The increasingly charged and polarized politics surrounding the climate crisis have asset managers between a rock and a hard place when considering their investment strategy. Should they abruptly divest from stocks of fossil fuel industries? Should they progressively withdraw?
Complete divestment from carbon-intensive industries has become a popular strategy internationally, and institutional funds—including, most recently, Concordia University in Montreal—have excluded oil and gas producers from their portfolios. Across the border, Harvard and Yale are facing pressure from their students as well as faculty to divest immediately – earlier this week Harvard’s Faculty of Arts and Sciences voted overwhelmingly in favour of divesting the university’s endowments.
In December, McGill’s Board of Governors opted not to divest its endowment fund outright but instead announced a major plan to decarbonize it. The decision prompted much debate – one tackled at the McGill International Portfolio Challenge, the world’s largest buy-side finance competition where 87 student teams from around the world tackled the divestment conundrum in November.
This year’s challenge centered on a hypothetical $15 billion pension fund based in Newfoundland and Labrador, a province highly invested in the local oil and gas industry. In the scenario, the board of directors are under pressure to divest but deeply conflicted on how to proceed.
Teams examined the pros and cons of the divestment strategy. On the one hand, divestment sends a clear message that the fund is serious about ending its dependency on fossil fuels. It also reduces the fund’s exposure to the risk that the fossil fuel industry will become stranded once greener technologies take over.
On the other hand, the divestment strategy raises a number of questions and concerns. Will the fund maintain its political power and ability to advocate for pro-environmental corporate decisions if it gives up ownership stake in the local oil producers? Is it advisable to divest from the entire oil and gas sector when no other technology can presently replace it as an equivalent energy source? Is a divestment strategy solely focused on oil and gas producers consistent with the broader objective of reducing carbon emissions? Last but not least, is a divestment strategy consistent with the fund’s fiduciary duty to generate returns to its pensioners?
The top solutions, vigorously vetted by professors, pension experts and asset managers, addressed concerns of all stakeholders and found win-wins that aligned environmental sustainability with long-term financial profitability.
The conclusion: the first pillar of a successful solution is to establish a planned transition toward responsible investments. The fund should progressively and partially divest from its holdings in oil and gas over the next 5 to 7 years in order to reduce its exposure to this sector. It should also push the province to sign a moratorium on future offshore oil exploration to re-channel future investments toward greener sectors and diversify the economy.
The transition should be communicated upfront and include feasible milestones to establish credibility. It should be moderate and progressive to ensure that no stakeholder is disproportionately affected. By retaining some ownership of the oil producers, the fund will continue to have a say on their business operations and environmental, social and governance (ESG) practices.
It was decided that the money from the sales of oil and gas holdings should be re-invested in a diversified set of sustainable ventures where the province has a need (infrastructure, real estate) and a comparative advantage (ocean technologies, aquaculture, low-cost electricity from its large hydro project). These investments will encourage entrepreneurship in sustainable ventures and decrease the fund’s reliance on oil and gas. As well, the fund should partner up with private equity firms to achieve economies of scale and acquire expertise in these sectors.
The second pillar of a successful strategy is to leverage the fund’s large size to establish a long-term and active stake in local ventures that have positive social and environmental impact. Doing so will incite the fund to implement good governance practices, work with local communities and make sure every stakeholder gains from the projects. This in turn will lead to improved risk management and profitability over the long-run.
The third pillar of a successful strategy is to globally diversify a large share of the portfolio in order to increase returns and decrease risk. By investing in a variety of ESG-focused funds that focus on clear metrics, such as CO2 emissions and ESG scores, the fund will be able to control its carbon footprint and ESG engagement while investing in a large number of firms.
In many respects, the McGill Board of Governors’ plan to decarbonize its endowment fund echoes the winning proposals’ recommendations to partially and progressively divest from stocks of fossil fuel industries, become a more active shareholder, and make new investments in green ventures. In addition, the fund’s mandate will be revised to prioritize ESG considerations for future investments.
I expect campuses across the continent to continue deliberating over divestment tactics over the coming months. In the end, win-win solutions will need to be comprehensive, pragmatic, cognizant of the needs of all stakeholders, and align environmental sustainability with long-term financial profitability. After much debate, what is clear is that environmentally sound investment strategies should go beyond a pure yes/no response to divestment.
Sebastien Betermier is Associate Professor of Finance, Desautels Faculty of Management at McGill University.