Nathalie Windlin

Divestment is often described as an important tool to achieve decarbonisation and fight climate change – but what is it all about? As the concept was new to me several months ago, I shed some light on Divestment and its cornerstones in this blog. Furthermore, I will dedicate close attention to the case of Switzerland and discuss whether Divestment could help Swiss pension funds and insurances curb its indirect GHG emissions.

Figure 48.1 – Divest to keep the fossil (fuels) in the ground (Source: http://lifeaterg.blogspot.com/2018/01/personal-divestment-from-fossil-fuels_22.html)

The concept of divestment

Divestment describes the socially driven withdrawal or withhold of financial capital from certain enterprises or countries. Divestments can be carried out both by a myriad of actors, including private people, university endowments, insurances, pension funds or asset managers, and in various sectors. The most prominent modern example of divestment concerns the withdrawal of capital from enterprises which are occupied with either the extraction, refinement or the sales and marketing of fossil fuels (Ansar et al., 2013). However, divestment is not a newly-created term but rather represents a historical concept: Quakers were divesting in order to inhibit slave trade back in the 18th century. In the 20th century, munitions or tobacco were divested. Later, universities and colleges divested the apartheid regime in South Africa, hoping that such measurements would be able to inflict considerable economic damage on and ultimately topple the apartheid regime. The idea of divestment as being a potentially powerful driver of change also inspired the Fossil Fuel Divestment (FFD) movement which emerged in the United States in 2012. Pushed by a grass-root movement, the FFD foresees that US investors should stop financially supporting companies based in the fossil fuel sector (Ansar et al., 2013; Kölbel et al., 2019). Over the past years, the movement has spread first to England and then across the rest of the globe (Fossil Free groups nowadays exist in Canada, Australia, New Zealand, Sweden, Norway, Great Britain, Japan, South Africa, Netherlands, Germany and Switzerland). The worldwide movement is united through the platform “Fossil Free” which is managed by the organisation “350.org” (Ansar et al., 2013).

The ambitions of the FFD campaign are as follows (Ansar et al., 2013):

• Force fossil fuel companies and governments to “leave fossil fuels in the ground”
• Convince fossil fuel companies to work on and promote more sustainable forms of energy supply that come with lower levels of carbon emissions
• Increase pressure on governments to amend their existing legal frameworks and pass effective laws to drastically curb carbon emissions, now and in the future (e.g. prohibition of drilling or carbon taxes)

There are two core motives that underpin the FFD movement`s agenda. The first and more important one falls into the realm of ecology: Burning fossil fuels is infamous for emitting substantial quantities of greenhouse gases (GHG) as CO2 which ultimately accelerates climate change. Along these lines, each Franc that is invested into the extraction and processing of fossil fuels today will entail increasing levels of GHG emissions in the future. A careful guidance of monetary flows into the fossil fuel sector is thus mandatory to mitigate climate change. Secondly, the FFD movement has fleshed out a strong economic incentive for divesting fossil fuels: “The carbon bubble”. Fossil fuel companies` shares are traded at high prices at today`s stock markets which makes them a supposedly interesting option for investors. Yet, these high prices fail to incorporate the high risks that are associated with investments in this sector in the future. In fact, there are three reasons to believe why the value of fossil fuel companies` shares will plummet in the future (= stranded assets). Firstly, in their attempt to mitigate climate change, governments are likely to pass increasingly pertinent laws to achieve a significant reduction in the demand for fossil fuels. If such legal amendments are followed by a significant drop in the quantities of fossil fuels sold, investors of fossil fuel companies will grapple with substantial financial losses. Secondly, the repeated occurrence of extreme weather events are expected to dampen the cost-effectiveness of various economic sectors and the fossil fuel sector won´t be an exception (Thomä et al., 2017). Thirdly, rapid technological progress and shifts in the people´s attitudes towards fossil fuels will probably at some point render different forms of renewable energy an attractive and affordable alternative to fossil fuels.

It is for these three reasons that investment into fossil fuel companies is financially much riskier than it seems today. Divesting fossil fuel companies can thus be seen as an efficient measure to mitigate the risk of the build-up of a bubble in the fossil fuel sector by preventing individual investors from putting their money on companies that are likely to go through financial rough patches in the future.

Sustainable Investment and the Paris Agreement

Generally, divestment is a specific form of “Sustainable Investment” (SI). This umbrella term refers to investment decisions that are based on a variety of different information, including financial, but also environmental, social and governance (ESG) information (Kölbel et al., 2019). Kölbel et al. (2019) indicate that today’s investors[1] focus on SI to deliver on environmental, social and governance objectives. Banks and asset managers have reacted to these demands and offer their clients an increasing number of investment products that foster sustainability. At the same time, banks stress both investors´ responsibility and the impact their investment decisions can have.

