Following the capital for fossil fuels

Sustainable finance means different things to different people. Unfortunately, for many people it refers to so-called responsible investment or ESG (environmental, social and governance) investment. Typically, that means fund managers and asset owners will try to protect a company, a fund or an entire portfolio from climate or inequality risks, instead of trying to actually improve those things in the real world.

My work in this field involves a much more strategic look at where new capital for fossil fuels is coming from, and how that capital might be redirected away from fossil fuels and towards more sustainable alternatives. It’s also about recognising the difference between new capital flows and the secondary market – that’s ownership of companies that are already listed on the stock market – and understanding the need to do something very different, typically a much more forceful form of engagement involving voting against the re-election of directors, for example.

Cooling towers of nuclear power plant emitting steam during golden sunset. by Gurgen Bakhshetyan

Sustainable finance often refers to activities that are just rearranging deck chairs on the Titanic, trying to protect portfolios against these enormous risks that probably aren’t avoidable anyway. But new forms of sustainable finance are really focusing on debt, paying attention to who the providers of debt are and following the debt flows into fossil fuel companies. That’s a really promising development. Another promising development is this renewed focus on a much more forceful form of shareholder engagement, rather than shareholder resolutions that are merely advisory and usually fail, or private engagements that centre around improving disclosure or other means-based goals. What I’m trying to do is much more impact-based, and that’s what I’m starting to see more generally in sustainable finance.

The trouble with ethical portfolios

If a retail customer goes to a fund manager and says, ‘I want to invest ethically’, that fund manager is very likely to bring them a product that excludes fossil fuel companies, weapons manufacturers and so on. It will probably be a public equity portfolio; that means companies that are already listed on the stock market. That customer will probably think, ‘Now I’m not contributing to Exxon or arms manufacturers’, but unfortunately, that’s not quite the case. It doesn’t actually matter which shares we own, because by definition, if we sell a share, there’s a buyer, and that buyer is another investor. The money doesn’t go back to the company. So if you’ve got that so-called ethical portfolio that’s trying to protect itself against climate change, it might exclude some of these companies, but that won’t really have an effect.

What does this focus on the risk to the company or to the portfolio do? This is an extreme example, but you could imagine that Exxon might decide to raise the level of its oil rigs in the ocean, rather than trying to decrease its emissions that contribute to the rise in ocean levels in the first place. In fact, Exxon has done that; they’ve raised the levels of their platforms in the ocean and obviously have done nowhere near enough to actually reduce their emissions. That’s what happens if you’re looking at the risk to the company or to the portfolio, instead of looking at it from the perspective of: how is this actually having an impact on the issue that you’re concerned about in the first place?

When investing responsibly isn’t responsible

Unfortunately, most retail investors have no idea that this is how it works. They think, ‘If my portfolio is free of these bad names, then that’s good and I’ve done my job.’ They don’t look into it further, which is fair enough. But we need to be looking at banks, bonds, private equity and all these other asset classes and sources of new capital to determine whether or not we can have an impact on which companies grow, and which companies enter into managed decline – which is what we need to see for most fossil fuel companies.

G-Stock Studio

We have quite a significant issue on our hands, because it is not clear to a retail investor that they are doing something useless by investing in something labelled an “ethical fund” or a “sustainable fund”. In fact, we’re starting to see court cases on that. In Germany recently, a company was pulled up for false advertising to consumers in suggesting that their investment would actually decrease carbon emissions and so on. And that needs to happen to clarify to the average person that this sort of investment does not have an impact. But it’s very counterintuitive. You might think, ‘If I’m not investing in this company, then I’m not helping them.’ But the first thing to understand is that if you’re investing in public equity, the effect on that company is marginal to non-existent, even if you’re a very, very, very large investor, which most of us are not.

How debt finances fossil fuels

If you are Exxon, let’s say, and you need to raise more money for your continued expansion and operations, then you do make some money from selling the oil and gas that you sell. But you also often need upfront capital to do very expensive things like explore for new reserves or build a refinery. To do that, typically you would raise debt financing, and that will look like going to a bank and getting a syndicated bank loan. Or it might look like going to the bond market.

