Article
Should we be treating fossil fuels like tobacco?
Fossil fuel divestment efforts could hinder energy transition efforts more than they help
Comparing fossil fuels, a (currently) essential resource with a non-essential, highly damaging past-time like smoking is likely to invite some eye-rolling. There are, however, some striking parallels between them:
Both sectors cause major negative externalities; both are in the process of being heavily taxed and more heavily regulated as a result; yet both are expected to find willing customers for decades to come.
Fossil fuels and tobacco share another commonality too: they both face major investor divestment movements. Signatories to the Tobacco-Free Finance Pledge represent over USD 16 trillion assets under management (AUM)1, though the true proportion of investors excluding tobacco stocks is likely much higher2. Similarly, institutional investors representing over USD 40.5 trillion in AUM have wholly or partly divested from fossil fuel investments according to Stand.earth3.
There is, however, a major difference between the two - and it is the reason why comparing them is so instructive: while the divestment of tobacco is justified on moral grounds as a first resort, it makes far less sense in the context of fossil fuels.
Typically, divestiture arguments contain four core elements. The first is moral - divestment can cleanse a portfolio of unethical activities. The second is about risk - it can help an investor avoid the legislative and regulatory risks as certain sectors come under increasing scrutiny, though such risks should, theoretically, be priced into stocks and therefore compensated for.
The third and fourth relate to impact. Divestment can make a political statement that may influence the public, policymakers, other investors, and the company itself (although shifting ownership from one investor to others who may prove less scrupulous may dilute this effect). Finally, divestment can raise the cost of capital for affected firms.
So has there been a positive impact? The evidence is mixed.
From a cost of capital point of view, divestment does not appear to have worked. Leading tobacco and fossil fuel companies continue to enjoy a cost of capital that is broadly comparable to the wider market. Put simply, too few of the investors who supply capital have been willing to divest from these companies. A Stanford paper by Berk and van Binsbergen4 estimated it would take 84% of the suppliers of available capital to divest from high-emissions stocks for their cost of capital to rise by 1%. If USD 40.5 trillion-worth have divested so far, that equates to only 16% of the world’s USD 255 trillion5 in financial assets.
The ongoing backlash against stock screening in the US suggests that divestment could in fact prove counterproductive in political terms, possibly serving to fuel culture wars and making broader ESG arguments more difficult to make.
It’s good to talk
It’s good to talk
Both the UN Global Compact and the World Health Organization reject any form of engagement with the tobacco industry because they maintain that the only acceptable outcome for the industry from a societal perspective is its immediate end. In contrast, if the fossil fuel industry disappeared tomorrow it would cause an almost immediate economic, financial, and humanitarian catastrophe, as transport, industry and power networks failed, creating shortages of just about everything, huge job losses, rampant inflation, and conflict over the remaining resources.
But it is also impossible to countenance the continued use of fossil fuels in the manner we do today, given their worsening impact on climate change over the long term. We need fossil fuel companies, but we also need them to change. Engaged owners can, at least in theory, help to facilitate this.
Investor engagement can take various forms. At the least public level it can involve private communication with company management, but it can also involve public statements calling for a company to change and submitting shareholder resolutions. Engagement can even lead to attempts to replace directors with candidates who are more aligned with shareholder priorities. The most high-profile example of the latter was when activist hedge fund Engine No. 1 successfully pushed for the replacement of three board members at US oil and gas giant Exxon Mobil6 in 2021.
Some have questioned how much of an effect Engine No. 1’s success has had on the strategic direction of Exxon7, but there is broader evidence to suggest that investor engagement can achieve changes in company behavior and even have a positive effect on returns8,9 . It can also, however, be time-consuming and costly, with success, of course, far from guaranteed. Many shareholders will lack the resources to lead their own engagement efforts, but all can add their weight to the initiatives of others by virtue of their equity. To be a shareholder is to have a voice.
This is not to say that divesting should never be an option, far from it. Divestment, or the threat of it, is itself part of the engagement process as set out by the UN10. Divestment has its place but should be considered as a blunt instrument – generally a last resort rather than the first.
So, are fossil fuels the new cigarettes? No. This is not, however, an argument to simply allow business as usual. Investors have an important role to play in nudging those companies onto a sustainable path. It is in all of our interests that they play it.
The author is grateful for feedback from: Aarti Ramachandran, Karianne Lancee, Adam Gustafsson, William Nicolle, Jackie Bauer, Mike Ryan, Richard Morrow.
For further information, please visit www.ubs.com/institute-disclaimer
