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February 7, 2018

What’s Missing from the Ecological Economics Divestment Report

A recent nine-page report published in Ecological Economics uses shaky methodology to claim that fossil fuel divestment would not lead to financial costs for a portfolio, alleging instead that energy stocks provide “limited” diversification benefits and “do not outperform other stocks on a risk-adjusted basis.”

This conclusion, of course, is in stark contrast to the majority of economic literature out there on divestment, including research conducted by Prof. Dan Fischel of the University of Chicago Law School, which found that removing the energy sector from a portfolio increases risk and reduces returns over time.

A closer look makes it clear that the authors jump to questionable conclusions by interpreting data in a way that achieves their preferred result.

Here are three things you need to know when reviewing this study.

1)The study does not account for transaction costs

The authors themselves admit that “We abstract from…any additional financial costs that the implementation of divestment might impose, such as selection, transaction, and monitoring costs (see Bessembinder, 2016; cf. Cornell, 2015; Fischel, 2015), which will strongly depend on the investment type, size, and objectives.”

Thanks to prior research by Prof. Hendrik Bessembinder of Arizona State University, we know that there are immense costs associated with the act of selling fossil fuel securities and actively monitoring investments.  By omitting these certain costs, the authors are not adequately quantifying the full price tag of divestment.  Prof. Bessembinder’s research found that these transaction costs alone can rob an endowment of as much as 12 percent of its total value over a 20-year timeframe.  So even if all else is equal, a large portfolio may be looking at billions in fees when it comes to divesting.

2) The authors focus on the wrong metric, and don’t put adequate emphasis on the increased risk associated with divestment

The economic terminology can get complicated (so bear with us) but this study leans on certain metrics too heavily and misconstrues the benefits of diversification in order to gain a more favorable conclusion.

Fischel’s first study on diversification found that divestment means an investor either needs to 1) sacrifice returns or 2) take on higher risk.  The results shown in Table 2 in the Ecological Economics report essentially confirm this very idea.  In their calculations, the market and fossil free portfolios have the same return, but the fossil free portfolio displays a standard deviation (read: risk) that is higher. When you adjust returns for risk, the divested portfolio underperforms by 0.14 percent per year, which is consistent with Fischel’s most recent findings.

The authors, however, come to the conclusion that “There is only a small difference between the beta of the fossil fuel portfolio and the rest of the market.  This means that fossil fuel stocks are more or less substitutes for the market index (which has a beta of 1) and as such provide limited diversification benefits.”

We know this to be wholly untrue.  No reasonable investor believes that a portfolio of energy stocks is a substitute for the market portfolio.  A portfolio of only energy stocks is highly sensitive to the ups and downs of the energy industry.  However, by spreading one’s portfolio across multiple industries, one is not subject to the swings of any one industry.

But again, a beta of 1 doesn’t directly address whether there are diversification benefits to holding these stocks.  The authors would assert that a portfolio with a lower beta would have the greatest diversification effects, but that is also not true.  For instance, a portfolio that placed half its investments in the market and held the other half in cash would have a beta of 0.5, but that doesn’t mean that the portfolio provides diversification benefits for those invested in the overall market.  It is in fact the opposite: this portfolio is perfectly correlated with the market – that is, when the market is up, the portfolio will also go up, and vice versa – and therefore offers no diversification benefits.

Beta is not an indicator of diversification benefits, correlation is what truly matters: Fischel’s report found that the energy sector has the lowest correlation with the rest of the overall market compared to other major sectors, thereby providing the greatest diversification benefits.

3) The report falsely claims that constraining a portfolio doesn’t impact returns

The report claims to evaluate the “four-factor risk-adjusted returns of fossil-free portfolios and the unconstrained market portfolio.”  They go on to claim that the “insignificant alphas” provide evidence for the argument that divestment has little to no impact on portfolio returns.

However, “alpha” of a given stock or portfolio is only a measure of whether the factors that typically explain the average returns of a stock are in fact explaining the average return of a given stock or portfolio.  An insignificant alpha for a portfolio merely says that those factors adequately explain the returns of the given portfolio, and does not say anything about whether the portfolio is adequately diversified.

In particular, it is fairly common for a single stock to have an insignificant alpha, but no one would say that a single stock is an adequately diversified portfolio.

Bottom Line:  The Ecological Economics report attempts to discredit the idea that divestment is a costly move, but the evidence doesn’t add up.  The high costs coupled with a lack of diversification have been cited by the vast majority of pensions, municipalities and universities who have rejected divestment.  The Vermont Pension Investment Committee, for instance, called divestment a “slippery slope” that would “add diversification and technological change risks to VPIC’s portfolio.”  When Harvard President Drew Faust explained why the school rejected divestment, she wrote in part, “Despite some assertions to the contrary, logic and experience indicate that barring investments in a major, integral sector of the global economy would — especially for a large endowment reliant on sophisticated investment techniques, pooled funds, and broad diversification — come at a substantial economic cost.”

So, upon further review, it’s clear that the report uses faulty reasoning to reach its conclusion.  Both research and real-world examples have shown that divestment carries a high price tag with no upside.  That is why universities and pensions from coast to coast continue to reject this empty gesture.