Climate change: the roles of divestment and engagement

As the effects of greenhouse gas emissions are cumulative, persistent and not localised, the response needs to be international. It requires a shared global vision of long-term goals and frameworks that will accelerate energy transition and other action over the next decade.

The ratification of the Paris Agreement was a step forward, and an example of the global co-operation required. To achieve the goals set in Paris, greenhouse gas emissions need to be substantially reduced. The Paris Agreement requires each country to set out – in its Nationally Determined Contributions (NDCs) – its commitment to reduce greenhouse gas emissions, and details of how it intends to adapt to the impacts of climate change.

There is a diverse range of views on what the reduction targets for greenhouse gases should be. At Ruffer, we expect that the NDCs or climate pledges will be tightened in 2023, to align with the pathway to meet the goals of the Paris Agreement.

For investors, there will be opportunities for companies that contribute to the mitigation of or adaptation to climate change. Yet the lack of clear and co-ordinated policies to mitigate the worst effects of climate change increases risks. The physical risks of climate change are becoming increasingly apparent: in a globalised economy with complicated supply chains, the number of companies affected is vast. This has caught the attention of central bankers, concerned about the threat to financial stability. The transition risks to companies are also significant, and the lack of clarity on government policies makes it difficult to plan effectively.

Work co-ordinated by the Principles for Responsible Investment (PRI) suggests that the delay in government action around climate change means the most likely policy response by 2025 will be “forceful, abrupt, and disorderly”.²

How companies manage their greenhouse gas emissions has become fundamental to their long-term financial performance. Investors need to consider these issues seriously, and incorporate them both in their analysis of individual companies and into their overall investment approach.

Some argue that companies which emit large quantities of greenhouse gases will never change, and so it is not possible to reconcile owning their shares with a concern about climate change. Others propose that by owning shares you have the opportunity to influence a company, encouraging its management to become part of the energy transition necessary to achieve the goals of the Paris Agreement. Others still seek to combine elements of these two approaches.

We discuss the options of divestment and engagement in more detail below, and introduce our approach at Ruffer.

Divestment involves selling the shares of companies because of concerns over environmental, social, governance (ESG) or ethical issues. Recently, the focus has been on fossil fuel companies.

Often, divestment is based on the beliefs or values of investors. For example, both the Church of England and the Catholic Church, through Pope Francis’ encyclical Laudato Si, have stated the importance of addressing the moral issues created by climate change.

Among those divesting, some have concluded that continuing to invest in companies that have significantly contributed to climate change is irreconcilable with their moral values. Some take this argument further. By encouraging divestment, they aim to reduce the ‘social license to operate’ of fossil fuel companies. This, in turn, would reduce the power and influence these companies have, and so make it easier for governments to take action to tackle climate change.

The second line of argument for divestment is based on the economic risks – specifically, the risks of continuing to invest in fossil fuel companies. To achieve the goals of the Paris Agreement, society needs to reduce its emissions of greenhouse gases considerably, and so it is likely that the consumption of fossil fuels will need to fall. Consequently, there is a risk that fossil fuel assets will not be able to earn an economic return for their entire useable life. This can happen for a number of reasons including regulatory, economic or physical changes. It is particularly important for conventional fossil fuel assets, due to the length of their useable lives.

A third line of argument is that engagement is ineffective. In this view, fossil fuel companies have known about climate change for many decades – if shareholder pressure has failed to change their approach to date, it is unlikely to be successful now, because the companies are simply unwilling to change. It was back in the 1990s that fossil fuel companies began accepting publicly the occurrence of global warming, and the link between greenhouse gas emissions and climate change. For example, John Browne spoke about this, as CEO of BP America, at a speech at Stanford in 1997.

While these arguments are all important, there are other factors that need to be considered.

First, divestment is only possible once. Yes, it can be used to make a statement, something that is likely to gain the attention of companies and perhaps also the media. But once the shares have been sold it is usually no longer possible to be involved in discussions on company policy. Second, there is an argument that by selling the shares and depressing the share price, other investors – less concerned about climate change – are able to purchase shares at a lower price, while the business model of the company remains unchanged. These are the main arguments in favour of engagement.

Engagement is the process of continued dialogue with companies and other relevant parties, with the aim of influencing companies’ behaviour in relation to environmental, social or governance considerations. Investment managers and asset owners, along with many environmental groups, have been engaging with companies about climate change for a number of years. There are valid concerns about the success of engagement so far. However, in the last few years there have been considerable shifts; engagement could now be a very powerful tool to effect real change.

As concerns about climate change have intensified, the desire to engage with companies on these issues has grown. This has led to the launch of a number of shareholder initiatives, including Climate Action 100+. (Ruffer was a founding investor signatory of Climate Action 100+ and we are actively involved in its work.) Through this five-year global initiative, investors commit to engaging with 161 companies with significant greenhouse gas emissions, in industries from metals and mining to consumer products.

