This post is quite a long one, so I thought it might be worth starting with a quick outline. I begin my story by introducing the growing campaign for fossil fuel divestment; I then argue that it’s unlikely to have any significant effect in achieving the aims of the movement, first because the divested sums are currently tiny, and second because financial markets will re-equilibrate relatively quickly, leaving fossil fuel companies no worse off. I then turn my discussion to the re-valuation of companies’ assets, and the role of legislative intervention. After an aside where I advocate that activists target debt markets rather than equity markets, I return to the question of divestment, arguing that it is most usefully regarded as a political rather than an economic action. I then contrast divestment with the opposite approach of influencing companies’ behaviour through shareholder activism, and close with a brief mention of some encouraging developments in the wider world of business / finance environmental responsibility.

Divestment

Environmentalists are increasingly united in calling upon private owners of wealth to pull their monetary investments out of fossil fuels, with the intention of making them less profitable than their renewable-energy competitors, and punishing those who seek to profit from environmental degradation. (Ideally, the cash raised by selling these shares will be re-invested into environmentally-conscious businesses.)

Universities, banks, corporations, NGOs, trusts, and individuals have all been targeted by the divestment campaign, whose popular support has in recent years been greatly enhanced by organisations (like 350.org) who are highly effective at engaging with the public and spreading awareness and constructive concern about climate change. Some investors have responded with enthusiasm – universities such as Stanford and Glasgow, religious organisations such as the World Council of Churches, and funds such as the Rockefeller Brothers Fund and large Californian pensions, have all moved to sell their shares and other equities in at least the most polluting sectors of the fossil fuel industry (e.g. coal and tar sands). However, other institutions have remained unconvinced by the campaign – for instance, in 2015 my own university (New York University) rejected calls to take out whatever portion of its $3.5bn endowment was in fossil fuels; and both the Bill and Melinda Gates Foundation and the Wellcome Trust received widespread media coverage for their decision, also in 2015, not to divest.

At the time of writing, 499 institutions have signed up to Fossil Free’s divestment commitment:


Immediate Impacts

There are two obvious motivations for considering divestment. The first is symbolic: conscientious investors may wish to assert that they have no desire to benefit from / be complicit in destructive and unjust practices. The second motivation is to make the companies responsible for those practices suffer by withdrawing financial support. If others do likewise, the companies will lose their economic viability and fail, unless they change their behaviour.

Past divestment campaigns, such as those targeting the tobacco industry or the South African apartheid government, have tended to begin with charitable and religious organisations, professional and academic societies, and conscientious individuals. Typically, universities are also among the first to experience internal pressure to withdraw their endowments from fossil fuels – they are not only home to an educated and explorative body of students with relatively few responsibilities; but also culturally they may be more inclined than individual investors to protect their long-term institutional existence at the expense of short-term profit. I’ll use them as an example to get some feel for the figures involved in divestment.

According to this study from 2014, combining the largest fifty endowments for US universities alone gives a figure over $330 billion. Assuming fossil fuel investments comprise 3-5% of this (e.g. tracking the Dow Jones or FTSE 100 indices), complete divestment would entail a loss to the industry of around $1 billion. Compare this with the 2015 market capitalisation (the total value of publicly traded shares) of the top fifty fossil fuel companies, which I make to be around $5 trillion, and you see that even in the best case scenario where all the fossil fuel shares were sold, it would only make a small dent in the industry’s finances.

Market Balance

Moreover, in an “efficient market”, where a company’s market capitalisation is a decent proxy for its real value, this dent will be transient. Fossil fuels are absolutely integral to the world’s economy and there will always be someone to buy and use each barrel of oil that is produced. Put another way, artificially devaluing a company through an external market perturbation does nothing to devalue its assets in real terms; so the company will regain its old equilibrium value.

