In the late 1970s, it was common for college students to mobilize and protest the legal racial oppression in South Africa called apartheid. They demanded that endowments divest from companies doing business there. As a young equity analyst working in my college’s Treasurer’s Office, I pored over footnotes in annual reports of companies like IBM, Caterpillar, and JP Morgan to determine the extent of their business involvement in South Africa. Many institutions complied with demands for divestment. In 1977, Rev. Leon Sullivan*, a Baptist minister, civil rights leader, and board member of General Motors, established the Sullivan principles. GM was one of the largest employers of Black South Africans, and the principles listed seven rules demanding equal treatment of employees. Over time, the market constructively engaged and called on other companies to sign the Sullivan Principles. Investors attended annual meetings focused on improving working conditions, equal opportunity, and supporting economic and social justice to end the apartheid system. In 1990, Nelson Mandela and other political prisoners were freed from prison, apartheid was dismantled, and Mandela was elected president in 1994. Divestment had morphed into engagement over many years, a positive force for the greater good.
For investors seeking change, which strategy is more effective, divestment or engagement? We can ask that same question today regarding energy investing. Should we screen energy issuers from portfolios – coal producers, oil sands companies, oil and gas reserve holders, CO2 emitters, or maybe even all fossil fuels and entities that use them? If there are enough investors that divest, it would raise the cost of capital for offenders, making investment in any of these endeavors less cost-effective and eventually untenable. Divested funds could be earmarked for new technologies, companies improving their efficiency, and those pledging net zero carbon emissions.
The Task Force on Climate-related Financial Disclosures (TCFD) promotes reporting of climate-related financial information. TCFD’s four thematic areas, governance, strategy, risk management, and metrics and targets, are based on the premise that present valuations may not be sustainable over the longer-term as more information becomes available. With more information, investors may realize that a company will struggle to transition to a lower-carbon economy. Despite their views, most investors would likely agree that more information is better.
We all value data and recognize that energy has been a central component of economic activity, production, and growth. As a result, limiting the non-renewable energy sector’s access to the capital markets may cause unintended downstream issues. California and several countries have announced bans on gasoline-powered vehicle sales within 15-20 years. The transition to electric vehicles (EVs) will be transformative – sales are quickly growing, although currently, EVs only represent about 2% of cars on the road globally. There are inarguable benefits to reducing the world’s dependence on fossil fuels; however, the path to doing so is complex. Will “electrification” consider the carbon emitted to generate electricity, mine rare metals, store and dispose of batteries, and the costs to upgrade transmission and charging grids (we have seen grids fail in California and more recently in Texas)? Toyota President Akio Toyoda said recently that Japan would run out of electricity this summer if all cars were electric, and with most of the country’s electricity produced by burning coal and natural gas, there is quite an offset to the benefit of EVs.
A bond issued by a utility with a renewable focus or an Auto ABS deal with EV collateral would seem to fit an ESG portfolio. What about a green bond issued by a heavily coal-based utility, with proceeds to be used for a renewable build-out? As an ESG manager, we wrestle with these decisions every day. In traditional portfolios, we apply an ESG overlay within our research process, focusing on key issues that may affect the sustainability of an issuer. For example, if an issuer carries a coal plant that may become a stranded asset requiring a large write-off, we might still buy its debt if we believe we are being compensated for the risk. In a dedicated, positively-tilted ESG portfolio, we weigh key industry ESG issues, avoid industry laggards in favor of leaders, and permit a small allocation for significantly improving stories. If energy is allowed within portfolio guidelines, we might favor a company that is committed to a low carbon future and working to become more renewable, or a liquified natural gas exporter who may aid in replacing coal at a foreign utility.
We accommodate our clients that request different divest vs. engage approaches to managing their energy exposures. Some follow the Carbon 100 screen (coal), others want to be totally fossil-free, and others ask, “What do you think we should do?” Perhaps we are in the “footnote” stage of uncovering the details of carbon emissions and other climate-related metrics; TCFD and other engagements may help broaden disclosures and investors’ understanding of risks. Perhaps divestment is the route to go for the sake of protecting our climate, ultimately limiting ease of access to financing for carbon offenders. On the other hand, engagement, backing a practical transition plan, and supporting those entities that are working toward a common good, may be where the market ultimately shakes-out, much as engagement helped pull South Africa forward 30+ years ago.
*Notably, in 1971, Sullivan joined the General Motors Board of Directors and became the first African-American on the board of a major corporation
Sources: Data as of 3/8/21. Task Force on Climate-Related Financial Disclosures (https://www.fsb-tcfd.org). The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.