A recent press release announced that 100 faculty and other staff at three Ontario postsecondary institutions have petitioned the University Pension Plan (UPP) to divest from the fossil fuel sector. The UPP manages the pension funds for over 30,000 employees at the University of Toronto, Queen’s and Guelph. The press release was issued by Shift Action, an organization that helps activist pension members agitate for divestment from what it calls “high-carbon, high-risk fossil fuel investments” such as oil producers and pipeline companies, and shift investments to a “decarbonized” portfolio focused on climate solutions.
I highlighted the UPP petition to draw attention to its activist source, but it is not unique, as it reflects a broader trend of politically driven or, as proponents prefer, “ethical” investing. The motivating claim for divestment in the Shift press release is that we are experiencing a “worsening climate crisis.” That too is a common sentiment nowadays. Because it is a crisis, we have a moral duty to mitigate the threat. The underlying reasoning is that divestment will starve fossil fuel companies of capital and less capital means less production which, in turn, means less CO2 emitted and ultimately slower climate change.
All campaigns of this sort trigger some immediate questions, such as, why choose a strategy as indirect as divestment? Why not reduce fossil fuel use in one’s own backyard, in this case the universities? Looking more broadly, Shift’s argument is more wishful thinking than sound economic analysis. Investors should feel free to hold any portfolio they want, but they should do so without illusions. In particular, they shouldn’t expect divestment to influence climate change by starving oil and natural gas companies of capital.
The Motivation is Wrong
The first thing wrong is the underlying motivation: there is no climate crisis. As well-known author Bjorn Lomborg states in his most recent book, False Alarm: How Climate Change Panic Costs Us Trillions, Hurts the Poor, and Fails to Fix the Planet: “Climate change is real, but it’s not the apocalyptic threat that we’ve been told it is.” One of the clearest ways to see this is through climate economics. Scenarios set out by the Intergovernmental Panel on Climate Change (IPCC) forecast that over the next 80 years worldwide GDP per capita will likely increase to 450 percent of today’s level.
Lomborg estimates that climate damages will reduce this anticipated increase to 434 percent. Climate change is a problem. Accepting all of the assumptions that went into this modelling, climate change is likely to leave us somewhat less well off than we otherwise would be, by modestly slowing humanity’s overall progress. But judging by these figures, it is not a crisis.
Other People’s Money
An ethical problem with university divestment campaigns is that proponents attempt to use the university’s resources to advance their personal political causes. I have no quarrel with individuals who manage their own investment portfolios as they see fit, including in ways that reflect their political or philosophical beliefs rather than strictly their financial goals. But attempting to manipulate pension investments to advance personal politics is outrageously selfish, because it can only undermine the purpose of the investment – which is to provide for the financial security of thousands of other people, many or most of whom don’t have the same beliefs.
According to modern portfolio theory, if a pension fund is well-run and its holdings are properly allocated to maximize returns at its chosen level of risk, then any deviation from that – such as politically motivated divestment – cannot increase returns or reduce risk. It can only make one or both worse. Threatening the retirement finances of co-workers to advance one’s own political agenda should be understood as theft.
Divestment Happens in the Secondary Market but Capital Comes from the Primary Market
Divestment seems very popular. Portfolios with self-described “sustainable” goals took in a record US$649 billion worldwide last year through November 30, up from US$542 billion in 2020. But these environmental, social and governance-driven investment trends do not imply capital starvation for companies, because funds trade in the “secondary” market. The secondary market is where securities are exchanged after they are first issued in the primary market by the company that is raising investment capital.
For example, when a fund manager sells shares of Shell Oil and instead buys Tesla on the New York Stock Exchange – or when you buy or sell stocks or fund units through your broker or an online service – these trades do not directly affect the issuing company. Of course, nearly every publicly traded company worries about its share price, because there’s a lot riding on it. Short-sale attacks, where short sellers drive a stock price down based on rumour, can severely pressure and constrain companies. But if the rumour is unsubstantiated and the company’s business is sound, then such attacks ultimately fail and the company carries on. To directly starve companies of capital with any real hope of success, one must restrict their access to the primary market.
There were times when Alberta’s energy sector consumed large amounts of new equity capital as it grew rapidly. A concerted divestment campaign in one of those periods might have done real harm. The thing is, the fossil fuel sector isn’t particularly reliant on primary markets right now. Big new projects like oil sands facilities, trunk pipelines and LNG export facilities are always capital-intensive, but these are few in number. While there are always some producing companies that require new equity to fund a drilling program, new processing facility or asset acquisition, Canada’s so-called “upstream” energy sector currently relies mainly on internally generated funds. Its external equity capital needs are comparatively modest and, in any event, represent a small fraction of overall primary markets.
