Students were ecstatic when Harvard University committed to divest its endowment from fossil fuel. This was a major win, other endowments would follow, and fossil fuel would soon disappear. But would it really? Divestment might not be that effective.
When there is a seller, there is a buyer
When you divest your shares, less socially conscious investors are usually the buyers. They will not engage the firms regarding their environmental or social practices. Therefore divestment can create even worse companies. Good luck with changing the company if you are the only ESG investor remaining.
But there is more...
Selling a stock does not deprive those companies of capital (money). A coal company can still borrow from a bank to finance its new project. It is only at IPO that the cash goes into the hand of the company, the rest of the time, it goes from one investor to the other. Divesting has no direct effect.
So when is divesting working?
Divesting is useful in some situations. First, it frees up some cash for other investments. If you sell $100 worth of your coal, you now have $100 to put somewhere else. You can invest:
- in a renewable energy company to boost its price. You signal your confidence in the industry's future to the overall market.
- in a neat IPO to bring more capital and help this company get into the next step
- in your solar panels on your roof to save up on the electricity bill
You got it. Freeing up some cash does not change anything for the coal company. But it helps the sending money to the good guys.
Remember when we said that divesting has no direct effects on the coal company?
Well, we kinda lied...
Yes the coal company can still borrow money on the market but selling decreases its price. This impacts how much they can borrow. Companies have certain limits as to how much they can borrow, and this is linked to their valuation. It is the leverage. This is similar to how much mortgage you can take when you buy a house. With a large downpayment, it is easier and cheaper to borrow.
Depressing prices limit the borrowing capacity of companies.
Divesting has also other secondary effects: low stock price decreases employee motivation, increases the risk of takeovers and worsens the CEO's reputation. Good news in the end!
Towards tilting, the best of the two worlds
Tilting might be the most efficient solution, new research shows. Tilting means:
- allocating most of the capital to sustainable companies
- holding the "best of the worst" in the controversial industries
- and excluding all the other controversial companies
Why this approach? You keep most of your dollars for the good guys, but you leave enough room for the bad ones to get better. Laggards are incentivized to take corrective action and get on the right track.
Who said you should never give someone a second chance?