About that exclusion thing again
In July, Capital Group published its 2022 Annual ESG study. It is full of interesting findings, and is the first major ESG survey that was conducted after the Russian invasion of Ukraine. How that event has changed (or not) attitudes towards ESG investing is a great read. I highly recommend the survey. What surprised me though, was the finding that 40% of institutional and wholesale investors still use exclusions as part of their approach to ESG investing. To be sure, this is down from 55% in 2021 but it is still more than the 36% of investors who use an active ownership approach and engage with corporate management.
I have recently softened my stance on divestment and exclusion in ESG after I saw a study from the University of Waterloo that showed that by now, the divestment campaigns have become so big, that they start to influence the share price of a company. However, as I said back then the problem that remains is that if you exclude fossil fuels from your portfolio you are changing the behaviour of your investments quite a bit. And that may not be for the better.
Now there is a new study that looks at divestments in more detail. Instead of just looking at fossil fuel companies, the study looks at all kinds of sin stocks, from alcohol to gambling, and of course coal, oil, and gas. The study tries to examine the impact of ESG divestment trends on the cost of capital, the valuations of companies, and whether divestment campaigns can motivate companies to exit a sector. What is important, though, is that while the study uses the years 2000 to 2019 as starting point, the authors sometimes split the period into the most recent decade (2010-2019) and compare the effects to the previous decade (2000-2009). This allows us to check if divestment campaigns have indeed become more effective over time.
And here is the good news for advocates of divestment campaigns and exclusions. During the most recent decade, the impact of divestment campaigns on the valuation of coal, oil, and gas companies has become stronger and these companies now face lower valuations than without the existence of divestment campaigns. That qualitatively confirms the results of the study of the University of Waterloo I mentioned above.
But note the phrasing of my sentence above and read between the lines. I said that the valuations of coal, oil, and gas companies have been negatively affected by divestment campaigns. But what about the other sin stock sectors like alcohol, tobacco, and gambling? Nothing. There is no negative effect on the valuation of these companies at all. And in the case of tobacco firms, the effect is even going in the wrong direction, meaning that ESG divestment campaigns lead to higher valuations. No idea what that is supposed to mean, though.
In any case, the study also finds that there is no discernible impact of divestment campaigns on the cost of equity capital or the likelihood that the company will leave the sector (either by going bankrupt or by changing its business model). So, divestment campaigns do not make it harder for these companies to find equity investors or incentivise the management to change their ways.
The only other significant effect of divestment campaigns that the study found was that debt financing became more expensive, particularly for coal companies. But that is a known fact, and it is driven by banking regulation less than divestment campaigns. In Europe, banks have to take greenhouse gas emissions and the costs of climate change into account when lending to businesses. And that means that banks start to demand a risk premium for loans to fossil fuel companies. Indeed, even in the US, where banks do not have these regulatory constraints, lenders demand higher interest rates on loans and other forms of debt to companies that are more at risk from climate change. That is just good risk management by the lenders and has nothing to do with divestment campaigns.
So, all in all, the evidence in favour of exclusions remains limited and, in my view, engagement is clearly the better approach than divesting from companies in certain sectors.