With regard to the latter aspect, researchers and experts nowadays agree that investors like private persons or pension funds can influence the behaviour of companies. This influence includes, but is not limited to questions of environmental and social concerns (= investor impact). Although expectations for investor impact are increasing rapidly, there is little knowledge on how impactful investors´ decisions are in reality. This is partly due to the lack of metrics that allow to systematically capture investor impact. Nevertheless, a recent review of the state of the art in the literature on investor impact highlights three mechanisms via which investors have been argued to affect companies´ decisions (Kölbel et al., 2019):

1. Shareholder engagement
2. Capital allocation
3. Indirect impacts

Shareholder engagement describes mainly the “voice” of asset holders and their opportunity to nudge a company towards certain directions by voting on motions at general assemblies, making requests and proposals, informally talking to and discussing with the management and criticising management decisions, respectively. Capital allocation is deemed a reward mechanism that investors have at their disposal. More specifically, once a company meets the ESG expectations of the investor, the latter will buy assets of the former and thereby endorse the company with private capital. In contrast, investors can sell assets to either express their dissatisfaction with a specific company´s decisions or to indicate that they no longer wish to support companies located in specific sectors. Companies vary in their vulnerability to investors´ capital allocation decisions though and it is mainly those companies with severe financial constraints that align their decision making process closely with investors´ preferences in order to attract the latter´s capital. This implies that investors might exert some influence on the behaviour of small companies that grapple with low budgets, but have little leverage over giant corporates with high financial clout. Finally, Kölbel et al. (2019) identify several other mechanisms via which investors can exert “Indirect impacts” on companies´ decisions. For example, investors can publicly endorse or asperse a company, thereby breeding satisfaction or outrage within the society that will in turn support or work against the respective company. In this case, investors affect companies´ decision making only indirectly via a third party such as the broad public.

Although all three mechanisms of investor influence are theoretically appealing, empirical evidence only supports the first mechanism, i.e. shareholder engagement. Capital allocation and indirect impacts, on the other hand, are found to be less effective tools for investors to manipulate companies´ decision making and additionally were weakly supported by literature (Kölbel et al. 2019)

Kölbel et al. (2019) used the evidence they compiled to derive three recommendations for investors who seek to make a change with their investments throughout their entire portfolio:

1. Shareholders should exploit their say in companies’ decisions, for all investments they make. Moreover, they should ideally submit proposals with high potential for transformation and high chance for approval.
2. Investors should shift capital from firms with undesired ESG characteristics towards companies with both a sustainable action plan and little financial resources.
3. Based on few low-standard practices which are easy to communicate and implement, investors should neglect those investments that fail to meet minimum requirements on sustainability.

Last but not least, the authors supplement these recommendations with additional advice for other actors than investors. These concern rating agencies which should develop suitable metrics to measure investor impacts and policymakers who should undertake serious endeavours to design new policies that push forward the transformation towards low-GHG-economies (Kölbel et al., 2019).

Both the FFD movement and Kölbel et al.´s (2019) analysis assume or conclude, respectively, that investors can use their financial leverage over companies to steer their course of action. This idea of powerful investors is equally acknowledged by the 2015 Paris Agreement which puts strong emphasis on the necessity to manage investment flows. More specifically, the signing parties agree that the “[alignment of] financial flows with climate goals” is key to achieving the ambitious goals of climate change mitigation and adaptation, i.e. limiting global warming to well below 2 °C above pre-industrial levels and adapting to the adverse impacts of climate change. In concrete terms, this implies divesting GHG-intensive sectors of the economy while both enlarging investments in low-GHG sectors and promoting green technologies and sustainable energy sources, respectively (Thomä et al., 2017).

All of the above said affects Switzerland which ratified the Paris Agreement. Despite its commitment to the Paris Agreement´s objectives, however, a recent study supported by the Federal Office for the Environment FOEN identifies a blatant gap between the level of GHG emissions caused by Swiss finance flows and the level of GHG emissions allowed under the 2 °C target. The following paragraph elaborates in more detail on this study.

The Case of Switzerland – 4 to 6 °C global warming through Swiss finance flows

The clear formulation of the 2 °C target poses the huge challenge of reliably measuring the level of CO2 countries, companies and even individuals emit. The project “Paris Agreement Capital Transition Assessment” (PACTA) offers remedy though. Its aim is to measure the performance of investment portfolios regarding the 2 °C target and identify their deviation from the specified climate goals. To this end, the project has designed a non-binding, anonymous and globally comparable “climate compatibility test” (CCT) that is free of charge. The CCT allows financial institutions to examine whether their investments comply with the 2 °C target.

