On hot-button issues, advisors should provide well-reasoned guidance that is devoid of their own ideological leanings. When faced with a client who asks whether to divest from fossil-fuel investments, that requires knowledge of the moral, scientific and financial consequences of their decision. Here is a template for having those conversations.
On March 16, 1979, the movie The China Syndrome, a white-knuckle thriller depicting a nuclear power plant accident and starring Jane Fonda, Jack Lemmon and Michael Douglas, was released to large audiences.
Only 12 days later, on March 28, there was a severe nuclear power plant accident at Three Mile Island in Pennsylvania, the first serious nuclear power plant accident ever.
No one was injured at Three Mile Island. But that accident and the release of that frightening movie delivered a double-whammy that stopped the progress of the nuclear power industry for more than 30 years.
Could something like this happen to fossil fuels?
Don’t bet against it.
The nuclear paradigm
The “China syndrome” of the movie’s title referred to the fanciful notion that if a nuclear power plant in the United States were to have a severe accident, entailing a meltdown of its nuclear fuel, the whole power plant would sink so deeply into the earth that it would come out on the other side in China. It portrayed a nuclear power plant accident as something that could have catastrophic, virtually unstoppable and inexorably spreading consequences. This impression has stuck with the public ever since.
In 2011 a Japanese nuclear power plant experienced – with no fatalities – the fourth strongest earthquake in history, followed by a tsunami reaching heights up to 128 feet that directly killed more than 16,000 people. The impression this left with the public was not that nuclear energy had survived the ultimate stress test with relatively little damage save a high cost of cleanup, but that it had proven too unsafe to use. In the aftermath of the Fukushima nuclear power plant disaster, Germany voted to phase out nuclear power completely. Even China slowed work on its nuclear power program.
This was probably because it was much easier for news coverage to film the hydrogen explosion and havoc at the power plant than to cover the 16,000 tsunami deaths. But if you ask people now what catastrophe occurred at Fukushima in March 2011, they would probably say it was a nuclear power plant accident.
Nuclear power entails risks, of course. But while the occasional crash of a commercial airliner killing hundreds of people has been accepted as the very small but unavoidable risk of flying, the idea of an occasional nuclear power plant accident as the price of clean energy has gained no acceptance and seems unlikely to do so soon.
This is partly due to the fear of radioactive nuclear fallout, which fueled ban-the-bomb protests in the 1950s and 1960s. Activists regarded radioactivity as an insidious and extremely dangerous poison. It was only after much study that it has been learned that – apart from massive doses such as those that killed 200,000 in the Hiroshima and Nagasaki bombings in 1945 – low-level nuclear radiation is not as deadly as previously thought; it may not even be dangerous at all. And yet, the widespread belief now is exactly the one that motivated ban-the-bomb activists more than 50 years ago.
Lessons for the fossil-fuel industry
A similar effort is underway now against the burning of fossil fuels. A similar group of activists is playing a leading role – a coalition of activists and scientists. As they did then, these present-day activists have a powerful and valid point. Then, it was that the world would fatally contaminate itself with radiation and ultimately blow itself up in an exchange of nuclear weapons if it did not change course fast. Now, it is that the world will heat itself into oblivion if it does not change course fast.
Most people assume that although the climate is changing and getting warmer and will continue to do so, we will muddle through with no greater apocalypses than occur in any era; be they war, pestilence, famine or massive poverty and homelessness.
Nevertheless, this insouciance could change rapidly. And, as the ban-the-bomb movement and The China Syndrome planted the seed for the demise of nuclear power, the seed for the demise of fossil fuels has been planted by climate change warnings.
Imagine an unusually severe string of climate catastrophes, coupled with a cataclysmic and spectacularly visible televised occurrence, such as the collapse of a massive Alaskan glacier, the calving of a large piece of the West Antarctic ice sheet into the sea or a wave of disastrous fires. The deep-rooted fear of nuclear radiation could suddenly transfer to a fear of fossil fuels.
What would this mean for the fossil-fuel industry? The coal industry has already suffered, not only because cheap gas from fracking is replacing coal for the generation of electric power, but also because of climate change regulation aimed at cutting back carbon dioxide emissions.
