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Economics and Business Review Vol. 9 (1), 2023: 65-93 https://www.ebr.edu.pl https://doi.org/10.18559/ebr.2023.1.3 Divest or engage? Eectiv ff e paths to net zero from the U.S. perspective 1 2 Andrew G. Buks Konrad Sobański Abstract Keywords The aim of this article is to critically review and evaluate two • divestment ESG-based investment strategies—divestment and engage- • engagement ment for alignment of investment portfolios with climate • ESG change mitigation goals of the United Nations. The article • net zero transition compares both approaches in terms of their eectiv ff eness • decarbonization of decarbonization, using the case study method. First, the case on fossil fuels divestment by Harvard Management Company is analysed. The second case study discusses shareholder engagement endeavors by Engine No. 1 hedge fund and its investment in ExxonMobil. The findings indi - cate that divestment may have non-immediate impact on corporate behavior and carries political and legal retribu - tion risks. Engagement, on the other hand, presents itself as a more plausible option as it takes less time to deploy and, therefore, can produce more immediate and impact- ful results. Nevertheless, both divestment and engagement can play mutually supportive roles in addressing climate change by the investment industry. JEL codes: G10, G11, G15, G24 Article received 19 December 2022, accepted 7 April 2023. Suggested citation: Buks, A.G., Sobański, K. (2023). Divest or engage? Eectiv ff e paths to net zero from the U.S. perspective. Economics and Business Review, 9(1), 65–93. https: //doi. org/10.18559/ebr.2023.1.3 This work is licensed under a Creative Commons Attribution 4.0 International License https: //creativecommons.org/licenses/by/4.0 Black Hills State University, College of Business and Natural Sciences, Spearfish, SD, U.S.A., firstname.lastname@example.org, https://orcid.org/0000-0001-8210-6068 . Poznań University of Economics and Business, Institute of International Business and Economics, Department of International Finance, al. Niepodległości 10, 61-875 Poznań, Poland, email@example.com, https://orcid.org/0000-0002-4941-7443 . 66 Economics and Business Review, Vol. 9 (1), 2023 Introduction In 1912 a New Zealand newspaper reported that burning fossil fuels leads to CO emissions into the Earth’s atmosphere, causing climate change and resulting in global warming for thousands of years to come (Rodney, 1912). Over 100 years later the eects ff of climate change have become increasing - ly more visible and extensive in every place on planet Earth and addressing atmospheric global warming is humanity’s highest priority (IPCC, 2022). The atmospheric carbon dioxide levels have reached the highest point in 800,000 years (Lüthi et al., 2008). Its eects ff cannot be overturned for decades to come and the potential outcomes associated with our economies’ decarbonization eorts ff will not be seen for several generations (Collins et al., 2013). It is also hard to predict the impact of our global decarbonization eorts. ff However, without mitigation eorts ff to achieve net zero by 2050, the likelihood of a cli- mate crisis will increase. Currently the mean global temperature is expected to increase by four degrees Celsius by the end of the 21st century, leading to catastrophic outcomes not only for our ecosystems but also changing the way of life on Earth (Collins et al., 2013). The investment community has re - sponded by factoring climate change risk into asset allocation models and launching ESG-based (Environmental, Social and Governance) investment funds across the globe with Europe and the United States being the biggest markets (Diab, 2021). The popularity of such investment vehicles continues to grow, and the ESG-based investing landscape is becoming increasingly reg - ulated. To support decarbonization eorts, ff investment strategies and asset allocation models vary from divestment to engagement of fossil fuel compa - nies in hopes that fossil fuel companies embrace decarbonization and thus preserve their long-term value by reaching net zero (Funk & Walker, 2021). Divestment includes negative and exclusionary screening of non-ESG stocks whereas engagement involves investing in non-ESG stocks and shareholder activism with the aim of leveraging shareholder power to aect ff corporate behavior (Cole et al., 2020). The aim of this article is to critically review and evaluate two ESG-based investment strategies—divestment and engagement—available to investors for alignment of investment portfolios with the climate change mitigation goals as per the 2015 Paris Agreement (COP21) and the 2021 Glasgow Climate Pact in Glasgow (COP26). The article compares divestment vs. engagement and analyzes their advantages and drawbacks in view of the decarbonization goals for the globe. The paper applies the case-study method. The first case study discussed is fossil fuel divestment campaign by the Divest Harvard stu- dent-led movement and Harvard Management Company managing Harvard University’s endowment fund. The second case study focuses on shareholder A.G. Buks, K. Sobański, Divest or engage? Ee ff ctive paths to net zero … 67 activism via an engagement strategy by Engine No. 1 hedge fund and its in - vestment in ExxonMobil Corporation. The article is organised as follows: In Section 1 stylised facts about green - house-gas emissions and their implications for the United States are present - ed. Section 2 provides a brief description of the global decarbonization goals and issues with their implementation. In Section 3 decarbonization goals and responsibility of the investment industry are discussed. Section 4 reviews the literature on sustainable investing, ESG-based investing, and impact investing. Section 5 critically analyzes advantages and disadvantages of divestment and engagement strategies. The article concludes with policy recommendations and directions for further research. 