Asset owners and fund managers are being forced to consider whether divesting the assets of companies that rank poorly for environmental, social and governance (ESG) is a wise idea today, given the combination of low-rates and highly liquid financial conditions.
Divestment – or selling the assets of issuers that fall below minimum ESG standards – is seen as a simple strategy to understand and execute. But its effectiveness has been called into question at a time when the institutional capital has become abundant and borrowing so cheap, say senior investment executives.
“I don't think [divestment is] quite as effective as people think. And the reason for that is that finance, not just because of central bank action, is like water. Money is like water,” Rick Lacaille, global chief investment officer at State Street Global Advisors, said during a panel at the third annual Global Research Alliance for Sustainable Finance and Investment (Grasfi) conference, hosted online last week.
“You might think you're going to squeeze people's cost of capital so much that they'll stop doing the thing you want them to stop doing. I'm very, very sceptical about that. That will not work,” he said. “There is plenty of capital around that is less constrained, both short- and long-term capital.”
The argument for divestment is simple: if more sustainability-focused investors decide to sell or refuse to buy the assets of non-ESG friendly companies, the cost of capital of these businesses will rise as their share prices fall. This limits their ability to invest in projects investors deem harmful and incentivises company management to improve their ESG ranks.
However, the efficacy of this approach is being diluted in current market conditions. The lower-for-longer interest rates allow the companies access to cheaper funding, while they can also turn to private equity funds, which boast big war chests and generally less concerns over ESG scores.
Gabriel Wilson-Otto, head of stewardship at BNP Paribas, cited an example that private equity firms became buyers of distressed coal assets a few years ago after thermal coal plants struggled to source public markets funding amid an intensifying campaign against global warming.
“One of the arguments against [divestment] is that you can potentially fall out of the public eye; it doesn't mean that no one will provide the capital. It means that they get taken private, potentially at a lower valuation, but it doesn't necessarily stop the activity from happening,” he told AsianInvestor.
BNP Paribas Asset Management manages about €68 billion ($80 billion) in thematic ESG and impact funds and €428 billion in investments which it applies sustainable principles.
MASS DIVESTMENT REQUIRED
Divestment also becomes less effective in a low-interest-rate environment, particularly if equity market participants are unwilling to provide additional capital. Fixed income investors might well be willing to offer a loan or buy bonds if the rates are slightly higher than that of peers, Wilson-Otto said. The only limiting factor is if the provider of the loan also applies ESG principles.
BNP Asset Management prefers not to divest because “as soon as you divest from the company, you lose the ability to influence that company,” he added.
“The only time that we think divestment is a good idea is when we don't have constructive recommendations for the company,” he explained. “For example, on our thermal coal mining policy, our recommendation for the company would be to close their operations.”
Ellen Quigley, responsible investment adviser to the chief financial officer at the centre for the study of existential risk at the University of Cambridge, agreed that low-key divestment was not particularly effective.
“If it's merely applying a screen and not telling anyone that you've done so, I agree – [it has] pretty much zero effect,” she said at the conference. Typically, in an ESG screen, companies with exposure to ‘problem’ or ‘sin’ industries are excluded, or companies are selected based on their positive ESG ratings.
However, if there can be a “scale of counterparties that refuse to do business,” divestment can yield strong results, noted Wilson-Otto. Quigley agreed, pointing to the success of the global movement towards the ban of the use of fossil fuels.
“There is actually a social effect from major announcements and social movements. And one of the things that we should keep in mind is that we are social mammals, and social norms do affect market dynamics,” she said, adding that the divestment movement has helped to sour investors’ view of the long-term prospects of fossil fuels.
FOSSIL FUEL DIVESTMENT
Globally, the movement against fossil fuel investments has gained traction. Pension funds in the US, UK and Australia have made commitments to divest from fossil fuel firms.
As of September 11, a total of 1,243 institutions and over 58,000 individuals representing $14.4 trillion in assets worldwide have either begun or committed to divest from fossil fuels, according to gofossilfree.org.
Scott Kalb, founder and director of the responsible asset allocator initiative at New America, argued that divestment is ultimately a moral or ethical preference that “belongs to the stakeholder, not to the asset manager”.
That is not an easy decision for many to make. “Most of the large asset owners, I know are very much in favour of divestment, but they can't make that decision".
Instead, investors largely agree that in terms of public equity, shareholder engagement would be a better tool instead of selling a firm’s stock if it falls under certain ESG criteria.
“As a universal owner, you'd want to actually reduce those systemic risks in the real world, and stock picking isn't the way to do that,” said Quigley.
That said, an engagement strategy has its own weaknesses. Many investors who pursue it fail to make overly strong demands of the companies and thus do not force them to improve their ESG standards.
“I would only be convinced by a very aggressive shareholder engagement plan that involved voting against directors and the like, which we still see very rarely,” she said.