The engagement with these companies has three goals: to improve their governance of climate-related risks; to reduce emissions; and to increase disclosure. By the end of December 2019, more than 370 investors representing over $35 trillion of assets had signed up to Climate Action 100+.³ The scale of this initiative gives considerable power to investors, and creates a valuable opportunity to exert continued pressure on companies to align their business models to transition successfully to a low-carbon economy. Academic research in this area has started to identify how to make engagement more successful, and the mechanisms by which it can create value for both investors and companies.⁴ A number of these findings have been incorporated into the structure of these collaborative initiatives, and we are hopeful this will lead to increased success.

At the same time, organisations such as CDP (formerly Carbon Disclosure Project) and the Transition Pathway Initiative have given investors tools and quantitative analysis to use as the basis for meaningful engagement with companies. This is important as it allows investors to measure the progress companies are making, both on an absolute basis, and relative to their peers within their industry.

Engagement and divestment can also be combined. For example, investors can commit to engage with a company for a set number of years, but if companies haven’t achieved certain targets by the end of this period they then consider divesting. This approach can be particularly powerful if the timeline is publicly shared with the companies. The time taken to effect real change must be considered though, with some academic papers finding that engagement takes on average 1.5 years to be successful.⁵

A growing number of companies are now making significant commitments to reduce their greenhouse gas emissions, and to align their business models with the goals of the Paris Agreement. This partly reflects public pressure – and related reputational risks for businesses – but also, importantly, the influence of shareholders through collaborative initiatives such as Climate Action 100+.

Even in the most ambitious scenarios that reach the goals of the Paris Agreement, oil and gas will still provide a significant proportion of our energy in 2050.

Ruffer believes that engagement is an effective tool and we are committed to engaging with those companies in which our clients’ assets are invested. For those businesses that make a significant contribution to global greenhouse gas emissions we are engaging to encourage them to adapt their business models to align with the transition to a low-carbon economy.

This includes fossil fuel producers, mining companies and producers of energy-intensive products. We also discuss with these companies why greater transparency around climate change disclosure, as well as tangible targets for reducing greenhouse gas emissions, are important to investors.

Given the largest corporate greenhouse gas emitters often have operations in many countries around the world, and the effects of climate change are not localised, we think that engagement through collaborative initiatives such as Climate Action 100+ has the best chance of achieving lasting and positive change. The companies this initiative is engaging with are of great importance, given their combined greenhouse gas emissions: their actions will have a meaningful effect on whether the goals of the Paris Agreement are met. As part of Climate Action 100+, Ruffer is in specific working groups and has committed to engaging with a number of European and American companies, including ArcelorMittal and ExxonMobil (see box on page 25 and 26 of The Ruffer Review 2020).

On fossil fuels, we take the environmental concerns seriously, while also recognising that fossil fuels will continue to provide a significant proportion of global energy for the foreseeable future. They will therefore need to be part of the transition to a low-carbon economy. Renewables are growing at a considerably faster rate than fossil fuels, but even in the most ambitious scenarios that reach the goals of the Paris Agreement, oil and gas will still provide a significant proportion of our energy in 2050. What’s more, there are some areas in which the practicalities make it incredibly difficult to substitute fossil fuels for renewables: aircraft fuels, and heat generation for manufacturing processes, are two good examples.

This is why we think that engagement is so important. We want to encourage these companies to adapt their business models to enable them to be a positive force for change.

The actions taken in the next decade will determine whether or not the world manages to limit the increase in global average temperatures to 1.5°C or even 2°C above pre-industrial levels.

2020 is an important year as each country has to submit its updated pledge to reduce its greenhouse gas emissions, its NDC, for the first time since the Paris Agreement was signed five years ago. The pledges to reduce greenhouse gas emissions made in the first NDCs are not sufficient to limit the increase in global average temperatures to well below 2°C, let alone achieve the more stretching target of 1.5°C. While there may not be widespread policy change in the next year or so, the Paris Agreement’s global stocktake in 2023, and the third submission of each country’s NDC in 2025, will be significant. By the mid-2020s, it is prudent to assume that we may see “forceful, abrupt, and disorderly” policy changes, to use the phrase of the Principles for Responsible Investment again.

For investors seeking to influence the behaviour of companies, it is not necessary to choose either divestment or engagement. It is possible to combine both approaches, in ways that can be tailored to specific concerns. And the decision of whether to divest or engage doesn’t have to be applied to the whole industry. On climate change, there is wide dispersion in both the achievement and commitment of companies, and so it’s unsurprising that engagement is more likely to be successful with some firms than with others.

The pace of change in this area is energising, and there is considerable momentum that has already led to some significant commitments by companies. There is still much work to be done but we think that engagement, often through collaborative initiatives, is the best way to encourage companies that emit significant quantities of greenhouse gases to adapt their business models to help achieve the goals of the Paris Agreement.