1. Stylised facts about greenhouse-gas emissions and their implications for the United States Since the beginning of the Industrial Revolution in the mid 18th century the concentration of carbon dioxide (CO ) in the Earth’s atmosphere has in- creased exponentially causing climate change and leading to global warming of our planet (Friedlingstein et al., 2022). Between 1850 and 2021 the cumu- lative fossil carbon dioxide emissions reached the level of 465 ± 25 GtC (giga - tons of carbon) and during that period, 46% of fossil carbon dioxide emissions came from burning coal, 35% from burning oil, 15% from burning natural gas, 4% from decomposition of carbonates and flaring (Friedlingstein et al., 2022). As of 1917 the United States has been the largest contributor of the cumula- tive carbon dioxide emissions and for the period of 1850–2021, the United States is responsible for 115 GtC (24% of the global emissions) followed by the European Union with 80 GtC (17% of the global emissions), and China with 70 GtC (14% of the global emissions) (Friedlingstein et al., 2022) (see Figure 1). In 2020 the largest source of greenhouse gas emissions in the United States came from burning fossil fuels for transportation (27%), electricity production (25%), industry (24%), commercial and residential (13%), agriculture (11%) (EPA, 2023) —see Figure 2. Global warming caused by climate change is having a significant impact on the United States and is aecting ff many aspects of United States’ environ - Land areas can act as a sink (absorbing greenhouse gas emissions from the atmosphere) or a source of emissions. In the United States, since 1990, forests and other lands have ab- sorbed more greenhouse gas emissions from the atmosphere than they emit (EPA, 2023). This is why the US government should support nationwide and global reforestation and aor ff esta - tion eorts. ff 68 Economics and Business Review, Vol. 9 (1), 2023 United States European China Others Union Figure 1. The major emitters of carbon dioxide, 1850–2021 Note: Share of countries in the global carbon dioxide (CO ) emissions from 1850 through 2021 (%). Source: Based on data provided by (Friedlingstein et al., 2022). Agriculture 11% Industry 24% Commercial & residential 13% Electric power Transportation 25% 27% Figure 2. Total US greenhouse gas emissions by economic sector in 2020 Notes: Share of economic sectors in the US greenhouse gas emissions in 2020. Greenhouse gas emissions include carbon dioxide (CO ), methane and nitrous oxide. Source: Based on data provided by the Environmental Protection Agency (EPA, 2023). A.G. Buks, K. Sobański, Divest or engage? Ee ff ctive paths to net zero … 69 ment and society. Some of the most notable eects ff include: (1) rising tem - peratures; (2) changing precipitation pae tt rns; (3) sea-level rise; (4) agricultur - al impacts; (5) health impacts; (6) impacts on ecosystems; and (7) economic impacts (IPCC, 2022). Average US temperatures increased between 1920–2020 by around one degree Celsius, with most of the increase occurring since 1970 (NOAA, 2022). Every year the US experiences more frequent and intense heat waves (Hicke et al., 2022). Changing precipitation paerns tt lead to more frequent flooding and more intense storms. Droughts across North America’s midwestern and western regions aect ff agriculture including ranching. Sea-level rise caused by melting polar ice caps and melting glaciers in Alaska have been threatening and flooding American coastal cities and regions, particularly in the South. Coastal cities such as Miami, New Orleans, and Houston suffer from more frequent and more powerful weather events making it increasingly difficult to live for millions of residents (Hicke et al., 2022). Climate change also neg- atively impacts US’s agriculture aecting ff crop productivity and causes chal - lenges for farmers and ranchers, changes in pest and disease pressure, and shifting growing seasons. Climate change is a leading factor contributing to an increase in air and water pollution, and exacerbating existing health prob - lems such as allergies and heat-related illnesses. Lastly the eec ff ts of climate change are having a significant impact on the US economy including: (1) increased costs for business and governments due to the need to adapt infrastructure to climate changed-related weath- er events. Also the increased frequency of such extreme weather events as hurricanes, wildfires floodings or droughts is leading to increased costs for insurance companies