The story in the U.S. is similar. Since 1995, the U.S. oil and natural gas sector has only been cash-flow-negative in five years – meaning that most of the time its operating cash flows covered its capital expenditure needs, according to an analysis I recently conducted. In the worst year, 2015, the shortfall was only $25 billion. To put that in context, in 2019 all U.S. corporations combined raised $2.1 trillion of new capital. In other words, should North America’s fossil fuel-producing sector need more equity capital at some point – even, say, four times as much as it needed in 2015 – it will still only require a small fraction of primary market investors to eschew political fashion and continue investing in fossil fuels.
Even if a divestment campaign was successful in starving fossil fuel companies of capital and constraining their extraction activities badly enough to reduce overall production, the result would be to increase fossil fuel prices. This is the very pattern we saw over the past year-and-a-half: investment collapsed throughout Covid-19, production sagged, and prices shot up as economies recovered. This, in turn, is all-but certain to attract more capital to bring production back up. But if we refuse to allow our own producing companies to invest within our own countries, much of that new production will come from countries like Saudi Arabia and Russia – places with terrible human rights and environmental records and little sympathy for the ESG movement.
Either way, a starvation campaign is futile if demand for fossil fuels remains strong. Will it?
Trends in Fossil Fuel Demand
Despite never-ending claims in the news media and from political leaders and activists that the “energy transition” is underway and we’ll soon do nearly everything with electricity, demand for fossil fuels is forecast to remain high for decades. As the accompanying chart shows, fossil fuels currently constitute 79 percent of the U.S. energy mix (which is roughly comparable to Canada’s). It also reveals the slow pace of energy transition. It took 70 years for fossil fuels to decline to their current proportion from 91 percent of the U.S. energy mix in 1950. These things take time. Crude oil in commercially usable amounts was first discovered in 1859, but oil did not surpass coal as the world’s primary energy source until 1960. There is no reason to think the next energy transition will be quick, easy or cheap; zero is a long way off.
Demand for fossil fuels is even stronger in the developing world – and growing rapidly. There are over 3 billion people in Africa, India and China still striving to join the middle class. Affordable energy is the main driver of their enrichment and fossil fuels are the cheapest large-scale energy source. Not surprisingly, they already provide the majority of energy in both China (86 percent) and India (76 percent). Not only do both countries consume copious quantities of oil and lesser but growing amounts of natural gas, they are also making large and sustained investments to increase their production of coal. It would be naïve to expect developing nations to choose poverty by shunning fossil fuels, and it would be cruel to deny them.
The International Energy Agency (IEA) forecasts that fossil fuels “will continue to make a major contribution to the global energy mix through to 2050.” Lomborg, using the IPCC’s “SSP2” scenario, forecasts that fossil fuels will still fulfill 75 percent of the world’s energy requirements even in 2100 (as indicated in the second chart). Strong demand will sustain commodity prices, and solid pricing will bring opportunities to make profits. Those profits will attract investors, unless the most basic assumption of economics stops being true.
Assumption #1: Consumers Prefer More to Less
For the capital-starvation strategy to work despite strong demand for fossil fuels, one must assume that investors will sacrifice investment returns to save the planet. That may be true for some or even many investors. But for starvation to succeed, it must be true for virtually all investors, because the fossil fuel sector needs only a small proportion of global capital to thrive.
I am sceptical that most investors will accept low returns, especially over time, because that means ending up poorer or working longer, neither of which has proven to be popular. For example, consider a representative investor named Claire. Claire is 30 years old. She plans to save $6,000 per year at a hoped-for average annual return of 8 percent in order to accumulate a little over $1 million by age 65. If divestment were to reduce Claire’s portfolio return even slightly, just to 7.5 percent, she would end up $108,000 poorer at retirement. If she still wanted to achieve her original investment goal, she would have to work one year and five months longer to give her portfolio time to catch up.
There is no evidence that Canadians are willing to make that level of sacrifice. A CBC News poll in 2019 found that while nearly two-thirds of Canadians see fighting climate change as a top priority, half of those surveyed would not pay more than $100 per year in additional taxes to do so. One can safely assume this same half would be unwilling to forego a material portion of their retirement savings in pursuing the same goal.
If continued strong demand for fossil fuels leads to high prices and profitable investment opportunities, then we should expect capital to continue flowing towards those opportunities, just as economic theory predicts.
