Blog - The financial costs imposed by fossil fuel divestment
|Datum:||21 februari 2017|
“If it’s wrong to wreck the planet, then it’s wrong to profit from that wreckage” by Arjan Trinks
This phrase by climate activist Bill McKibben has inspired the fastest growing divestment movement in history: Fossil Fuel Divestment. The movement calls on investors all over the world to cut financial connections with companies that supply coal, oil, and gas. Divestment campaigns mainly target big institutional investors, such as pension funds. These investors manage vast amounts of wealth for ordinary citizens (the ultimate ‘investors’). As such, it is momentous to look into the implications of fossil fuel divestment for investment portfolios.
While cutting ties with fossil fuel suppliers could be worthwhile for ethical reasons, it might not be so for financial ones. In fact, putting a constraint on an investment portfolio reduces the opportunities to diversify the portfolio and as such can be expected to increase risk for a given level of return. Trinks, Scholtens, Mulder, and Dam (2017) analyze the magnitude of the financial costs imposed by divestment. The authors compare the risk-adjusted return performance of investment portfolios with and without fossil fuel companies for US common stocks over the period 1927-2015. Contrary to theoretical expectations, they find that fossil-free investing doesn’t seem to impair financial performance. These findings can be explained by the fact that fossil fuel companies fail to show any extraordinary (above-market) performance and provide relatively limited diversification benefits as their returns and risks closely mimic the market as a whole.
This main result may seem as a welcome finding for proponents of divestment. On the other hand, Trinks et al. (2017) further show that fossil fuel divestment could be more costly when applied to less diversified investment portfolios. A growing preference for fossil-free investments could furthermore reduce expected returns of fossil-free investments in favor of unconstrained ones. Moreover, in reality, a divestment strategy comes with additional financial costs related to selection, transaction, and monitoring. In all, this study calls for a careful consideration of the merits and demerits of divestment as a social and political tool to address climate change.
The full working paper can be found at https://ssrn.com/abstract=2903926