and governments to respond to these events and as- sist aect ff ed communities; (2) increased costs associated with disruptions of supply chains due to changes in temperature, extreme weather events such droughts or floodings; (3) decreased revenues associated with the tourism industry. For example, the decline of such iconic species as polar bears and sea otters is aecting ff the tourism industry in Alaska and leading to decreased revenues for local businesses and governments; the 2022 flooding of the National Yellowstone Park in Montana led to the park’s closure, negatively aecting ff revenues not only for local businesses, but also neighboring states (Pratt, 2022). Furthermore, declining snowpacks in the Rocky Mountain region and changes in snow precipitation paerns tt are aecting ff the ski sector lead - ing to decreased revenues and job losses in the Colorado tourism industry; (4) climate change is aecting ff various industries such as fishing and forestry (Hicke et al., 2022). For example, warmer ocean temperatures are aecting ff the distribution and abundance of fish species leading to decreased catch levels and decreased revenues for the US coastal communities (Hicke et al., 2022). Similarly, changes in precipitation paerns tt and temperature are ae ff ct - ing the productivity and viability of forests leading to decreased timber yields 70 Economics and Business Review, Vol. 9 (1), 2023 and decreased revenues for forestry communies ti ; and (5) addressing climate change creates opportunities for growth in renewable energy industries such as wind and solar power and in energy efficiency technologies (The White House, 2022). The transition to a low-carbon economy can create new jobs in areas such as renewable energy, energy efficiency and conservation which can also help offset the job losses in traditional energy industries (Hockett & Gunn-Wright, 2019). According to the US administration it is expected that transition to renewable energy is expected to generate several million jobs (Hockett & Gunn -Wright, 2019). Additionally, investing in clean energy can increase energy independence and reduce reliance on foreign energy sources which can have positive impacts on the US economy. Undoubtedly the eects ff of climate change are widespread and have a sig- nificant impact on the United States. In order to mitigate the negative con - sequences and adapt to climate change-related impacts extensive measures need to be taken. For this reason members of the investment community are actively incorporating climate change and other sustainability goals into their investment decisions. Whether these are the Paris Agreement (COP21) or the Glasgow Climate Pact (COP26) recommendations these all provide roadmaps for the investment community as to what factors incorporate into their investment decision-making processes and, thus, fulfill their fiduciary duty to investors. 2. Decarbonization goals of COP21 and COP26 and challenges with their implementation The 2015 Paris Agreement (COP21) set forth the following four objectives: (1) keeping global temperatures from rising two degrees Celsius above pre- industrial levels; (2) pursuing eorts ff to limit the temperature increase to one point five degrees Celsius; (3) strengthening the ability of countries to deal with the impacts of climate change; (4) and providing a plaorm tf for regular reviews of progress to ensure ambition in emissions reduction targets (UN, 2015). Six years following the Paris Agreement, the 26th Conference of the Parties (COP26) to the United Nations Framework Convention on Climate Change Conference met in Glasgow in the fall of 2021 to further expand on The literature taking the global perspective on carbon emissions discusses multiple mea - sures. For instance, Akbulut (2022) indicates that in order to reduce carbon emissions it is rec- ommended to increase environmental policy stringency. In turn, Temurlenk and Lögün (2022) call for the policies needed to transfer clean technologies to developing countries to address the problem that trade openness positively aects ff CO emissions in the long term. 2 A.G. Buks, K. Sobański, Divest or engage? Ee ff ctive paths to net zero … 71 its climate change mitigation ambitions. The main objectives of the confer - ence include: (1) reaching carbon neutrality by 2050; (2) keeping global warm- ing below one point five degrees Celsius; (3) mobilizing finance, technology, and capacities to implement the Paris Agreement; (4) supporting develop - ing countries in implementation of the Paris Agreement; (5) and promoting international collaboration to achieve carbon neutrality (UN, 2021, 2022a). To implement the goals of the Paris Agreement several countries intro- duced cap-and-trade programs and carbon taxes. While the United States has a few cap-and-trade programs in place they have only been introduced at the state level (Stavins, 2019). The most prominent U.S. cap-and-trade program is the Regional Greenhouse Gas Initiative (RGGI) which is a market- based program that covers power sector emissions in nine Northeastern and Mid-Atlantic states: Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, and Rhode Island. Under the RGGI program a cap is set on the total amount of carbon