More precisely, this happens in the following way. When the market cap goes down, neutral investors (who aren’t burdened by the moral scruples that prompted the divestors to sell their shares) will see that the company’s assets are being undervalued. Seeing an opportunity, they will hasten to buy the cut-price shares, and wait to collect their profit when the company’s equity (its shares) inevitably re-equilibrates, recouping its short-term losses. Their actions embody the self-fulfilling nature of market dynamics: the neutral investors buy shares because they think their value will go up; the value goes up because the investors invest in the shares. So even if all the world’s primary divestment candidates – universities and pension funds and the like – did make the brave moral decision to divest completely (and this certainly won’t happen, cf. the highly incomplete divestment in the tobacco industry, despite a concerted campaign and wide media attention), the result would be merely to concentrate wealth in the hands of immoral investors.

Now, the efficient market assumption is not always a good one, and in situations where there is low transparency, inadequate communication infrastructure, or a narrow range of potential investors, there would likely be a more severe and sustained effect on the divestment targets. Honestly, it’s hard to imagine that any of these conditions will be met in the context under discussion; though it’s worth noting that coal and natural gas are less versatile than petroleum (which can be turned into a variety of products such as petrol, plastic, and industrial chemicals), and consequently the markets around the former commodities are shallower, with fewer potential investors and longer equilibration times (they are less “liquid”). Any repercussions from divestment are likely to be felt somewhat more strongly in these markets.

I’d still expect that any effect of finite liquidity is likely to be minor, though; and this prompts me to ask the central question of this post:

Will divestment affect the market value or the cash flows of the company, or directly hinder its ability to carry out normal business or acquire capital?

The answer so far seems to be no: at this level of discussion we must conclude that the divestment campaign is pointless, because it attempts to distort a market which is more powerful than it will ever be. And it might even be counterproductive, because it sacrifices wealth to less scrupulous competitors without affecting the fossil fuel industry in the long term.

Stranded Assets

It is impossible to influence the value of a company if you are unable to influence the value of its product.

This (very approximate) realisation should be at the core of any credible plan to destabilise the fossil fuel industry. It leads us to the key concept of “stranded assets”: assets which suffer from downward revaluations – or even become liabilities – in response to a changing market environment. The assets in question here are fossil fuel reserves, and the stranding is to be done by legislators. Why?

Because fossil fuel companies today collectively boast larger stocks of coal, petroleum, and gas than can be burned in the future.

This fact is well documented. For instance, Carbon Tracker (an economic / legal think-tank dedicated to investigating the financial ramifications of climate change and related legislation) reports that in order to have an 80% chance of maintaining global temperature rises below 2°C, we must use no more than 20% of known and reported fossil fuel reserves. Other studies, which actually model the economics and technical challenges of resource extraction, provide a more detailed picture of how much of each resource should be left untouched, and by whom, in order to best achieve greenhouse gas reductions. (Extracting and burning all of the currently accessible reserves would lead to at least 4°C of warming, entailing catastrophic climate change, sea-level rise and disruption of ecosystems.)

And yet fossil fuel companies still claim such “liabilities” as assets; and each year they spend billions on exploring for new liabilities to, perversely, inflate their share prices. Clearly this is an existential unsustainability, and the world of finance must develop accounting strategies to deal with the fact that the majority fossil fuel reserves can never see the light of day.

Changing Markets

The problem is that in the current state of global economic affairs, there is little pressure to regard fossil fuel reserves as stranded assets: little to stop every last drop of oil and lump of coal being extracted from the Earth. The recent UN climate conference in Paris, though an impressive demonstration of international unity and probably the best politically viable agreement that could have been achieved, does nothing to restrict the supply of fossil fuels – it only encourages industrialised countries to lessen their demand by e.g. increasing efficiencies of power generation and investing in alternative energy infrastructure, and to provide financial and technological support to poorer countries which need to adapt to the changing climate.

In principle, this leaves fossil fuel companies to do whatever they want with their reserves. Until there are robust, economically competitive alternatives to our current infrastructure, it’s reasonable to assume that once the fossil fuels are extracted they will be burned.

