Werner's Blog — Opinion, Analysis, Commentary
Fossil-fuel divestment at UBC: feat or folly?

Over the last year, some universities have embarked on divesting out of fossil fuel stocks. In May 2014, Stanford University announced that it would purge its $18 billion endowment of coal stocks. Harvard University refused to do the same, and a few Harvard students have actually taken the fossil fuel fight to Court. The campus divestment campaigns have been spurred by the 350.org movement that is led by the environmentalist Bill McKibben. The movement wants universities to divest out of the 200 companies with the largest global carbon reserves. This includes oil giants such as Exxon Mobil, BP, Shell, and Chevron.

A similar divestment campaign was launched at UBC, known as Divest UBC, by students and a group of 170 faculty members from across the campus. Students voted 4-to-1 in favour of such divestment, and faculty members are voting between January 26 and February 8, 2015, on a similar motion. It is meant as a mostly symbolic act: to raise awareness about climate change and the lack of political action to reduce greenhouse gas emissions.

Economists are a skeptical bunch, and I am no exception. So in the spirit of friendly academic discourse, I take a stand and question the wisdom of this campaign. I hope that the supporters of the divestment campaign—many of them good friends of mine—will take my criticism as a friendly reality-check. After all, we share the same good intentions: we all want to tackle climate change and promote sound policies. But the question is: does fossil-fuel divestment get us any closer to that goal?

The idea of fossil-fuel divestment is born out of frustration: the frustration about governments that prevaricate about climate change and lack concrete actions and policies that have more than a marginal impact. So fossil-fuel divestment has become a symbolic act of success, a cathartic purging of our links to the purveyors of carbon. It is easier to convince fellow academics to divest out of fossil fuels than to convince ignorant or feeble politicians in the US Congress or our Canadian Parliament that climate change is real, costly, and urgent.

So let me take a step back and scrutinize some of the key arguments in favour and against fossil-fuel divestment. Supporters of the campaign may take heart in that I don't see fossil-fuel divestment causing grievous harm to the profitability of university endowments. On the other hand, I find no merit in vilifying the oil and gas industry. And on closer inspection, fossil-fuel divestment also turns out to be highly impractical and costly. Below is a discussion of the pertinent issues with questions and answers.

Will fossil-fuel divestment hurt the profitability of investments?

The answer to that question depends to some extent on where funds are invested in. There are a number of benchmarks that we can use to make comparisons over different time horizons. The first thing to note is that investment funds that have a large share of domestic stocks are much more exposed to the energy sector than either U.S. investments or worldwide investments. To give a sense of the different sectoral weights, the table below shows sectoral weights for three popular exchange-traded funds from iShares: XIC (S&P TSX Capped Composite Index Fund), VUS (U.S. Total Market Index), and XWD (MSCI World Index). The table is sorted in descending order of the XIC weights. The composite index for Canada is dominated by the financial industry (about one third), followed by the energy sector (about one quarter). Dropping the energy sector would thus rob the portfolio of one quarter of its assets. The energy sector weights are much less in the United States and worldwide: roughly 9 percent each. Therefore, an investment portfolio that is heavily diversified internationally will be much less influenced by returns in the energy sector than an all-Canadian portfolio.

Industrial Sector Canada
Financial Services 30.88   14.58   18.67  
Energy 23.63   9.03   8.81  
Basic Materials 10.56   3.65   5.34  
Industrials 8.80   11.81   11.22  
Communication Services 5.50   3.67   4.37  
Consumer Cyclical 5.00   11.07   10.33  
Real Estate 4.58   3.49   2.68  
Consumer Defensive 3.58   8.34   9.92  
Healthcare 3.23   13.81   12.99  
Technology 2.19   17.53   12.37  
Utilities 2.01   3.02   3.30  
The sector weighting of the three exchange-traded funds were as of November 2014.

The more pertinent question is about the returns. Let's stick to a purely Canadian portfolio for the time being. I have analyzed daily index data from the Canadian Financial Markets Research Centre, which provides sectoral indices in addition to the composite index, and I have calculated annualized returns for time horizons of 1, 3, 5, 10, and 25 years. (The complete 2014 data was not yet available, and obviously energy stocks have taken a hit since the collapse of the oil price in late 2014.) I have also estimated the coefficients on a very simple CAPM model. The intercept, the alpha (α), captures the presence of a significant premium or discount. The slope, the beta (β), captures the degree to which the sector moves with the overall market; if it is larger than one the sector exaggerates market movements, and if it is smaller than one it moves less than the market. The table below shows the results of this analysis.