dioxide emissions from power plants and power generators must purchase allowances to cover their emissions. The cap is lowered over time which creates an incentive for pow - er generators to reduce their emissions or purchase additional allowances. California also has a cap-and-trade program that covers multiple sectors of the economy including power generation, industry and transportation. The California program in the United States is linked with Canada’s (Quebec) cap- -and-trade program. There have been proposals for a national cap-and-trade system and carbon tax but none have been enacted into law (Stavins, 2019). While COP21 and COP26 were aended tt by several head of states including U.S. Presidents, the U.S. domestic climate change fight has encountered mul - tiple obstacles making the implementation of COP21 and COP26 goals par - ticularly challenging for: (1) partisan political reasons; (2) economic reasons; and (3) legal challenges. Climate change has been a highly contentious issue in the United States with the Democratic and Republican parties having fundamentally different views regarding climate change causes and solutions. For example, in 2018 the Republican administration withdrew from the Paris Agreement which was subsequently reversed by the Democratic administration in 2021 (Blinken, 2021; Friedman, 2019). Some politicians and businesses raised opposition to climate agreements due to fear they will negatively impact the US economy particularly in the fos - sil fuel sectors. In 2021, for instance, the Democratic Senator from the coal- mining state of West Viriginia voted against the Build Back Beer tt act due to its pro-climate provisions before he agreed to support the Inflation Reduction Act of 2022 which contained concessions for the fossil fuel industry (Plummer & Friedman, 2022). In 2022, Republican-run State of South Carolina, Texas, and Florida have divested from funds that employ ESG-based investing strate - gies. Texas passed a new “anti-woke” law designed to protect fossil fuel com - 72 Economics and Business Review, Vol. 9 (1), 2023 panies by banning the US largest asset manager, BlackRock, and nine other asset managers including Credit Suisse and UBS from doing business in the state (Kerber & Schroeder, 2022). Texas is not the only state legislating against climate conscious investors. States like Louisiana and West Virginia have re- cently joined in a push against ESG-based investing, especially when it calls for taking climate change risks into consideration (Crampton, 2022). Finally, climate change is frequently a cause for litigation in the US courts. For example, in the summer of 2022, three United States Supreme Court Justices ruled in favor of stripping the United States Environmental Protection Agency of its authority to regulate emissions by delegating such authority to the United States Congress (Supreme Court of the United States, 2021). This constituted a significant victory for climate change deniers and the fossil fuel industry lobbyists (Crownhart, 2022). The above are only some of the examples associated with challenges of im- plementing the Paris Agreement and the Glasgow Climate Pact. Nevertheless there are many eorts ff to address climate change and reduce the US carbon footprint. These eorts ff are closely linked to the 2030 Agenda for Sustainable Development, adopted by all United Nations Member States in 2015 and its seventeen Sustainable Development Goals (UN, 2022b). 3. Decarbonization goals and fiduciary responsibility of the investment industry As nations continue to commit to decarbonization as per goals of the COP21 in Paris and COP26 in Glasgow asset managers are increasingly establishing sustainable investing practices (Gandhi & Diak, 2022). One such institution - al investor is the US-based and the world’s largest asset manager BlackRock with the AUM (assets under management) of $10 trillion as of the end of 2021 (BlackRock, 2022). Its CEO in his communique to the managers of all BlackRock’s portfolio companies noted that companies, whether private or public, need to serve a social purpose, make a positive contribution to society, and consider the systemic threat of climate change. Companies which do not consider the climate impact of their investments are not acting in the best in - terest of their clients hence failing their fiduciary responsibility (Fink, 2023). A similar investment philosophy is followed by other large US asset man- agers including the Vanguard Group and State Street Global Advisors which also take climate change into their asset allocation process (Funk & Walker, 2021). Global climate investing has grown exponentially in the last decade prompting investment houses to launch many green-labeled products offer - A.G. Buks, K. Sobański, Divest or engage? Ee ff ctive paths to net zero … 73 2016 2018 2020 … 2025 Figure 3. Global ESG assets under management (trillion USD) Notes: The dotted line represents a linear trend. Forecast starts in 2025. Source: Based on data provided by Bloomberg. ing ESG-based investing and impact investing opportunities. It is expected that global ESG assets will exceed $50 trillion by 2025 representing over a third of $140 trillion in projected total global assets under management (Diab & Adams, 2021) (see Figure 3). Climate change, decarbonization eorts ff and other forms of ESG-based in - vesting have led to a robust debate on how investors can influence compa - nies’ behavior regarding their stance on decarbonization. Should investors adhere to exclusionary screening? Should investors divest partially? Should investors divest completely? Should investors engage shareholders or board members? Such questions baffle many pension plans, financial advisory firms, university endowments, or hedge funds. This debate also brings up the role of macro-financial policies implement - ed by central banks on the decarbonization of the global economy. Although the issue of global warming and the climate crisis is not currently an area of interest for central banks opinions are being expressed that their role in solv- ing climate problems could be vital. However, this is contingent on institu - tional changes in the international financial architecture. Chmielewska and Sławiński (2021) advocates transforming the International Monetary Fund into an international central bank to mobilize sufficient resources to decar - bonize developing economies and implement a truly global climate policy. The authors take a new perspective on the old challenge related to burning coal in developing countries. This issue has been consistently raised since 74 Economics and Business Review, Vol. 9 (1), 2023 the early 1970s, and many authors have advocated that developed countries should support developing nations by sharing resources (including technol - ogy) with them to minimize challenges such as the climate crisis and other impediments to economic development (see Brandt, 1982; Meadows et al., 1972; Schumacher, 1973). 4. Literature review There is an abundance of academic and non-academic literature on sus- tainable investing, ESG-based investing and impact investing (Cole et al., 2020; Latinovic & Obradovic, 2013). While some academics and non-academics use these terms interchangeably each term has a dier ff ent meaning and purpose. Cole et al. (2020) who defines sustainable investing as a broad range of in- vesting strategies through which investors aemp tt t to achieve above-average investment returns and enhance environmental, social and corporate govern- ance standards. Sustainable investing can be divided into two categories. The first, ESG-based investing, is concerned with investments in public markets and aims to mitigate risks and create opportunities by incorporating ESG-related information into stock valuation and investment decision making process (Cole et al., 2020). The second, impact investing, is primarily concerned with private equity markets where investors are willing to accept below-market- rate returns in exchange for positive societal impact due to capital deploy - ment (Cole et al., 2020, 2021). This article is concerned with two aspects of sustainable investing: ESG-based investing through divestment and impact investing via shareholder activism. The ESG-based investing literature can be divided into multiple streams as - sociated with ESG’s ee ff cts on cost of capital, stock valuations and returns on investment based on material factors. There seems to be a broad lack of con- sensus on most of the above-mentioned aspects with the exception on the cost of corporate borrowing for companies with favorable ESG-scores. Cost of capi- tal for ESG and non-ESG companies has been the subject of extensive research. Over the last decade there have been multiple studies on how ESG-based in - vesting may influence the cost of capital for non-ESG stocks and ESG stocks. Earlier studies on the subject tend to reach similar conclusions that compa- nies with favorable ESG scores have easier access to capital tend to have beer tt credit ratings, and a lower cost of capital. A prominent study by Heinkel et al. (2001) suggests that exclusionary ethical investing leads to lower stock owner - ship and, therefore, higher cost of capital for non-ESG companies. Bauer and Hann (2010) evaluated over 2,000 US bond issues and correlated CSR (corporate social responsibility) scores to cost of capital. They concluded that companies A.G. Buks, K. Sobański, Divest or engage? Ee ff ctive paths to net zero … 75 with beer tt CSR scores had lower loan spreads. Schneider (2011) concludes that low CSR scores from negative environmental practices pose a significant risk potential for costs associated with cleanup and legal risks. These increase the lender’s risk. El Ghoul et al. (2011) also suggests that US companies with beer tt CSR scores have lower cost of equity financing. It is important to note though that many studies from the previous decade depended on scarce data coming from the first decade of the 21st century when CSR scores and reports were not widely available. Such data availability became more accessible af- ter 2010 following the emphasis on ESG issues by the US government. The US Department of Labor recognized that ESG was not only about providing col- lateral benefits but also identifying material investment risks and opportuni - ties and issued guidance on the evaluation of material ESG factors by invest - ment funds fiduciaries as essential part of their fiduciary duty (Hale, 