Of course I’m merely saying something we knew all along: that there will have to be some pressure on markets to change how they assign value to fossil fuel assets. Broadly, there are two ways for this to happen. The first is changing “market norms”. Market norms are behaviours of investors, and other market actors, which are culturally determined rather than rational – collective superstitions, historical or underfounded protocols for dealing with certain situations, herd mentality / panics, and the like. An example of a market norm with which we are all familiar would be banks’ routine issuing of sub-prime mortgages in the early 2000s. In retrospect, and even according to some economists at the time, this was obviously an idiotic practice. But most followed the norm and here we are.

One way that the divestment movement might cause a shift in market norms would be to encourage funds with a wide range of stocks (e.g. mutual or exchange-traded funds) to conspicuously declare the proportion of fossil fuels in their portfolio. The free availability of this information may engender a broader awareness / concern about the precarity of such shares, and hence the short-term and low-magnitude outflows of capital accompanying the initial wave of divestment would become amplified as neutral investors lose faith in fossil fuels. It isn’t inconceivable that such a change might happen; but for a small number of divestors to influence the established habits of the majority of investors is hard, and the outcomes are uncertain. Moreover, it is conceivable that the amoral market will not simply regulate itself to irrationally consider “80%” of fossil fuel companies’ assets stranded without any clear external suggestion that they might become so.

So we must turn to a second, more obvious, way to effect the shift in market valuations: political legislation. Time-ratcheted taxation of fossil fuels, traded greenhouse-gas-emissions permits, governmental restrictions on mining projects’ approval permits, funding for research into alternative technologies, subsidies for alternative power generation, removal of subsidies for fossil fuel companies, or some other mechanism, would clearly send a message that fossil fuel companies’ cash flows (and hence the payoffs to investors) will become depressed in future. If the stated intention behind the enactment of any of these legal tamperings is to ensure that fossil fuels stay in the ground, the market will regard those assets as stranded and both the real and the market value of the companies will fall. (Of course, individual governments have little effective control over the global market: international collaborations like the aforementioned Paris conference are necessary to get anything done.)

Some prominent financial institutions have already begun to anticipate that future legislation will render fossil fuel equity severely overvalued – here are examples from the World Bank, the US Treasury, and the Bank of England. In the words of the Bank of England’s Paul Fisher,

As the world increasingly limits carbon emissions, and moves to alternative energy sources, investments in fossil fuels –- a growing financial market in recent decades –- will take a huge hit.

Aside: Targeting Debt

So far I’ve only been talking about investors as equity-holders, whose investments in a company are rewarded in proportion to the company’s success in generating cash flow. It is significant that the three institutions just mentioned are important providers of another financial instrument, namely debt or loans, where a (substantial) sum is provided up front by the creditor, and pre-arranged repayments (with interest) are made by the debtor.

There are many potential investors in equity – every individual or company with an Internet connexion can buy shares. But there are comparatively few loan providers, since they must be trustworthy, well-regulated, and crucially have very deep coffers (globally, five banks – J.P. Morgan, Bank of America Merrill Lynch, Citi, Wells Fargo, Mizuho – have a 40% market share of lending). This scarcity of debt means that even if a small number of banks decide to stop providing loans to certain fossil fuel projects, the pool of available creditors might become quite severely limited.

Though a diminished availability of debt is unlikely to significantly affect the cash flow from existing operations, it will make expansion of fossil fuel business more difficult – especially for technically complex or economically marginal projects like shale gas, polar sea-bed drilling, and tar sands. (For a slightly more detailed example, I found this article on coal mining in the US illuminating, as it discusses several factors, including access to debt, that have contributed to coal’s plummeting fortunes.)

Since this is already an aside, it should be mentioned that a similar line of thought applies to national / global greenhouse gas emissions reduction targets. Trying to control consumption, the focus of pretty much all laws and treaties that I’ve heard about, entails influencing the behaviour of seven billion people. Trying to control production, on the other hand, entails influencing a few thousand companies.

