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The Fossil Fuel Divestment Debate for Fiduciaries: It's the Portfolio....

March 25, 2015

dougfriedenbergWhat's a Poor, Gainfully Employed Fiduciary to do?

Charles Skorina discussed the fiduciary's obligation vis-a-vis the movement to divest fossil fuel investments from many endowment portfolios on these pages on March 5. He argues against divesting because of fiduciary responsibilities and says: "What the divestment debate comes down to is how boards define their fiduciary duty. Traditionally that duty included getting the best possible returns from donated funds consistent with an appropriate level of risk."  We'd agree that this is de rigeur if one is to be the very model of a modern major fiduciary.

We suspect that Mr. Skorina's comments reasonably portray of the view of many Wall Streeters.  This may be because the divestment logic fiduciaries are hearing (as portrayed in Mr. Skorina's post)  is the notion that one should divest solely because it is good for the planet and many of the non-investing creatures who live on earth.  The basic do-gooder argument has never been particularly easy for the investment community to understand, foreign as it is to that community's raison d'etre.  Benefits to capital they don't manage generally does not compute.  And that, we believe, is why the message is lost on many fiduciaries.  It's just not a point many investors can understand, much less want to act upon. And we do fault some divestment advocates who may not know how to convey a message that effectively appeals to the logic of Wall Street.

The typical investment manager is more likely to understand the divestment argument if he is shown that the dynamic effects of climate change on his fossil fuel portfolio holdings will be like a knife to the brain of one of TV's Walking Dead zombies, portfolio splatter included.

Before we get into the elements that might upset your tidy little portfolio and keep you awake nights, let's take a look at Mr. Skorina's argument against divesting.

Is Past Performance Any Guarantee of Future Results?

Mr. Skorina's centerpiece is inescapable proof that over the last 50 years, a portfolio sans fossil investments would have underperformed a normal diversified portfolio by about 50 basis points annually. This is enough to allow the fully diversified portfolio to earn 25% more in real dollars over a fifty year holding.  We certainly can't argue with historical results.  We're just not sure how that applies to the next fifty years.

Neither, apparently,  is Dow Jones.  We decided to take a little walk down Memory Lane and review the history of the Dow Industrial Average components going back to 1928, when that venerable index first went to 30 components. Surely the names of the Dow Thirty are about as prudent a bunch of stocks as a fiduciary could ever hope to find. These are mature, seasoned, adult stocks, reflecting the dominant industries obvious to all, not the rowdy teenagers whose potential may thrill, but who might still throw toilet paper on your carefully manicured lawn.  The Dow Thirty quintessentially reflect the present moment in financial history, and are stocks which a fiduciary could take home and love, with no fear of straying too close to the fringe of the known investment world or incurring any criticism other than being boring.

What we found was that the key industries didn't change so much from 1928 to 1979, but then!  During the last 36 years, a number of stalwarts have been dropped in favor of industry groups never before seen in the Dow.  In 1979, there were zero financial, technology or healthcare companies in the Dow.  In 2015 there were five and a half financial (let's say that GE went from zero financial to half financial), five technology and four healthcare companies in the same index.  Virtually half the Dow Industrials are now from industries not even considered two generations ago.  Google and Facebook, both within the top fifteen highest market cap companies today, didn't exist in the mid-90's.

The point?  Diversification is rather a faster moving target today than fifty years ago.  An argument against divestment of fossil fuel investments on the grounds of diversification can only be made based on a vision of the future which is as clear as that of the past. Good luck with that.

Mr. Skorina was kind enough to restate the divestment argument, although he almost left out the only point worth mentioning. He wrote: "There are really only two ways the divesters can convince anyone to (divest). The first, easiest, and most popular tactic is to simply ignore the economics.  Their cause is too transcendently important for them to be concerned with such trivia. The second, slightly more legitimate tactic is to concede that divestment may have some marginal negative impact on investment returns in the short term, but only a trifling amount which can be easily recouped by more enlightened investing."

Mr. Skorina's perfect hindsight argument then alludes to a third, magnificently potent point for the pro-divestment case which should send chills down fiduciaries' spines. One may wonder if he realized its force in his reference.

He referred to "the so-called stranded-assets argument to persuade us that future returns in energy stocks will inevitably be much lower than past returns."  His post might have turned out differently had he taken the time to consider what that was all about.

Ironically, there is substantial reason to agree with Mr. Skorina and the other worthies who state:  "the impact of divestment would not be negligible."  Although it is likely not to be in the way that they intended.

