Divestments – side effects and risks

Divest or engage? This is one of the fundamental questions in the realm of sustainable investing, and the current climate and geopolitical pressures have pushed it back into the foreground. Recent studies show that the “simpler” solution – divestment – indeed makes an impact, but comes with its own risks.

A tricky question

Should one divest in order to quickly reduce ESG risks in an investment portfolio this way and indirectly raise unsustainable companies’ cost of capital (via a falling stock price), or is better to engage in a dialogue with ESG laggards and companies operating in controversial industries to collaboratively find a way to a more sustainable path? This question is being pondered mainly by large institutional investors, but increasingly also by retail investors. “Brown” companies particularly in the petroleum and natural gas sectors are often at the center of the “D or E?” question. But there are no simple answers in the current climate and geopolitical context. The green energy revolution to combat rapidly advancing climate change requires transitional solutions like atomic energy and natural gas. It’s not for nothing that those technologies have recently been deemed eligible to qualify as environmentally sustainable under the EU taxonomy. So, even though this may pain some ESG proponents, deleting companies involved in such areas from one’s personal investment universe perhaps is not the best solution.

Meanwhile, the conflict in Ukraine raises an entirely different question: Does the defense sector also have to get a spot in the sustainability corner of the ESG grid so that it doesn’t risk suffering the divestment fate? Proposals put forth last year by the European Union to designate the defense industry as socially harmful appear, in any case, to have been rejected in a final report on what constitutes socially sustainable finance published in late February. Swedish bank SEB, for its part, has already made a U-turn: after having imposed a blanket ban on defense stocks last year for some of its investment funds, SEB recently overturned the exclusion and now allows investments again in the defense sector. The war in Ukraine reminds us once more that ESG – like so many things in investing – is complicated and nuanced. Large institutional investors are also split into two camps on the question of divestment or engagement. Back in 2019, Norway’s sovereign wealth fund decided to offload USD 7.5 billion worth of investment holdings in oil and gas companies. On the other hand, one of the largest US pension funds (CalSTRS) recently voiced opposition to a legislative bill that would require it to divest from “brown” enterprises (though it did so less out of a green conscience and more in view of the potential adverse impact on investment return performance). Japanese pension fund GPIF, in turn, has long been a staunch advocate of engagement on climate-change challenges.

The divestment evidence

The availability of data on the real-world impacts of divestment strategies has improved considerably in recent years. This enables investors who see themselves confronted with the D question to at least condition their decision on facts and study findings. This applies at least for the oil and gas sector. A research paper published by the University of Waterloo (in Canada) points out, for example, that shares of energy companies underperform the broad market after large institutional investors disclose their divestment plans. A study on the European energy sector by the University of Augsburg confirms that the selling pressure exerted by divestment campaigns leads to lower stock prices. But not only that, the companies affected react to this and subsequently lower their CO₂ emissions significantly. The divestment trend has evidently become so powerful in the meantime that it has already achieved its actual objective. Divestments can exert sustained downward pressure on stock prices, tarnish corporate images and raise the cost of capital for companies. The managements of the companies affected thus increasingly find themselves compelled to shrink their ecological footprints.

Particularly sensitive | The energy sector rises and falls with the price of oil

Energy sector (USA and Europe), indexed and price of Brent crude oil in US Dollar

Source: Bloomberg, Kaiser Partner Privatbank

The oil price wager

So, viewed through this lens, divestments could be a suitable and, last but not least, a less time- and cost-intensive alternative to engagement. But hold on, not so fast. If investors completely eschew investments in energy companies, their portfolios accordingly are underweight in the oil and gas sector. This means that they are ultimately placing an active bet on the price of petroleum because energy stocks have the highest beta by far to the price of oil. This is not a problem when crude oil is in a structural bear market (like it was in the 2010s). But what if the price of oil soars sharply and stays high? The past year vividly illustrates the effect on energy stocks. Whoever didn’t have them in his or her portfolio risked posting a below-average return performance. This may be immaterial to a retail investor who primarily feels bound by his or her conscience. But for institutional investors, which usually (must) measure their performance against a benchmark, the picture looks different because the “risk to performance” can be huge: if the energy sector had been excluded from the MSCI World index for the first decade of this century, this would have lowered its return by 1.2 percentage points. We do not want to take such potentially very expensive bets in our asset management mandates. Kaiser Partner Privatbank therefore does not categorically exclude “brown” companies from the investment universe. Divestment or engagement? We think that we can make a bigger contribution to sustainability by engaging in active dialogue with companies.

Mind the gap | Energy sector as a risk to performance

Annualized performance MSCI World vs. MSCI Energy

Sources: Bloomberg, Kaiser Partner Privatbank