Divest or engage?

As environmental damages triggered or intensified by climate change increase around the globe, the public pressure on companies and politicians to mitigate environmental and social harm from their activities increases. For investors, this leads to the inevitable question of how to deal with investments in stocks of companies that damage the environment or society.

The traditional approach in the ESG world has been to divest from companies that harm the environment or produce harmful goods, such as guns or tobacco. This is still the mainstream approach to turn a traditional portfolio into a green portfolio.

The main idea is that divestment campaigns might eventually create price pressure on the stocks of these companies and hence an incentive to change. I have always been sceptical about the impact divestment campaigns have in real life, but the momentum of divestment campaigns – especially in the fossil fuel industry – has increased dramatically, to the point where the CIO of the Cambridge University Endowment Fund resigned due to student pressure.

But the evidence that divestment campaigns work is rather thin. In the 1980s and 1990s, investors around the world divested from South African companies or companies that did business in South Africa to put pressure on the Apartheid Regime. However, Siew Hong Taoh, Ivo Welch and Paul Wazzan showed that this did nothing to impact the price of the stocks of these companies and had hardly any effect on the cost of capital for these companies either. Instead, a successful divestment campaign can incentivise CEOs of harmful companies to become even more reckless in their behaviour. Shaun William Davies and Edward Dickersin van Wesep have shown that two factors in the compensation of executives can turn divestment campaigns into a self-defeating and even harmful proposition. 

First, senior executives of companies are incentivized by stock options and share packages that become more profitable if the share price increases. Since the mitigation of environmental and social damages of a company is costly, the share profits decline in the short- to medium-term for a company that mitigates harmful externalities or divests from harmful activities altogether. It usually takes many years, before the benefits of a mitigation strategy accrue to the bottom line. But executive compensation is usually linked to three- or maybe five-year performance of the share price. And that is so short that it is better for the executives of a company to delay mitigation expenses as long as possible to maximise their salary and bonus payments.

Second, if your investor base consists of fewer and fewer investors who are concerned about the environmental and social harm of your company’s practices, the executives have less and less of an incentive to listen to them or accommodate their preferences. In the extreme case, the company ends up with shareholders who are indifferent to the damages it creates. In this case, the executives of the company have an incentive to go all in and increase activities that are harmful to the environment and society because they face no resistance from shareholders and have no downside risk on their share prices.

Instead, investors concerned about the environment and social harm from companies should buy as many stocks of these companies as they can to form a large group of shareholders that has access to senior management and cannot be ignored by it. This is essentially what Elroy Dimson and his colleagues found when they analysed a large database of 1,671 shareholder engagement at 964 companies worldwide. They found that if shareholders coordinate their efforts to engage management and appoint a lead investor to lead the charge, then the chance of success in changing corporate activities is up to one quarter higher than if they do not coordinate their engagements. Ideally, the lead investor is a large institution in the home country of the targeted company so that investors and corporate management share the same language, culture, etc. 

In my view, what is also important is that the investors who join the syndicate are active investors and not passive funds. Corporate executives know that passive investors cannot divest from their stocks, so they are inclined to discount the views of these passive investors. However, even passive investors have voting rights and a syndicate of investors that engage with company management can tie the company’s hands if they can win a majority of shareholder votes for new initiatives at the general meeting. 

The best case is the nuns and religious institutions who took on US gun manufacturers in 2018 – and won. Traditionally, religious institutions excluded gun manufacturers from their portfolios since these investments did not match the values of the churches and convents who benefited from the investments. However, in 2018, Sister Judy Byron, a nun who lives in a Wedgwood Convent in Seattle and is director of the Northwest Coalition for Responsible Investment started to buy the stocks of Sturm, Ruger & Co, American Outdoor Brands, and Dick’s Sporting Goods to force them to develop and publish plans to monitor gun violence and make their guns safer. Joined by the Catholic Health Initiatives, a syndicate of churches and religious institutions they persisted and got Blackrock and other major shareholders to back their proposals. In May 2018, they succeeded and got 69% of the votes at the annual shareholder meeting of Sturm, Ruger & Co. for their proposal, forcing company management to take meaningful action to increase gun safety. In a little more than a year, they managed to create more change in the gun industry than decades of divestment campaigns ever did.

And let’s face it, which CEO or CFO of a company can sit opposite a group of nuns in their habits and tell them to f… off when they ask for change? At first, the nuns may be asking nicely, but anyone who has ever seen the movie Blues Brothers knows that nuns can be quite persuasive.