Divestment: Uncertainty and Stigma

Most companies see greenhouse gas controls as inevitable, but are waiting for a market signal.

Professor Andrew Hoffman (University of Michigan)

We hope that the fossil fuel divestment movement can help break the hold that the fossil fuel industry has on our economy and our governments.

Fossil Free

Let’s return to divestment. I concluded that the direct economic effects are likely to be meagre at best; and also that, because of the self-interest of the majority of investors, widespread divestment will happen only once it becomes unprofitable to hold on to fossil fuel stakes. A pertinent question, therefore, is whether we can expect the divestment movement to hasten the stranding of assets (indirectly and through political channels). The answer may be a hopeful yes.

Past experience tells us that, since information flow in real market is imperfect, a campaign pursued fervently enough fosters uncertainty among all investors, which in turn lowers the general expectation for the industry’s future cash flows. Devaluation of those companies then becomes a market norm, at least temporarily. One way to understand this rise of uncertainty is through the language of stigmatisation. According to a report by Oxford University,

The outcome of the stigmatisation process, which the fossil fuel divestment campaign has now triggered, poses the most far-reaching threat to fossil fuel companies

Stigmatisation leads to a reduction in sales, reductions in the availability of suppliers, human resources, contracts, and finance, and a reduction in the relative negotiating strength of the stigmatised company with its suppliers, as well as their sway with government ministries. In crude market terms, these negative impacts are “irrational” responses because the company has lost nothing of tangible value. But that isn’t the case from a business perspective, where intangibles such as reputation and trust are paramount. In short, businesses do respond to public stigma, constantly recomputing the multidimensional trajectory which balances the demands of their shareholders with the demands of their stakeholders.

Those companies more vulnerable to stigmatisation attacks are those who are more prominent in the public eye (e.g. BP), those engaged in more polluting activity (e.g. coal mining and oil from tar sands), those who don’t have substantial capital devoted to green energy projects (e.g. all of them) and those less able to launch PR campaigns to redirect blame / distract and misinform the public (e.g. none of them).

It’s hard for me to judge whether stigmatisation will have any real effect on the fossil fuel industry – we must remember that they are selling a product that is absolutely integral to our way of life: one for which demand is highly inelastic (on timescales on the order of years). However, assuming the stigmatisation campaign is successful to some extent, the management side of the fossil fuel and related industries will have to soften its resistance to restrictive legislation from the political arena (currently half of the world’s 100 largest companies are directly obstructing climate change legislation, and 90% are members of organisations that do so on their behalf). Thus, the indirect and irrational effects of the divestment campaign can potentially become actualised into reductions in cash flow and, crucially, into stranding of assets. It seems a high-risk and roundabout strategy for achieving this, but I suppose it’s worked in the past.

Another Approach

The companies that are vilified at the hands of the environmental movement are paradoxically in an ideal position to invest in change. They know energy markets, and have already established themselves as R&D powerhouses. It was therefore surprising to see the likes of BP and Shell retreating from investments in renewable technologies in the last ten years, and joining the likes of ExxonMobil in prioritising PR spin over corporate responsibility. But putting aside the historical realities, from the perspective of what could be, the divestment movement’s drive to fight an economic battle and with the offending companies (and dream of crippling them) is misguided: wouldn’t it be so much better to direct their considerable influence and resources towards green technology?

Indeed, some staunch advocates for environmental concerns – e.g. Greenpeace and the Coopertive Bank – take the opposite route to the divestment movement by buying up shares in fossil fuels (and munitions and whaling etc.). This gives them powers to table and vote on motions at those companies’ general meetings. More broadly, by pooling the investments of like-minded shareholders, it’s possible to form activist voting blocks that can demand changes to the board, management and business strategy. Traditional business structures give owners control over managers: an opportunity that could sadly be wasted.

Which approach is better? Is it more effective to sell shares, a public demonstration of disgust which will inspire others to do likewise, and, more importantly, build support for legislation curtailing supposedly reprehensible activity? Or is it more effective to bend the course of corporate governance from within, appealing to the social responsibilities of other shareholders and the company’s managers? I have no idea. Despite their diametric opposition, to me they sound like equally credible (or hopeless) strategies.