79 Swiss insurances and pension funds of differing size have conducted the CCT in 2017. The core duty of the latter is to ensure that the money of savers is invested in profitable ways to secure their clients´ future income. In expectation of climate change´s disruptive effects for the global economy, including the Swiss one, these actors should thus not only be investing in the funds of highest returns but also in those that promise lasting financial benefits, e.g. renewable energy instead of fossil fuels.

Together, the 79 participating companies and pension funds denote 2/3 of the total market share “as measured by assets under management”. For the assessment of the investment portfolios, the model applied in the CCT focused on those sectors which account for 70 – 90 % of the indirect GHG emissions in global capital markets, namely (Thomä et al., 2017):

• Energy
• Electric power
• Transportation (automobile, aviation, shipping)
• Cement and steel.

The results obtained in the climate compatibility assessment of Swiss insurances and pension funds are both sobering and scary: The investment portfolios of these two types of actors support a 4 to 6 °C global warming. In spite of the fact that there is huge variation with regard to their “climate” performance across the investigated companies, a clear picture emerges: Swiss insurances and pension funds favour high-carbon technologies such as coal, gas and oil production, as well as petrol and diesel vehicles when creating their investment portfolios. In contrast, low-carbon technologies such as renewable power, electric power and hybrid vehicles play a minor role, although investments in renewable energies are globally on the rise. It is important to mention though that there was huge variation among the companies sampled with regard to their investment into renewables: Companies were found to allocate between 3 % and 91 % of their investment budget to renewables. Even worse, other sectors such as transport (aviation, shipping) or in industry (cement and steel) offer only very poor opportunity for investments in low-GHG alternatives (Thomä et al., 2017).

A major weakness of the CCT conducted in Switzerland thus far evolves around the fact that many areas of finance flows have been neglected. In 2018, about 7000 billion Swiss Francs were managed in Switzerland, within sectors such as real estate, infrastructure, banks, private savings, insurance capital as well as Survivors Insurance. Knowing to what extent these huge financial flows comply with or undermine the 2 °C target is crucial in order to identify Switzerland’s climate sinners and initiate measures to change their behaviour accordingly (Thomä et al., 2017).

Along these lines, the experts involved in the preparation of the CCT 2020 plan to extend the scope of the assessment of Swiss finance flows´ climate compatibility, now including banks, asset managers, global loans and real estate investments. Both observers and experts hope that various of these actors that formerly refused to participate in the CCT will now join in order to live up to their announcements to take the challenge of fighting climate change seriously (Thomä et al., 2017).

Whatever the CCT 2020 will reveal, the results of the analysis´ recent iteration highlight the necessity of creating climate strategies for the financial market place in Switzerland which are centred on the 2 °C target, if necessary by legally binding rules. Any such strategy should identify and push for a menu of low GHG emission alternatives that promises to adhere to the 2 °C target. Each sector of the economy must then decide which of these alternatives to implement. Inspirations could be found abroad: The European Commission for example has presented a ten measurements Action Plan in March 2018. Planned improvements include e.g. the “transparent presentation of sustainability risks of financial products” or ask for the establishment of a “taxonomy for green economy activities”.

As a final mark, a close examination of the Paris Agreement should incentivise Swiss insurances and pension funds to proactively curb the GHG emissions of their investments: According to the 2ii report´s simulations, the economic losses predicted under the 4 – 6 °C scenario by far exceed the losses under the 2 °C scenario (Thomä et al., 2017). Going for green investments thus appears to be a smart and urgently required move for pension funds and insurances to fulfil their main purpose in a sustainable manner.

[1] For the sake of simplicity, this blog uses the terms “investor” and “shareholder” synonymously.

Sources:

Ansar, A., Caldecott, B., and Tilbury, J. (2013). Stranded assets and the fossil fuel divestment campaign: what does divestment mean for the valuation of fossil fuel assets?
Kölbel, J., Heeb, F., Paetzold, F., & Busch, T. (2019). Can Sustainable Investing Save the World? Reviewing the Mechanisms of Investor Impact. Reviewing the mechanisms of investor impact.
Thomä, J., Murray, C., Hayne, M., & Hagedorn, K. (2017). Out of the fog: Quantifying the alignment of Swiss pension funds and insurances with the Paris Agreement.