One small caveat applies. The energy sector in the analysis above comprises all types of energy companies. This includes both fossil fuel companies as well as those producing renewable energy. However, the market capitalization of the fossil fuel companies is dominant in this sector.

What do the numbers tell us? Over long time horizons, the TSX has generated a return of 8.0-8.4%. Energy stocks have done slightly better over long time horizons (about 10%) but more recently have slightly underperformed. The collapse of oil prices in late 2014 has obviously had a strong negative impact as well, but the data in the table ends in 2013. The alpha is not significant in the CAPM regression, which indicates that this sector does not perform statistically better or worse than the market overall. The alpha is only significantly positive for consumer staples, financials, telecoms, and utilities. The energy sector is also moving much in synchronicity with the market overall. This is not surprising as energy demand is strongly pro-cyclical. The beta for the energy sector is very close to one. What that means is that the energy sector tracks the overall market quite well, and thus taking the energy sector out has relatively benign effects on the remaining portfolio. Taking the results together, excluding the energy sector from an all-Canadian portfolio will probably not depress returns significantly in the long run. However, over short time horizons performance may differ. That's what all investment advisors will tell you: past performance is no guarantee for future performance. But if past performance is our benchmark, fossil-fuel divestment is not going to depress the returns of an investment portfolio dramatically.

TSX Canada
Industrial Sectors
Annualized Returns [%p.a.] CAPM Estimates
1 yr 3 yrs 5 yrs 10 yrs 25 yrs α β
Composite 13.0  3.4  11.9  8.0  8.4    
Energy 13.6  0.6  10.0  10.0  10.1  1.7%  0.959c 
Materials -29.1  -19.2  -0.7  4.7  4.6  -3.9%  1.023c 
Industrials 37.5  18.2  19.6  10.8  7.5  0.4%  0.867c 
Consumer Discr. 43.0  13.9  16.3  7.1  7.2  2.3%  0.635c 
Consumer Staples 23.6  17.4  14.0  7.1  12.0  8.6%c 0.385c 
Health Care 72.1  47.8  46.8  11.3  8.7  3.0%  0.702c 
Financials 23.7  12.2  17.8  9.7  12.6  5.4%a 0.856c 
Inform. Technology 37.3  -14.1  -4.2  -4.1  3.4  -7.9%  1.406c 
Telecom Services 13.1  16.4  15.5  11.0  13.2  7.2%a 0.644c 
Utilities -4.1  2.0  8.4  8.0  9.5  5.8%a 0.424c 
Note: CFMRC Index Series through December 31, 2013 for the TSX. (The 2014 data was not available yet.) CAPM estimates are based on the regression of daily returns on the composite index returns. Statistical significance is indicated at the 95%, 99% and 99.9% level of confidence with superscripts a, b, and c, respectively.

For international comparisons, MSCI maintains all-country world indices (ACWI) for large and mid-size stocks. In addition to the composite ACWI, MSCI also calculates an ex-fossil-fuel MSCI, starting in 2010. This is unfortunately not a very long time horizon for comparison. For the last four years, the composite and ex-fossil-fuel indices have not diverged much. In fact, the ex-fossil-fuel index has slightly outperformed the composite ACWI during that period.

With these numbers in mind, it may appear as if it would be easy to divest out of fossil fuel stocks if the returns do not look all that different. However, divestment faces a number of practical hurdles that are ultimately very costly.

How difficult is it to divest out of fossil fuel stocks?

The May 2014 UBC Endowment Fund Combined Report from RBC Investor & Treasury Services shows that UBC is holding $1.2 billion in assets, of which about $1.0 billion is in equities. Only about 8% of assets are in common stocks. By asset category, UBC holds 11% of its common stock in oil and gas companies, for a market value of $10.2 million. This is a tiny amount of assets that UBC holds directly in the oil and gas industry. Most equity that UBC holds is through pooled equity funds. It would be extremely impractical and costly for UBC to divest out of these pooled equity funds. It would severely limit the options available to UBC to provide the degree of diversification that is necessary for such a large endowment.

What is UBC's current investment policy?

UBC has not been sitting idle as far as corporate social responsibility is concerned. However, the university's options to engage companies directly are extremely limited. UBC has adopted a responsible investment policy for its endowment, which commits the university to incorporate environmental, social, and governance (ESG) factors in its investment choices. Specifically, UBC requires its fund managers to incorporate these factors in the management of their portfolios. Because UBC invests in pooled equity funds rather than directly into companies (except for a small part of its portfolio), UBC encourages its fund managers to use their proxy votes to promote transparency on ESG policies.