2020). More recent studies rely on a larger amount of data and suggest that whether companies embrace ESG metrics or not it does not have a meaningful impact on companies’ access to capital. Berk and van Binsbergen (2021) evaluate the quantitative impact of ESG divestitures. The study compares companies from FTSE USA vs. FTSE USA 4Good and concludes that divesture initiatives have a minimal impact on the cost of capital of 0.35 basis points. Given this small number Berk and van Binsbergen are of the opinion that cost of capital is not a decisive factor in ESG-based investing strategies. Last but not least Eccles et al. (2022) find that non-ESG stocks do not experience higher costs associated with the cost of raising new equity but they experience higher costs associ- ated with the new debt issuance. Stock valuations and ESG-based investing have also evolved over the last two decades. Initial studies focus on the Tobin’s Q ratio which measures the relationship between the market valuation and the intrinsic value of an asset. Hong and Kacperczyk (2009) suggest that companies with poor ESG-ratings (referred to as “sin stocks”) have lower valuations. Ioannou and Serafeim (2014) show that greater CSR engagement generates positive analyst recom - mendations. Furthermore, Zhang (2019) reaffirms that environmental pro - tection investment adds value to a company by increasing its earnings with- out a significant impact on the cost of equity capital. However, Eccles et al. (2022) revisit the firm value and pricing implications of the negative screen - ings of non-ESG stocks. This study establishes, unlike prior studies, that valu- ations related to non-ESG stocks are statistically indistinguishable from valu - ations of ESG stocks. Returns on investment are another aspect of ESG-based investing paral - lel to the valuation aspect. Bauer et al. (2005) find no evidence of significant differences in risk-adjusted returns between ethical and conventional funds. Studies by Fabozzi et al. (2008) and by Hong and Kacperczyk (2009) suggest that returns of “sin stocks” (using today’s nomenclature—non-ESG stocks) which include alcohol, gaming and tobacco outperform the market. Fabozzi 76 Economics and Business Review, Vol. 9 (1), 2023 et al. (2008) find that a “sin portfolio” generated a return unambiguously out- performing common benchmarks in terms of both magnitude and frequency. Hong and Kacperczyk (2009) suggest “sin stocks” have higher expected returns than “non-sin stocks” suggesting that investments in non-ESG stocks are more attractive to investors from the return standpoint. Trinks and Scholtens (2017) demonstrate that non-ESG stocks generate high risk-adjusted returns in multi - ple markets and there are opportunity costs to negative screening. In contrast, Khan et al. (2015) suggest that by focusing on material ESG issues investors can make more accurate decisions and select investments that maer tt the most in terms of materiality. They demonstrate that companies with superior perfor- mance on material ESG issues outperform their peers. Morgan Stanley’s 2020 Sustainability Update suggests that investing in ESG stocks has proven more rewarding for investors during market expansions and downturns. Funds which incorporate ESG criteria in general either slightly outperform or are on par with traditional funds (Morgan Stanley Institute for Sustainable Investing, 2020). There is also literature which focuses on divestment eorts ff and divest - ment outcomes for large university endowments. Cornell (2015) in his paper on divestment by university endowments argues that divestment is going to have negligible impact on fossil fuel companies while contributing to worse performance of endowment funds due to a lack of diversification. In the case of Harvard University Cornell concludes that the financial losses would not exceed $100 million. Cleveland and Reibstein (2015) pose a question should the university endowments divest from fossil fuels? They argue that divest- ment strategies should not be limited to moral motives or reputational risks reasons but should also consider financial risks associated with holding oil companies’ assets. They also argue that universities should learn how to invest responsibly by identifying new and cleaner investment opportunities. Deeks (2017) discusses Harvard’s and Stanford’s divestment movements to analyze the discourse of the fossil fuel divestment campaigns while focusing on the goals of such campaigns and fiduciary duty of endowment managers. Quigley et al. (2020) discusses the advantages and disadvantages of fossil fuel divest- ment for the University of Cambridge across social, moral, political, financial and reputational dimensions. Ryan and Marsicano (2020) examine how total or partial divestment impacts values for all universities as well as a select few. They conclude that either form of divestment does not have a significant ef - fect on endowment values. While most of the ESG investing literature focuses on answering questions about investing in ESG stocks or divesting from non-ESG stocks research on engagement has been growing as well. Funk and Walker (2021) suggest that engagement can accelerate the transition to net zero. The authors elaborate on why