Of Divestment, Stranded Assets, Tipping Points and Fiduciaries

There is reason to believe that climate change is THE investment story of the 21st century, with an abundance of scientific data pointing to human causation of material changes in Earth's climate.  You can see a regular update of the latest material developments here at, including links to climate-related social unrest in Syria, misrepresentations by paid climate deniers, and US vulnerability to increased flooding.

This excerpt from the 2014 Quadrennial report issued by our Department of Defense outlines the national security issues: "Climate change poses another significant challenge for the United States and the world at large. As greenhouse gas emissions increase, sea levels are rising, average global temperatures are increasing, and severe weather patterns are accelerating. These changes, coupled with other global dynamics, including growing, urbanizing, more affluent populations, and substantial economic growth in India, China, Brazil, and other nations, will devastate homes, land, and infrastructure. Climate change may exacerbate water scarcity and lead to sharp increases in food costs. The pressures caused by climate change will influence resource competition while placing additional burdens on economies, societies, and governance institutions around the world. These effects are threat multipliers that will aggravate stressors abroad such as poverty, environmental degradation, political instability, and social tensions – conditions that can enable terrorist activity and other forms of violence."

Meanwhile, there are increasing reports of climate-linked issues affecting large population groups, like the California drought, an effect more easily understood by a large number of Americans.  When the agency charged with US national security cites climate change as a serious risk to the country, how do purported patriots justify opposition to the science?

You don't have to be much of a scientist to understand the connections.  If you've ever put a child in the bathtub and seen the water level in the bathtub rise, you can sort out what happens when melting glaciers displace the water in the ocean.  If you've ever done a chemistry experiment in high school, you know that certain chemical combinations produce predictable results. So any high school graduate can understand that burning fossil fuels creates carbon dioxide, which, in large enough accumulations produces spin-off effects on a much larger scale.

The divestment movement is afoot, catalyzed by scientific findings generally accepted everywhere on earth except for a portion of the United States, the country with a robust economy made possible by, well, science.

Fiduciaries will know that financial markets discount the future, not the past.  Some fiduciaries will know that the SEC now requires disclosure about climate change risk factors to a company.  Exxon, among others, has begun to disclose. Exxon knows that they can "believe" that climate influences will have no effect on the value of their asset base. They and other oil companies also hope that fiduciaries will "believe" along with them. But consider the change in real estate market values in a place like Norfolk, Virginia (also an at-risk military base of great concern to the DoD). Homeowners now worry if the increased flood risk will make it impossible ever to sell their homes. What do you suppose will begin to happen to your portfolio when some deep-pocketed hedgie decides to litigate a company's failure to disclose the negative effects of climate change on their ability to monetize the vast reserves on which your investment is based?

Malcolm Gladwell noted that a tipping point is that magic moment when an idea, trend, or social behavior crosses a threshold, tips, and spreads like wildfire. The sea change in the American view of gay marriage has occurred in about three years.  Five years ago you'd have gotten great odds if you wanted to bet on broad acceptance of gay marriage everywhere but Alabama.  The generally accepted view changed almost overnight, after no apparent movement for years.  The same can happen with a fashion trend, the popularity of a new product, or a drop in the crime rate.

Facts or Faux?

In our view, the fiduciary needs to worry not about when climate science is commonly accepted (although it is everywhere but the US), but rather when the tipping point is reached, when the idea has taken hold.  Informing your opinion should also be an awareness of the accuracy of the climate change information you receive.  A study by the Union of Concerned Scientists revealed a wide variance in the accuracy of news reporting by the major cable news channels in the United States.  CNN's climate change reportage was misleading about a third of the time, MSNBC only 8% of the time.  Fox News made misleading reports about climate change a whopping 72% of the time.  Garbage in, garbage out, you know, and fiduciaries do not necessarily have the luxury of blaming tainted sources for their mistakes, as some who stuck with Madoff too long eventually learned.

The fiduciary role may inhibit the ability to be early adopters.  But fiduciaries may need to be especially conscious of the climate change tipping point, as it will likely provide the central theme for the many challenging portfolio decisions they will face going forward.

A Brief Word to the Divestment Community

If you want to get investors to divest more quickly, show the divestment case to aggressive hedge fund managers.  They like nothing better than a good short story, especially a good short macro story.  Actually, they do like something better -- betting against an investor whose research they know to be compromised.  That's like catnip to those guys.