Will fossil fuel companies react to divestments?

It is extremely unlikely that divestments from a handful of universities will have any noticeable impact on stock prices of fossil fuel companies. Compared to the total market capitalization of fossil fuel companies, university endowments are a mere drop in the bucket. Over longer time horizons, fundamental factors determine stock prices. If divestments depressed the stock price in the short-run, investors who are not concerned about holding fossil fuel stocks will find these stocks a bargain—and will buy them. Even a total boycott of owning fossil-fuel stocks in Canada would not necessarily hurt the more senior companies as they can raise equity and debt in other countries. In short, fossil-fuel divestments will not hurt fossil fuel companies financially or impede their ability to finance their operations. For them, this campaign is merely a matter of public relations and appearance, but not a matter of profitability and financing.

Wasn't the divestment of South African stocks helping to bring down apartheid there?

Proponents of fossil-fuel divestment often point to the economic boycott of South Africa and similar divestment campaigns directed against the apartheid regime in South Africa. Based on their thorough empirical research, Siew Hong Teoh, Ivo Welch, and C. Paul Wazzan report in The Effect of Socially Activist Investment Policies on the Financial Markets: Evidence from the South African Boycott (The Journal of Business 72(1), January 1999, 35-89) that "despite the publicity of the boycott and the multitude of divesting companies, political pressure had little visible effect on the financial markets". While divestment appears to have had little impact on South Africa's economy, the isolation of that regime probably did. Trade sanctions probably helped too, because curtailing imports had more noticeable outcomes.

There is a strong argument to be made to divest out of stocks that are associated with illegal or unethical activities. Where companies break the law wilfully, divestment may become a moral imperative. Unethical practices may trigger similar sentiments among investors. Arms manufacturers that peddle weapons to unsavoury regimes come to mind. And when tobacco companies were misleading consumers and the public about the links between smoking and cancer, divestment can be a suitable form of distancing oneself from the activities of such firms. But the equation for fossil fuels is not that simple. As fossil fuel companies are not engaged in an illegal activity, the remaining question is about the ethics of producing fossil fuels.

Are fossil fuel companies unethical? Is producing fossil fuels unethical?

Fossil fuel companies are not worse than other industrial companies. In many ways they are very respectable corporate citizens. They supply a commodity that is highly demanded world-wide. Western oil and gas companies treat their employees well, and in fact they often pay a premium over wages in other industries. Oil and gas companies also pay lots of taxes and royalties. They even try to improve their environmental performance, difficult and slow as that may be. Environmentally, things can go wrong, and sometimes spectacularly. The Exxon-Valdez spill in 1989 and the Deepwater Horizon spill in 2010 are the most prominent examples. Despite such large setbacks, these companies are evolving. They even embrace energy diversification, and some companies are even quite enlightened about their attitude towards climate change.

Of course, fossil fuel companies are not among the most enthusiastic to battle climate change. Some of them lobby governments, often very effectively, to resist climate initiatives that would prove costly to them. That oil companies pursue their self-interest is not unethical if they do so openly and transparently. We can judge them by their statements and their actions. Neither is it unethical that they hold views that are different, and that they promote their views through a variety of channels. For corporate behaviour to be unethical it has to involve deceptive practices, purposeful misrepresentations, personal attacks, defamation or slander. While some climate change deniers are prone to using such practices, the oil and gas industry cannot be accused broadly of employing deceitful or unethical practices.

‘Oil and gas companies are not the problem, but they can be part of the solution.’

Oil and gas companies are not the enemy. I see litte benefit in casting them as the villain in the debate about climate change. Oil and gas companies are not the problem, but they can be part of the solution. Many of them are investing in renewable energy, even if that remains a small percentage of their overall activity. Their financial strength can help develop technological innovations for carbon capture and storage—if governments can only find the willpower to impose carbon pricing. And as oil and gas will eventually dwindle, energy companies will seek out a new future in other, renewable types of energy.

Oil and gas companies are not unethical simply because they produce the oil and gas that generates greenhouse gases. Pointing the finger at them means pointing four fingers back at us—the consumers of oil and gas. We demand oil and gas for our cars, or airplanes, and for heating our homes. As long as we are intense users of oil and gas ourselves, it is hypocritical to point the finger at oil and gas companies. It is our addiction to cheap energy from fossil fuels that is the problem, and not the resource companies that provide the oil and gas. When you have an alcohol addiction, you shouldn't blame the whisky distilleries for it. Likewise, we should not blame our addiction to fossil fuels on the gas and oil companies.

Will fossil-fuel divestment raise support for introducing climate change policies?

