“Despite its depressing realism at times, the report proposes a role for the world’s largest Sovereign Wealth Fund that might surprise many,” says Ellen Quigley, a PhD student at the University of Cambridge who has been working with the Newton Centre for Endowment Asset Management in the area of responsible investing.
The big question
In the midst of growing concern over the climate crisis and the emergence of a truly global divestment movement, the question has been asked of some of the most important players in the global market: Should the world’s largest funds divest from fossil fuels? The short answer, according to a report put out by an Expert Group commissioned by the Norwegian government, is no. The long answer is much more interesting.
The report explores the conundrum confronting the Expert Group: How to advise a country on fossil fuel divestment when that country is disproportionately dependent on fossil fuels? Oil represents 20 per cent of Norwegian GDP, a third of government revenues, and half of exports; the growth of the Fund itself reflects a proportional decrease in Norwegian fossil-fuel assets. The Expert Group questions the hypocrisy of divesting from fossil fuels while depending on them, and it takes the view that to assign blame selectively to the producers – but not consumers – of fossil fuel products is questionable: “The villain is our current society,” not any particular node in the network among producers and consumers of fossil fuels.
The Norwegian Fund
The Norwegian Government Pension Fund Global (“the Fund”, for short) puts its host country in a category of its own. Of all resource-rich countries in the world, Norway alone has set aside a significant proportion of its oil revenues for the benefit of future generations. The Fund, which could well hit one trillion USD next year, is the largest Sovereign Wealth Fund in the world; Norwegians collectively own on average 1.3 per cent of every publicly listed company in the world.
The Fund is famous for more than its size. It is impressively transparent and democratic, and it wields considerable influence among investors, not least for its approach to ethics. Wednesday’s report was a result of the government’s request for the Expert Group to make a recommendation as to whether or not the Fund should divest from all fossil fuel sector investments, the latest in a series of ethical questions the Fund has grappled with since its inception.
The Fund has long relied on a dual-pronged ethical investment strategy – first shareholder engagement, with the hope of influencing company behaviour, and finally exclusion from the Fund should the company remain intransigent. Wednesday’s report from the Expert Group, however, may portend a shift in the Fund’s approach to ethics, and indeed it will be particularly interesting to other institutional investors – pension funds, university endowments, charitable foundations, insurance companies – that own a more or less representative slice of the global economy and whose fates are therefore tied to the performance of the economy as a whole.
To divest or not to divest?
Some of the report’s conclusions are depressingly realist. It acknowledges that the two-degree scenario is not the most likely climate change scenario at present, which renders economical many projects that are incompatible with a safe amount of warming. Furthermore, oil and gas stocks appear to be more sensitive to overall market shifts than changes in oil prices in the longer term, meaning they may not be particularly dangerous to hold. There is significant risk-sharing between petroleum companies and governments, moreover; only after-tax cash flows matter in terms of asset pricing. Finally, Norway itself is less exposed to risk in a relative sense; national oil companies have less risk exposure than listed companies, and the oil majors face less risk than smaller upstream companies, many of which are unlisted. Norway’s primary risk comes from its own dependence on oil, followed by its exposure to listed companies.
Divestment would also constitute a dramatic shift in the Fund’s role, and indeed its current mandate does not allow for significant deviations from the benchmark. Already the Fund is underweighted in the fossil fuel sector and has invested slightly disproportionately in renewable energy. Besides which, exclusion (selling a company on ethical grounds) merely involves shares changing hands, since the underlying asset values remain the same, and therefore there is little direct effect on companies’ conduct. The risk of stigma is a possible exception, but in this case Norway cannot reasonably shame fossil fuel companies since it produces petroleum itself. The report maintains that it is not even desirable to use the Fund as a climate policy tool; it would be impossible to meet financial and environmental objectives simultaneously, and in the process of trying the Fund might lose credibility with – and therefore influence over – other investors.
Despite this conclusion on divestment itself, the report recommends an expansion of the current Guidelines for Observation and Exclusion to include “contribution to climate change” as a criterion. By establishing this new criterion, the Fund may contribute to upward pressure among fossil fuel companies as they compete not to be worst-in-class.
