I have written before that I think divestment campaigns are plain stupid. What happens if a major investor sells its shares in oil and gas companies is that it gives the management of these companies a carte blanche to do whatever they want without being held accountable for their actions. It’s much better to invest in these companies and become an active shareholder, engaging with company management and voting on critical issues. I have written about anecdotal evidence that engagement works in my previous article linked above.
Now there is evidence from a systematic study of more than 6,000 US stocks between 2006 and 2018 that the rise of ESG investing can be linked to a reduction in the carbon intensity of companies. Normally, one has to be very careful with such findings because correlation is not causation and, in this study, just like all the other studies on the topic before, there is no direct proof that increased shareholding by ESG funds and environmentally conscious investors cause companies to reduce their carbon emissions.
But what the study does is show how the causation could work. They show that if there is more money invested in ESG funds and with ESG criteria in mind, the managers of these ESG funds first invest in companies that are highly sustainable and top of their peer group in terms of environmental impact. However, as ESG assets grow, fund managers are increasingly forced to invest outside of this elite group of top ESG firms. The growing size of their portfolios forces them to invest in browner companies and engage with company management to reduce their carbon intensity.
One way this coercion by ESG investors works is that companies with higher carbon footprints are modeled by investors with a higher risk premium. Thus, investors think these carbon-intensive companies should have a higher cost of capital and as a result, when these companies try to raise money in the equity market or borrow in the bond market, they face slightly higher costs of capital than their greener peers.
This small effect alone is enough to incentivise company management to reduce its carbon footprint and improve its carbon efficiency. In fact, what we can observe in the market is that those companies that have relatively low abatement costs (i.e. low costs to reduce their carbon footprint) tend to react to these higher costs of capital faster than companies with higher abatement costs. Obviously, if you can reduce your carbon footprint at relatively low costs and you indirectly get that money back by reducing your cost of capital, you’d be stupid not to reduce your carbon footprint. The study shows that if assets under management of ESG investors double, then the carbon intensity drops by c. 5% per year for the next three years. Luckily, both in Canada and the United States we saw ESG assets double between 2014 and 2018 alone while in Europe they grew by 25%, albeit from a much higher starting point.
Both in Europe and in Canada, about half of all institutional assets are now managed with some form of ESG approach (most commonly shareholder engagement and voting, followed by exclusion criteria). In the United States only about a quarter of all institutional assets is managed with some form of ESG approach, but Deloitte predicts that by 2025, the United States will also reach the 50% mark.
And this is why divestment campaigns are so damaging to environmental sustainability. If an institution manages ESG assets with exclusion criteria and divests from oil and gas companies, not only can they no longer engage with company management, but company management faces no increase in its cost of capital. Yes, the total pool of capital they can access to sell stocks or bonds is smaller, but the pool of traditionally managed assets is still so large that there is no shortage of capital just because a couple of university endowments have divested from fossil fuels to keep their students happy. Ironically, divestment campaigns reduce the cost of capital for brown companies. If there are no potential investors that demand a risk premium for investing in them, then there is no market pressure to push the price of equity down or increase the yield of bonds. And this means that these companies can finance their operations at lower costs than they otherwise could.