choose to use disinvestment as one of their tools to improve their own portfolio’s short term carbon metrics, particularly with TCFD on the near horizon, the financial risks of doing so need to be borne carefully in mind. A policy of engagement, or escalation, is more effective in the medium to longer term, albeit for those whose sense of urgency is greater that may not be fast enough.
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