A political role for the Fund
The effect of the exclusion recommendation may well be dwarfed by that of others proposed by the Expert Group, however. The role for the Fund that the report proposes is different from what fossil fuel divestment advocates want, and its various features may surprise nearly everyone. In short, the Fund can more effectively reduce the threat of climate change – to its portfolio and to the world – through active ownership, and by playing a prominent role on the political stage and ensuring that the companies in which it is invested do so as well. The report states clearly that a precondition for the attenuation of the climate crisis is a price on carbon, which neither engagement nor exclusion achieves, and that the Fund’s efforts are best put into fostering a political environment in which a carbon price is possible.
Companies in the Fund’s portfolio may well find it more difficult to lobby against carbon pricing or for subsidies should its active ownership agenda attract the attention of other universal owners. Lobbying efforts represent only one example of the ways in which the Fund can leverage its influence as an owner, however; the report argues that it is not a question of whether fossil fuels will continue to contribute to the global energy mix in the coming decades, but which fossil fuels, which companies, and which investors should own them.
The best owners may well be the largest, those with the motivation and resources to promote environmental stewardship. Funds of a certain size have little hope of beating the market, for a number of reasons. Investment decisions must be made carefully; the Fund is too big to move quickly without incurring large trading costs, and its moves can shift the market as a whole. Infinitely long investment horizons, no explicit liabilities, and no short-term liquidity requirements necessitate investment strategies that differ somewhat from those of the average investor. Even in the context of markets ever more characterised by high-frequency trading, the Fund holds assets for years and decades as opposed to minutes or days. Moreover, externalities from one sector of the economy will be internalised by other sectors – and if a fund owns a slice of them all, it has an interest in ensuring that one sector does not outperform at the expense of others. Such is the dilemma of what we call “universal owners”.
The report takes the view that the markets price assets reasonably well, but that the trajectories of discrepancies move at ever stranger angles upward or downward the further forward in time we look. For example, the report cites evidence that, in the longer term, assets expected to be relatively high-growth end up producing disappointing returns, while stocks expected to be low-growth end up outperforming relative to expectations. The main opportunity and risk for the Fund, then, is in its investment horizon. This may be particularly important in the coming decades; there is evidence that the market expects a gradual increase in the price of emissions when in fact there is likely to be a sudden jump, and much sooner than investors think.
A new kind of ownership
Active ownership, according to the report, could help the Fund attenuate risk and take advantage of longer-term opportunities through support for research on the effects of climate change on investment, enhanced reporting and the release of research for the benefit of other investors, and working with companies, regulators, investor initiatives, and others in the responsible investment space. Active ownership may even pay dividends in the short term, often literally. Recent Carbon Tracker Institute research cited by the report points out that cutting capital expenditures to marginal or inaccessible projects such as those in the Arctic could decrease risk associated with dropping oil prices while freeing up cash for dividends. In this way the Fund might put pressure on companies in a coordinated fashion, enforcing an equal standard among the largest historical emitters so that Shell does not have to compete at a disadvantage with BP; they are subject to the same policy shifts simultaneously, which may make them more profitable as they avoid a race to the bottom.
Between that and the recommendation that the Fund play an increasingly political role, there is a reasonably credible plan for increasing fund value by cutting company spending that drags down profitability over the time period the Fund normally holds shares – years or decades – while improving the odds on the bet on moving away from ill-conceived capital expenditures by contributing to a political climate in which these investments are increasingly at risk of being the first victims of climate change mitigation legislation. The report’s recommendations are cleverly complementary in this way, and their combined implementation could bode well for the Fund, other universal owners, and, indeed, the planet.
Ellen Quigley is a PhD candidate in the Faculty of Education at the University of Cambridge. She has a BA (Hons) in English and American Literature and Language from Harvard College and an MSc in Environmental Policy from the University of Oxford. Her research encompasses the education of Canadian economists and responsible investment among institutional investors. She has been working with the Centre for Endowment Asset Management in the area of responsible investing.