This would likely not be good for the industry and for oil company stock prices, as it already has not been good for coal companies.
This could be a major asymmetric risk and uncertainty for the fossil-fuel industry. The upside for the industry is no better than it always has been, but the potential downside if panic drives draconian government regulation is great.
The fossil-fuel divestment movement
The activists against climate change have coalesced around a mission to get institutional investors, such as college endowment funds and pension funds, to divest themselves of their fossil-fuel industry holdings. The prime impetus for this movement came from an article in Rolling Stone magazine on July 19, 2012, by climate activist Bill McKibben.
In the first half of that article, McKibben presented a well-constructed argument for divestment, buttressed by numbers. The first number, drawn from the face-saving Copenhagen Accord that wrapped up the 2009 Copenhagen climate conference is 2°C, or 3.6°F. The Copenhagen climate conference was widely regarded as a failure, but this number stuck. The Accord recognized “the scientific view that the increase in global temperature should be below two degrees Celsius.”
McKibben wrote reasonably about this number, acknowledging its arbitrariness. “It was as conventional as conventional wisdom gets,” he said. However arbitrary it may have been, the climate change movement has adopted this number as the maximum temperature increase at which we can forestall the ultimate disaster. If you accept this first number, all of the others follow.
Scientists have created a relationship between the level of carbon emissions and temperature rise. We must, of course, accept this relationship as well, though there is much uncertainty about it. But by applying that relationship, McKibben found that, of the “proven reserves” owned by fossil-fuel companies, about 80% cannot be burned. To burn more than that would, according to the calculations, produce enough CO2 to increase temperatures by more than 2°C.
“Proven reserves” are fossil fuels in the ground that have a 90% chance of being produced using current technology. Exxon-Mobil reports in its 2014 10-K that it has proven reserves of about 25 billion barrels of oil and 70 trillion cubic feet of gas. Total future production from these reserves is estimated at an undiscounted value of about $1.5 trillion. After subtracting production costs and discounting at 10%, the value is estimated at about $225 billion.
Exxon-Mobil’s current market cap is about $360 billion. If 80% of these reserves cannot be burned, that would put a pretty good nick in the future profits and market value of the company. And the industry continues spending billions to find more oil and gas.
The moral case and the financial case
But after his introduction, McKibben’s article took a pivotal turn. He said, “A rapid, transformative change would require building a movement, and movements require enemies.” With that, he identified the fossil-fuel industry as the enemy. The movement to divest from fossil-fuel companies became a moral crusade. He quoted the inflammatory writer Naomi Klein: “…these numbers make clear that with the fossil-fuel industry, wrecking the planet is their business model. It’s what they do.”
Pitching the divestment movement as a moral crusade against evil fossil-fuel companies is a dangerous strategy. Robert Stavins, Director of the Harvard Environmental Economics Program, argued in a New York Times debate on the subject that the “moral” crusade is misguided. In his contribution to the debate he said, “Don't exacerbate the ideological divide and political polarization that has paralyzed Washington on climate change.”
Pressuring universities to divest from fossil-fuel companies in their endowment funds for moral reasons can have a reverse effect. For example, it enabled Harvard’s President Drew Faust to respond to activists pressing the university to divest by saying, “we maintain a strong presumption against divesting investment assets for reasons unrelated to the endowment’s financial strength and its ability to advance our academic goals.” In other words, she has focused entirely on the moral argument for divestment, not the financial one. She further argued that “[s]ignificantly constraining investment options risks significantly constraining investment returns.” This is nonsense because Harvard hires active managers and active management always begins by constraining investment options. But it shows how framing divestment as a moral issue helps enable Harvard’s president to issue the standard pablum response to appeals for socially responsible investing.
The deeper problem with the moral case
There is unquestionably a sound argument for divestment from fossil-fuel companies, but let’s face up to some of the problems with the way the divestment advocates are pursuing their crusade.
Unlike the targets of previous divestment campaigns, such as the campaign to divest from apartheid South Africa and from tobacco companies in the 1980s and 1990s, fossil fuels have identifiable positives as well as negatives. Coal, the most carbon-intensive of the fossil fuels, has been responsible for bringing hundreds of millions of people out of poverty in industrializing countries like China and India. The fossil-fuel companies themselves – such as Exxon-Mobil – in their response to the divestment advocates, simply claim that all of their reserves are likely to be produced because there will be a demand for them.
