Im not a big fan of institutional investors divesting from fossil fuel companies. Why? Because I think weve got one shot with endowments, pensions or sovereign funds in the area of carbon mitigation due to the resource constraints of these funds. And, as a result, Id rather use the scarce time and attention of these funds to push them towards something that is more meaningful for them and the world than a passive and half-hearted divestment by funds that deem it important to propitiate its stakeholders through such policies rather than drive meaningful change in the world. Building investment organizations that can truly act like owners and think about long-term sustainability in everything they do is one of my main objectives in life, and everything I do circulates around this notion of professionalization.
But, alas, many investors are pressing ahead with divestment policies. So I feel obliged to write this column. In short, if youre committed to divesting from fossil fuel companies, at least take the time to understand what it is youre doing so you can do it right.
Divesting Reduces Risk
A divestment is, quite simply, a risk-reduction strategy. Most people perceive a divestment as the sale of an asset that has some set of unfavorable characteristics. But investors should instead or at least also view a divestment as the sale of a basket of risks, some of which are financial and some of which are non-financial (i.e., environmental or social risks). This is an important differentiation to make, because most people think that its the underlying assets that provide returns. Its better to view assets as providing exposure to risks, which investors can use to extract returns for providing capital to help develop or grow the asset.
As Ive said before, institutional investors are little more than professional risk takers. They assess, mitigate, manage and trade investments risks. The best investors are those that use a specified amount of risk (aka, a risk budget) to generate the best possible return. William Sharpe has written extensively on risk and return and, more recently, on the use of risk budgets:
The goal of the organization is to achieve the most desirable risk/return combination. To do this it must take on risk in order to obtain expected return. One may think of the optimal set of investments as maximizing expected return for a given level of overall portfolio risk. The latter provides the risk budget, and the goal is to allocate this budget across investments in an optimal manner. Once a risk budget is in place, the portfolio components can be monitored to assure that risk positions do not diverge from those stated in the risk budget by more than pre-specified amounts.
What does all this mean in the context of divestment strategies? Well, it means that investors almost certainly get compensated in the form of higher returns for bearing the non-financial risks that they are divesting from. And, as such, my hunch is that the reason so many people see divestment as something that will impact their returns negatively is due to the fact they think about divestment in terms of returns... not in terms of risk. So, when an investor does decide to divest, it needs to realize that it is divesting from a whole series of risks that it may not be capturing in investment valuation models, and dropping these risks from the portfolio could reduce returns.
Key Takeaway: A divestment should not necessarily impact an investors returns; it affects the risk (which then affects the return). So if youre going to divest an asset, make sure youve understood the risks that are being sold so you can either replace them (to maintain the specified risk budget) or manage expectations that returns could be lower due to the lower risks (see below).
Lower Risk Here, Higher Risk There
Many of the best institutional investors (CPPIB, GIC, NZSF, etc.) have started to operate on the basis of risk budgets. Rather than allocating capital to countries, markets, asset classes, sectors, industries, companies, securities, people, or even ideas, these investors allocate risk to these things. Why? They want to know exactly what the bets are that they're taking so that they can, in turn, attribute their returns to some risk-bearing decision. This is about getting clarity around the risks, returns and the decision-making inputs used to choose risks and generate returns. Theres a lot that can be said about risk budgets, but the key here is that thinking in terms of risk allows a fund to be more flexible about where it captures its returns.
Lets take the case of CPPIB as an exemplar of risk budgeting: Because it operates in the context of a total portfolio risk budget, it funds all its investments in ways that seek to maintain a predetermined level of portfolio risk. So, when it looks to make a $1 private equity investment, it sells $1.30 of public equities from the same commercial sector and geographic region. One dollar of the proceeds then go into the PE investment and 30 cents is held in cash. Why the cash? The fund is adjusting its overall portfolio risk level to control for the fact that the PE investment will be riskier than the public equity investment. The objective here is to hold the portfolio at a certain risk budget, which seems logical.
But this sell-to-buy approach demands the fund characterize each investment or strategy in terms of its underlying risk attributes. And the CPPIB acknowledges that its not easy: Our approach requires complementary technology, detailed risk measurement and coordinated decision-making across the entire organization.
Indeed, the problem with this approach is complexity, as the number of risks that drive returns is innumerable. As such, many economists limit risk factor models to a small set of factors. The assumption being that a small group of core investment risks can describe most investments, which minimizes the estimation problem. But does this assumption hold true in the context of a company that you are thinking of divesting for social or environmental reasons? If this company or region has significant non-financial risks, the residual risk may no longer be negligible.
Key Takeaway: Investors need to have clear assumptions and indeed estimates for their risk exposures. Put another way, investors need to understand what is actually driving their investment returns. Once this is well understood (and it sure isnt easy to understand), that investor can begin to creatively develop portfolios that divest from the bad risks and invest in the good risks, all while maintaining a specific risk budget and, we hope, expected return.
Using Risk Budgets Sustainably
Im continually surprised at how many institutional investors remain ignorant about their risk exposures. They can point to managers that generate high returns, but they cant be certain how those returns are generated. (This is especially true for funds pursuing the endowment model; it's shocking but most dont really know what underlying bets they are making let alone what fees they are paying to make those bets.) As a result, investors struggle to understand how they can divest without it impacting their returns.
But an investor that has strong conviction about the risks it is taking recognizing that there are lots of uncertainties that can disrupt plans, and that risk can evolve over time can start to be creative about where they source risk to generate the returns they need to achieve long-term objectives. Indeed, there are infinite variations of assets available for investment, which means there are countless different ways that risk can be spread to achieve the same or even better long-term objectives.
An investor that understands the factors driving returns can, in theory, use a divestment of fossil fuel companies (e.g., which provides a panoply of non-financial risks, such as environmental, judicial, geopolitical, regulatory, etc.) to create space in a risk budget to do something quite creative in other parts of the portfolio. More to the point, the risk-conscious investor could take the extra-financial fossil fuel risks embedded in the fossil fuel investment and seek exposure to those same risks through more sustainable investments.
Key Takeaway: There are many ways to get the risk exposure required to achieve objectives. In fact, it is conceivable that an investor could invest in technologies that will disrupt the companies being divested from, and get many of the same exposures. Let me explain.
Non-Financial Risk Exposures
Heres the part where I start pushing out onto shakier ground, but bear with me.
Recall that risk is often calculated with reference to volatility. And volatility is a statistical measure of movement, which means by definition its never negative. So, as a simple example, whether an assets price is going up fast or down fast (or both) is not the issue; its the distance moved that helps to understand the risk. So, heres the question Im trying to wrap my own head around: Arent the risks driving some of the returns in a fossil fuel company the same as for an energy startup challenging the company?
If there is a risk that legislation could be passed killing fossil fuel companies and making green energy companies successful, both of these companies have to deal with the same legislative risk.
Key Question: By divesting from the fossil fuel company and investing some of the risk in the startup, can an investor maintain an exposure to many of the same risk factors it has in the fossil fuel company?
I understand there are issues of probability and that the risk may not be equally distributed, but that could be solved via scaling the risk up or down with leverage (or some other mechanism). This assumes that many of the other risk factors can be isolated, such as technology risk and commercialization, but you get the idea. Somebody else can sort that out.
Anyway, the over-arching point here is that if you plan to divest from fossil fuels, you have to understand the risks that you are actually selling, as you'll want to make sure that you don't create space in the risk budget without realizing it and then have to try to explain the lower returns...