In any case, it’s clear that neither the market, business nor government will or can effect the necessary systemic changes on their own: they will only respond to changing cash flows, political interference, and public outrage.

Reasons to be Optimistic

For some time now, businesses and figures in financial markets have been calling on governments (albeit haphazardly and equivocally) to make hard commitments on tackling greenhouse gas emissions, so that unambiguous price signals can be absorbed into market operations. This recent Citigroup report is just one of many to outline the economic turmoil that would accompany inaction on climate change, and provide a carefully costed road-map for avoiding it. This translation of environmental issues into economic impacts saw a first comprehensive treatment in the Stern Report of 2006, and has served as a wake-up call to economists and politicians ever since.

In the past year, the growing certainty of a global deal leading up to the Paris conference, coupled with the desire for multinational companies to show leadership, has brought many positive developments in the corporate world. In the words of Professor Clive Hamilton (Charles Sturt University),

The unmistakable message [to business] is that the world is changing: the major economies are beginning the transition to low-carbon systems, and if you are not planning for it you are not doing your job.

This new consciousness has led to initiatives such as Science Based Targets, which at the time of writing had recruited 116 major corporations (such as Coca-Cola, Proctor and Gamble, Pfizer, and Sony) to sign up for relatively impressive reductions in carbon intensity (greenhouse gas emissions per kilowatt-hour of energy consumed) and absolute emissions. And more relevant to the present discussion, the Montreal Pledge, which requires investing firms to ‘measure and publicly disclose the carbon footprint of their investment portfolios on an annual basis’, has seen rapid growth to over 120 investors worth a total of $10 trillion.

The important thing, though, is that the message gets through to the energy sector. As I said before, to my knowledge there exist no realistic plans to explicitly strand fossil fuel reserves. But these examples are surely steps in the right direction.



Comments

Dan 30 January 2016, 18.06

I think you know more about economics than you give yourself credit for.

I agree that there aren't any "realistic plans to explicitly strand fossil fuel reserves," but fossil fuel companies face a few headwinds. You asked for my thoughts from an equity valuation standpoint. The two main frameworks are discounted cash flow which attempts to find the intrinsic value of a business, and relative valuation which compares a business to similar businesses and its industry. Relative valuation might be tricky because the protests against fossil fuel energy affect the whole industry, so I'll just focus on the intrinsic value.

From the viewpoint of the efficient markets hypothesis, stock prices should capture the present value of a business's future cash flows. Many of the protests you describe are attempts to change market expectations for the fossil fuel industry. Pinpointing an exact impact becomes tricky, and some story telling comes into how people value companies. How certain are the future cash flows? That depends on many questions including how long fossil fuel energy will be the dominant form, and what kind of government regulations will be put in place as you mentioned. However, in 2013, the economics Nobel prize went to research showing that markets are irrational and revaluations with different expectations cannot justify the variance in stock prices. Prices are set more or less due to the moods of the markets, but to many, the intrinsic value of a business doesn't really change if a few people divest. It's hard to guess the impacts of these protests and see which short term and long term effects will win, but my feeling is that they can't be great for the fossil fuel industry.
Cato 15 February 2016, 10.12

Since writing this post I've come across two further sources that might be of interest. They broadly agree with my conclusions, but with the advantage of expertise.

First, this article, written by the Director of Oxford University's Stranded Assets Programme, provides a concise and compelling take on stranded assets and the surprising naivite of financial markets.

Second, this research paper by University of Washington PhD student Alex Lenferna assesses the divestment movement's potential impacts in both economic and ethical dimensions. While accepting that much of the dialogue of the movemnt is naive and dogmatic, it is still likely to hasten the bursting of the "carbon bubble". Furthermore, the author argues that the goals of the movement are consistent with widely-accepted philosophies of ethics.