engagement plays a significant role for index asset managers who cannot divest due to their investment mandates. Furthermore, the authors also argue that engagement and proxy voting are “critical tools for over - A.G. Buks, K. Sobański, Divest or engage? Ee ff ctive paths to net zero … 77 sight of corporate management on climate-related disclosure and practices” and provide several examples of successful engagement strategies includ- ing ExxonMobil Corporation, Chevron Corporation, Commonwealth Bank of Australia, Dominion Energy, and Unilever (Funk & Walker, 2021). Berk and van Binsbergen in their 2021 study on the eects ff of sustainable investing conclude that instead of divesting it is more advisable to exercise the rights of control to influence corporate policies to achieve desired out - comes. Aa-Daruk tt a et al. (2022) in a paper on decarbonizing institutional as - sets compare porolio tf tilts with engagement to curb emissions. In their study they conclude that most investors decarbonize their portfolios through tilt - ing vs. engagement. Nevertheless there is growing evidence for engagement, especially following the Paris Agreement. Edmans et al. (2022) demonstrate how portfolio tilting instead of complete divestment may be a more eectiv ff e strategy for non-ESG firms to take corrective action. Eccles et al. (2022) sug - gest that engagement particularly through private equity investments may lead to more promising results in advancing ESG-aligned goals of investors. However, Gupta et al. (2022) conclude that socially responsible investors can slow the pace at which companies reduce negative externalities. Lastly Broccardo et al. (2022) compares eectiv ff eness of divestment versus engage - ment in advancing socially desirable outcomes in companies. In their study they establish that engagement is more eectiv ff e in convincing companies to pursue socially responsible business strategies. 5. Divestment vs. engagement: Comparative analysis from the perspective of decarbonization goals ESG-based investment strategies include divestment and engagement. Divestment can involve negative or exclusionary screening strategies by ex - cluding certain industries or companies from a portfolio based on specific ESG criteria, for example, the entire fossil fuel industry sector or specific companies from that sector (Cole et al., 2020) Engagement involves leverag- ing shareholder position to influence corporate behavior through investing in target companies and direct engagement with shareholders, boards of com- panies or their managerial teams. For example, by engaging in an oil and gas company, activist investors can guide such a company towards developing net zero goals and commitments (Cole et al., 2020). Both strategies aim to achieve common goals of constructing value-aligned portfolios and advancing environmental and social values, although they differ in their overall strate - gies, risks, and outcomes. 78 Economics and Business Review, Vol. 9 (1), 2023 A) Divestment The history of divestment at Harvard University dates to the late 1980’s and early 1990’s when Harvard University students made headlines by de- manding that Harvard University’s Management Company which manages Harvard’s endowment fund divested from companies that were engaged in do- ing business in apartheid-governed South Africa (Toffel & Gulick, 2020). While Harvard students’ South African divestment campaign enjoyed the support of many faculty members it met with resistance from the university admin- istration. Nevertheless, it paved the way for other divestment campaigns at Harvard and other prominent universities with large endowments (Rodman & Zhu, 2015) (see Table 1). Table 1. US universities with the largest endowments at the end of 2021 fiscal year University name Endowment size ($) Harvard University (MA) 53.2 billion Yale University (CT) 42.3 billion Stanford University (CA) 37.8 billion Princeton (NJ) 37.0 billion MIT (MA) 27.4 billion Source: Based on (Wood, 2022). Harvard’s divestment debate from fossil fuels dates to 2012 when the Divest Harvard movement was formed. The movement included Harvard stu- dents, faculty members and alumni who pressured the Harvard Management Company to divest Harvard University’s endowment fund from fossil fuel com- panies (Toffel & Gulick, 2020). On the outset of Divest Harvard in 2012 this eort ff was supported by 72% of Harvard students and between 2012 through 2017, students and faculty members organized several divestment-related events to exert pressure on Harvard’s leadership to divest from fossil fuels (Toffel & Gulick, 2020). Initially the arguments of Divest Harvard climate ac - tivists failed to convince Harvard’s President who in 2013 argued the endow - ment was not an instrument of social and political change (Faust, 2013). This did not deter Harvard students from their mission. In 2014 an open lee tt r with 93 faculty signatures called for Harvard to divest from fossil fuels (Harvard University, 2014). This was followed by a 2014 lawsuit of seven Harvard stu- dents who claimed that Harvard was breaching its fiduciary and charitable duties by investing in fossil fuels. While the lawsuit was dismissed, it helped generate significant public aen tt tion to