Not only are there clearly identifiable positives, but divestment advocates also do a poor job of specifying the negatives. They make what a friend of mine has called an “argument by violent assertion.” For example, after McKibben, in his Rolling Stone article, labeled the fossil-fuel companies as the enemy and quoted Naomi Klein’s battle cry against them, he proceeded in his rhetoric along the same lines as if it has been conclusively proven that 2 degrees Celsius represents the edge of a cliff and that the fossil-fuel companies are driving us over it. For example, he casually referred to fossil-fuel companies as “companies that are destroying the planet,” and says of college students, “[i]f their college’s endowment portfolio has fossil-fuel stock, then their educations are being subsidized by investment that guarantee they won’t have much of a planet on which to make use of their degree.”
This is so far from proven in any sense that it should not be part of a reasonable argument. We really don’t know what effect warming temperatures will have. Surely, they will disrupt the planet, but in ways that may be on a par with political disruptions that routinely occur anyway. The strongest argument against allowing climate change to happen is that it adds a very serious risk to all the other risks. This risk has unknown but possibly disastrous consequences and may interact in strongly negative ways with other risks, such as political risks. For example, we are probably seeing the effects of climate change as one of the drivers of the current refugee crisis. But to go from that to phrases like “they won’t have much of a planet” and “companies that are destroying the planet” is an excess of language that disqualifies the argument from consideration.
More reasonable than either Harvard’s boilerplate response or Exxon-Mobil’s is that of the University of Oxford. A well-considered report issued by its Smith School of Enterprise and the Environment concluded, “There are a wide range of current and emerging environmental risks that could result in stranded assets.[1] These risks are poorly understood and are regularly mispriced, which may result in a significant over-exposure to environmentally unsustainable assets throughout portfolios.” It argued that portfolios should be stress-tested for “potential environment-related risks that could impact fossil-fuel companies.”
Interestingly, the Smith report also has advice for divestment campaigners. It argues that the campaign might be more effective targeting debt markets than equity markets. It says that debt markets “are ‘clumpier’ than the more decentralized equity markets” and that therefore “it might be easier to block off channels of debt finance than equity. Campaigners can thus target large lending banks and pressure them to commit to a set of principles – equivalent to the anti-apartheid Sullivan Principles – that create obstacles for the debt financing of marginal fossil-fuel projects.”
Perhaps as a result of input from this report, the University of Oxford has taken a sensible middle road wait-and-see approach to divestment. It declined to divest from all fossil fuels, but a year ago ruled out investing in coal and tar sands, the most carbon-intensive and environmentally-destructive of the fossil fuels. This decision has stood Oxford’s investment performance in good stead since then.
Should you divest?
If you are a passive total-market investor, you are unlikely to divest from any market segment – perhaps on the principle that if that market segment is weak or suffers a high asymmetric risk, these deficiencies will have been priced in.
But if you believe you can identify risks better than the market can, you should be monitoring the fossil-fuel risk. It may be a big one. Complicating the issue, however, is that heavy restrictions placed on fossil fuels will affect not only fossil-fuel producers like big oil but also motor vehicle manufacturers and dealers, electric utilities and many other industry sectors as well. And as we have seen with the failures of a number of renewable energy companies recently, investing in energy alternatives is a risky business too – at least in the short run.
Nevertheless, if one is not a passive investor, it is sensible to try to envision what the future will or should look like and to invest in it. There is a substantial chance that in the 20-, 50- or 80-year future, we will burn a lot less fossil fuels. Any investor who believes that he or she possesses a modicum of predictive skill should be contemplating that.
Michael Edesess, a mathematician and economist, a senior research fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong, chief investment strategist of Compendium Finance and a research associate at EDHEC-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in June 2014.
[1] “Stranded assets” are assets that cannot be utilized to produce revenue, such as prematurely decommissioned coal or nuclear plants, or fossil fuel reserves that cannot be produced and sold.
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