March 6, 2020

LETTER TO THE EDITOR | Divestment Folly

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To the Editor: 

Climate Justice Cornell, a campus organization agitating for Cornell University to divest its endowment from energy companies, recently hosted socially responsible investing specialist Katelyn Kriesel to discuss the economics argument for fossil fuel divestment. As a skeptic of politically-motivated divestment campaigns, I was curious to hear the financial case for why endowments should liquidate any holdings they have in energy companies.

Historically, the primary obstacle to endowments adopting an anti-fossil fuel stance is the pesky phrase “fiduciary duty.” In a nutshell, fiduciary duty obliges trustees to act in the best interest of the trust beneficiaries, which in this case means maximizing the risk adjusted return of Cornell’s endowment.  Adopting the stance advocated by CJC would entail a blanket mandate to eschew the energy sector, which could trigger legal action since one could argue, with some justification, that a categorical sector ban may not align with beneficiaries’ interests.

Realizing this, divestment advocates take a different tack by building a so-called “financial case” for the university to divest.  As Ms. Kriesel outlined, the energy sector has underperformed the S&P 500 index in the past several years. (For the sake of argument, we will ignore the half a dozen errors in her methodology which used three prominent energy companies as a proxy for sector performance, the S&P 500 as a benchmark and disregarded dividends and risk.) On the basis of this information, she argues, universities should divest because energy companies have performed poorly in the past. However, her logic is deeply flawed. Making investment decisions based on long term past price moves, sometimes called “technical analysis,” has been soundly disproven by research and in any case would not limit the endowment to non-energy stocks.

Anyone with a basic familiarity with financial theory will also recognize that this argument is tantamount to telling the endowment, “sell anything that has done poorly, buy anything that has done well.” Unfortunately, buying high and selling low is not a recipe for generating outsize returns. Financial markets exhibit both long run cyclicality and mean-reversion, and numerous academic studies have shown that the opposite strategy — selling things that have gone up, buying things that have gone down — outperforms in a diversified, long term portfolio. The argument is also intellectually dishonest; if energy stocks rebound, I doubt we will hear many CJC members clamoring for Cornell to start buying.

There is one scenario where it would be rational to sell underperforming securities. Ms. Kriesel described this as cutting your losses. But there’s an implicit assumption — cutting your losses is only rational if you can reasonably expect that the asset will continue to lose value. Maybe energy stocks will continue to underperform; maybe they will eventually go to zero. But how do you make this case to an endowment, run by professional money managers? Clearly, the market has some confidence in the energy sector; New York State’s employee pension system alone owns nearly $1 billion of Exxon stock. And perhaps with good reason: Most analysts estimate that oil demand won’t peak until at least 2025, and, despite growing adoption of electric vehicles, transportation, power generation, manufacturing and petroleum-derived plastics, will continue to drive fossil fuel demand for the foreseeable future.

To circumvent this hurdle, divestment advocates contend that conventional quantitative financial metrics fail to capture the whole picture. Instead, investors should chart a course by examining traditional quantitative as well as qualitative “environmental, social, governance” factors. They aren’t the first to advance this idea; it has gained widespread traction in the past few years as investors have turned a spotlight on all manner of corporate practices which fall under the ESG umbrella. According to Ms. Kriesel’s analysis, not only can you feel better about your investments, in a twist of financial karma your investments perform better too.

Unfortunately, the reality is more complicated. Aside from obvious challenges ESG investing poses from a portfolio management standpoint (e.g. how do you quantify environmental policies, or board diversity, or governance standards, or wages, etc. and aggregate them into a useful — and statistically sound — metric?) it is not even clear that ESG investing outperforms, as Ms. Kriesel claims. From an intuitive level, artificially limiting the assets portfolios can invest in reduces optionality and thus potentially constrains returns. And, in fact, research bears this out. A recent Wall Street Journal analysis of ESG performance across more than 200 ESG funds found that on average they underperformed the S&P 500 in both the short and medium term.

California’s public pension system, Calpers’s, experience with divestment is illustrative. In 2000, the retirement system decided to divest from tobacco companies on the grounds that these firms represented negative social influences. It has since forsworn other politically unpopular sectors such as weapons manufacturers. Two decades later the tobacco industry is still with us, and these well-intentioned restrictions came at a cost; pension consultant Wilshire Associates estimated that Calpers’s ban on tobacco stocks has lost the endowment around $3.6 billion. At a time when U.S. pensions face record projected shortfalls, adding social restrictions on investment mandates will have a tangible impact on the future wellbeing of our public servants.

Ms. Kriesel brushed off New York State Comptroller Thomas DiNapoli when, in a recent meeting, he asked whether she drives a gasoline powered car (she does). But he had a point. Reaping the benefits of energy companies like affordable, reliable transportation, but denying the benefits of investing in those same companies to teachers and firefighters — materially affecting their retirement security — is the definition of hypocrisy.

Climate radicals will need a better case than this if they expect sophisticated trustees with contractual fiduciary obligations to adopt their plan. Until they come up with a strategy backed by sound data and economic theory, Cornell and other institutions should continue to reject calls to divest from energy companies.

Peter Anderson ’20