It is tempting to couch the debate over fossil-fuel divestment in terms of a moral debate about "good" or "bad", or "right" or "wrong". But pragmatically, the pertinent question is whether fossil-fuel divestment increases pressure on policy makers to introduce policies to mitigate climate change. If fossil-fuel divestment comes at a cost, what will we get in return? As far as such symbolic action goes, I seriously doubt that it will have any noticeable impact on policy makers.

My concern is that the ensuing battle over fossil-fuel divestment at universities is irrelevant to the public debate over climate change and may even cause a public backlash. The campaign gives opponents of climate change policies an easy target to aim at: academics who seek the moral high ground but continue to benefit from all the goods and services that depend on fossil fuels. It makes it possible to brand academics who promote sensible climate change policies as hypocrites. Or worse, it may cast us as naïve if we suggest that divestment actually reduces GHG emissions. And much worse, we may end up fighting over our position on fossil-fuel divestment among ourselves rather than focus on fighting for sensible climate change policies in Washington and Ottawa.

For onlookers outside academia, framing the question as one about morality can only undermine support. It doesn't help to make people feel guilty about using oil and gas. Instead, it helps if we can reframe the debate as one about the welfare of our children and grand-children: after all, they will suffer the brunt of the consequences of climate change. Our political inaction on climate change is a sad admission about how little we (and our elected representatives in Ottawa and Washington) care about future generations.

‘Fossil-fuel divestment is a red herring.’

So what can society (and universities) do about climate change?

The answer to that question is remarkably simple: put a price on carbon. In fact, the proponents of fossil-fuel divestment all agree with me on that. Economists universally agree that the most efficient approach to dealing with a negative externality is to put a price on it. Unlike command-and-control regulation, carbon pricing is a market-based instruments that allows firms to figure out the most efficient way to respond to this price signal. There are different forms of carbon pricing, ranging from a carbon tax such as the one in British Columbia, to cap-and-trade systems as in Quebec, to various hybrid forms. My favourite market-based solution is the carbon dividend, which I have described in a previous blog, Getting energy prices right. I will continue to focus my energy on promoting this solution. Once a price for carbon is in place, other energy sources (wind, solar, geothermal, nuclear) will become more competitive. As for fossil-fuel divestment, I urge caution. fossil-fuel divestment is a red herring: it preaches to the choir, but will do little to broaden support for climate change policies among the more skeptical, less-engaged part of society.

As for universities and us academics, we can do better by intensifying our research into climate science, fostering innovation into carbon capture technologies and clean energy, and lead by example. We can invest in reducing our own greenhous gas emissions and showcase technologies and solutions. UBC is already doing that with many projects, and I would say successfully.

What about the UBC pension fund? Would fossil-fuel divestment be easier there? Or more desirable?

The UBC pension fund is an entirely separate affair from the UBC endowment. The UBC pension fund gives faculty and staff the option to invest their retirement savings in one or more of the five funds they offer: a balanced fund, a bond fund, a canadian equity fund, a foreign equity fund, and a short-term investment fund. These funds are meant to represent the "broad market".

Forcing divestment on unwilling participants would be unethical. Participation must be voluntary rather than mandatory; nobody should be forced to divest out of their chosen portfolio. However, the pension fund could consider offering a new investment fund that specifically follows environmental, social, and governance (ESG) principles. Thus, individual faculty members could voluntarily choose to invest all or part of their pension in such a separate fund—and bear the risk that it underperforms or enjoy the benefit if it overperforms.

Creating an "ethical investment" option for the pension fund is not an easy task either because different investors may have different notions of what they consider as "ethical". There may not be one ethical portfolio that satisfies everyone. At most, the pension plan could add only one such aggregate ethical fund. And the stricter the ethics definition of that fund, the smaller the universe of eligible stocks. Adding another investment vehicle to the UBC pension fund would likely involve additional administrative costs that would be borne by all faculty members regardless of their participation in the new fund. Creating such a fund on an "opt-in" basis should only be considered if a significant number of faculty members express a firm—rather than fleeting—interest in participating.

Some final thoughts

To those who find my skepticism over fossil-fuel divestment disagreeable, let us not forget that the only thing that really matters is the total amount of CO2-equivalent emissions. Fossil-fuel divestment will not make a dent in that number. Really. I sympathize with the enthusiasm of the divestment campaigners: you want to do something—anything—to help bring about positive change. But let us not get distracted from focusing on the only solution that will really help—putting a price on carbon.

Further readings:

Posted on Sunday, February 1, 2015 at 19:30 — #UBC | #Environment
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