A bond is a loan, essentially, but it’s in a kind of structured security. If Exxon is borrowing money from you, you are buying their bond. Whenever you buy bonds, you are lending money to the company that has sold them to you. This means that Exxon is not raising new funding to do new things from public equity; instead, they are gaining new cash to expand their operations by selling bonds and by borrowing from banks and other lenders. That’s where the vast majority of new financing for fossil fuels comes from: about 90% comes from debt, which is wild. And that’s why it’s so important to pay attention to debt.

Banks and pension funds

Your bank is probably one of the major financiers of fossil fuels through their lending, and they also underwrite the bonds, as well as initial public offerings or IPOs. That’s when a company lists on the stock market in the first place; that’s new money. But you also have to pay attention, I would posit, to your pension fund, because pension funds are major purchasers of bonds, and they also invest in banks as well, so they can engage with banks on their financing of fossil fuels.

Anton Violin

If we are trying to have an impact within the space, it’s good to have that laser focus on new capital and especially new fossil fuel infrastructure. When I talk to banks or fund managers, I really centre my remarks around bonds and banks and the building of new infrastructure that would continue to use and emit from fossil fuels for a long time yet to come.

Does shareholder engagement work?

I’ve done a complete review of all of the literature that exists on the efficacy of shareholder engagement. How well does shareholder engagement work to produce real-world outcomes? That’s depressing reading, to be honest. Most shareholder engagement is quite ineffective, focusing on tactics that are very unlikely to produce even marginal results, let alone the transformational results that we actually need in this time.

There are two promising things that came out of that literature review, however. One was this idea of voting against directors. And the mechanism there is, oddly enough, more shame-based than we might imagine. You don’t have to come anywhere close to actually replacing that board member or voting them off the board. It’s actually embarrassing for them to receive even a few percentage points less support than they’re accustomed to.

The pressure of embarrassment

Normally, board members get 99% of the support of shareholders because it’s almost a routine vote that goes entirely the way of the board. To lose even a few percentage points is viewed as a pretty big stick for the high-status individuals that typically occupy these positions. You don’t have to win; you just have to embarrass people a little bit. And it really does focus the mind on the issue on which you’ve decided to vote against them.

The other tactic that seems to work fairly well is the threat of exclusion from an index. There are a couple of studies looking at the FTSE4Good index, which is supposed to be a responsible investment index for companies. What the researchers have found is that a company that is threatened with exclusion from the index is significantly more likely to respond to engagement on that basis and to comply with the standards of the index. By the way, the standards of the index are way too low, almost comically low. But it does mean that the threat of that loss of status and recognition can be quite motivating for companies, allowing them to actually undertake the work that’s required to comply with whatever standards have been set.

The role of government regulation

Governments are absolutely critical to getting to where we need to go considering climate change, inequality and a lot of other issues. Universal owners can be supportive in making that happen, because currently we have a couple of major barriers to companies actually being regulated or legislated. One is lobbying: a lot of companies spend quite a lot of money, either directly or through trade associations, to change the government decisions. That’s actually within the control of shareholders to change, so that’s one big thing they could do to support government action on these critical issues.

But the other big problem is that companies can forum shop, which means that they can establish their operations in a different country. If they don’t like one country’s laws, they can always change where they operate, where they domicile themselves, where they base themselves for tax purposes etc. And that creates a race to the bottom in terms of legislation and regulation.

What universal ownership does, on the other hand, is that it basically means that companies don’t have anywhere they can escape to. They have to actually meet these standards regardless of where they operate, where they’re domiciled. It’s an across-the-board standard that should be supportive of government regulation, since companies would not be able to avoid these standards no matter where they operated.

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Quigley, E. (2020, May 28). Universal Ownership in Practice: A Practical Investment Framework for Asset Owners. SSRN.

Quigley, E. (2020, May 21). Universal Ownership in the Age of COVID-19: Social Norms, Feedback Loops, and the Double Hermeneutic. SSRN.

New approaches to sustainable finance