The Economic Consequences of Divestment
Even if divestment were initially successful, it would sow the seeds of its own failure. To see why, let’s think through the implications of a successful divestment campaign. We don’t need much imagination. Current campaigns have already pressured companies like Shell, Exxon and all of Canada’s largest oil sands producers to make net-zero commitments. And senior global figures like Mark Carney, former governor of the Bank of Canada and the Bank of England, currently vice-chairman and head of “impact investing” at Brookfield Asset Management, has sought to warn investors away from fossil fuel companies by predicting that most of their resources in the ground could be rendered worthless (“stranded”) should future climate change policies rule out producing them.
But reduced supply causes prices to rise. The halving of oil prices in late 2014 caused oil and natural gas capital spending to decrease in Canada and around the world. The Covid-19 lockdowns triggered further reductions. But by late 2021 global demand had recovered almost to pre-pandemic levels which, coupled with reduced supply, produced a bull market in oil and natural gas. The benchmark Brent crude oil price rose from US$40 per barrel in October 2020 to over US$80 per barrel one year later – a seven-year high. Analysts expect the bull market to continue through 2023. Natural gas prices also soared around the world, in places to all-time records, and even Alberta is at last being lifted out of its more than 10-year-long natural gas trough.
Shareholders in energy-producing companies will want to profit from the high oil and gas prices. There is already evidence of such a response in Western Canada, where 40 percent more wells were drilled last year than in 2020 and analysts expect another big increase in 2022. Last fall Canada’s crude oil production reached an all-time record of 3.84 million barrels per day, prompting Jack Mintz to declare in the Financial Post just over a week ago that “Alberta is getting its mojo back.”
If the management teams of publicly traded energy-producing companies resist investing in exploration and development despite the high prices, then they are likely to be replaced. This can happen through takeover or shareholder revolt. The 1980s saw a wave of hostile takeovers that were motivated largely to remove underperforming management, and such churn is commonplace in the energy-producing sector. Similar pressure can also come from lenders, either informally or via a company’s board of directors, as large lenders often have a seat on the boards of their major borrowers.
Alternatively, a company’s board of directors will sometimes remove underperforming executives to forestall a takeover. Danone is a good example. Its CEO, Emmanuel Faber, became an ESG celebrity by doing things like organizing a business biodiversity group at a UN climate summit. But early last year his board dumped him because shareholders complained that he wasn’t maximizing their interests. Canada’s energy company executives are no strangers to such tactics by their own boards.
If underperforming management still isn’t replaced, then such companies will instead exit the fossil fuel industry by selling assets. They won’t simply walk away from the wealth and future cash flows represented by their proved and probable reserves, or of less developed “plays” that hold strong resource potential in need of capital and drilling. There will be many eager buyers such as Saudi Aramco, PetroChina, Gazprom, Rosneft and Sinopec, to name a few. These companies, notably, aren’t domiciled in North American or Europe. American and European oil and natural gas companies make up only one-third of the international top 20. The other two-thirds are even more acquisitive, aren’t sensitive to capital market fads and will eagerly replace investors who divest.
To stop foreign investors from doing so, advocates of divestment will have to lobby governments to impose foreign ownership restrictions. If that happens, their success will be due to government intervention. Government intervention (and prohibition) is an increasing trend. In the U.S., the new Biden Administration last year imposed several measures to discourage investment and drilling – before cravenly asking oil companies last month to “produce more” after gasoline prices spiked to record levels. In Canada, a good example is the federal government trying to ratchet down oil sands extraction by imposing ever-tighter emissions caps (along with other measures such as discouraging new pipelines, imposing the West Coast “tanker ban” and continually increasing the regulatory review burden on new projects). In Canada, investors don’t need to divest, they can simply vote for the Liberal Party.
From Fantasy to a Genuine Alternative
Divestment won’t stop fossil fuel production because it does nothing to reduce energy demand. Demand is expected to remain high until at least 2050, and more likely beyond 2100. Strong demand sustains high prices, which create profitable investment opportunities that attract capital – domestic or foreign. For the individual investor, all that divestment will accomplish is to lower their investment returns.
If we truly want to accelerate the transition away from fossil fuels, we must support the development of alternatives that are economically, technically and environmentally viable. In my opinion, Generation IV nuclear reactors appear to be the most promising non-carbon energy technology. Regardless, individuals who are concerned about CO2-induced climate change should advocate for government funding of research into alternative energy technologies. Trying to stop extraction of fossil fuels in the absence of alternatives will simply raise prices and impoverish humanity.
William McNally is a professor of finance at Wilfrid Laurier University and a supporter of climate policies that benefit more than they cost.
Source of main image: Shutterstock.