Divest Harvard (Urist, 2015). A.G. Buks, K. Sobański, Divest or engage? Ee ff ctive paths to net zero … 79 In 2017 faced with more public scrutiny Harvard Management Company announced that it would pause its fossil fuels investments and is unlikely to invest in them in the future (DeBenedictis & Park, 2017). While this certainly was a victory for Divest Harvard it still did not constitute an official university policy to divest from fossil fuels. This led to a resignation of a member of the Harvard Board of Overseers in 2018 and the same year’s motion by Harvard faculty calling for Harvard Management Company to divest from fossil fuel companies (Guillaume & Halper, 2018; Rosenberg, 2019; Toffel & Gulick, 2020). In 2021 in an emailed leer tt sent to the Harvard community Harvard’s President stated “climate change is the most consequential threat facing hu - manity” and Harvard “does not intend” to make any future investments in fossil fuels (Bacow, 2021). Undoubtedly the Divest Harvard student-led move- ment accomplished a significant victory in 2021 but it took Harvard almost a decade to reach this landmark decision. Despite the considerable length of time and eor ff t it took the Divest Harvard campaign to set Harvard University on the path to net zero the campaign had proven successful. According to Harvard Management Company’s 2022 Climate Report, the endowment fund is committed to the following goals: (1) achieving carbon neutral operations; (2) investing in climate transition; (3) collaborating with investors to encourage climate change-related disclo - sures and reduce greenhouse gas emissions; (4) avoid fossil fuel holding ex- posure; (5) continue to phase out legacy fossil fuel holdings and (6) improve data access when engaging external asset managers to beer tt understand climate-related risks associated with such investments and developing meth- odologies for calculating greenhouse gas emissions exposure across Harvard Management Company’s portfolio (HMC, 2022). Furthermore, in 2021 Harvard Management Company doubled its climate investment from 2020 and its cli- mate investments made up 1% of the endowment (HMC, 2022). The Divest Harvard movement also has had a profound impact on other American higher education institutions leading to full fossil fuel divestitures at sixteen American universities and colleges and partial divestitures at an - other six universities between 2011 and 2015 (Ryan & Marsicano, 2020). The trend continued and between 2016 and 2020 thirteen American universities divested from fossil fuels (Ryan & Marsicano, 2020) and expanded beyond higher educao ti n instituo ti ns. In 2022 there were over 1,500 educao ti nal, phil - anthropic, faith-based, governmental, healthcare and non-governmental insti - tutions representing a total value of $40 trillion in assets under management which are either partially or fully divesting from fossil fuels (GFFDCD, 2023). It is worth noting that despite its initial opposition to Divest as of September 2021 Harvard University is the largest university endowment committed to achieving full divestment but also the first university endowment committed to reaching net zero by 2050 (Bacow, 2021). Considering the above Harvard University is well positioned to fulfill its fiduciary duty to its community through 80 Economics and Business Review, Vol. 9 (1), 2023 its adoption of divestment policies and to protect its endowment fund from unpriced climate change-related risks (Serafeim & Fulton, 2014). Lastly divestment campaigns can increase public awareness and increase political pressure regarding climate change. Passing of one of the most ambi - tious U.S. climate laws to date—the Inflation Reduction Act of 2022—serves as an example of how divestment campaigns can help raise climate change awareness and result in meaningful climate legislation. The multi-faceted pur - pose Inflation Reduction Act aims at lowering healthcare and energy costs for American families, combating climate change, reducing the deci fi t and asking the largest corporations to pay their fair share of taxes. The climate provisions of the Inflation Reduction Act include the total investment of $369 billion in lowering energy costs, building a clean energy economy and reducing harm- ful pollution (The White House, 2022). Divestment, however, comes with a set of disadvantages including: (1) a drop in portfolio value, (2) lack of diversification, (3) and political pres - sure. In 2022 the CEO of Harvard Management Company in his FY22 (Fiscal Year of 2022) end leer tt to the members of the Harvard Community informed that Harvard’s endowment fund returns on investments were negative af - ter distributions for operations and the addition of new endowment gifts. Overall the endowment shrunk from $53.2 billion (FY21) to $50.9 billion (FY22). Aside from the inferior performance of the global financial markets FY22 returns were influenced by “the necessity of focusing on long-term, risk adjusted returns” (Harvard University, 2022; HMC, 2022; Narvekar, 2022). Undoubtedly, financial aspects of divestment include focus on long-term re - turns, thus, eliminating opportunities to generate returns when the fossil fuel industry sector is performing well. For example, in 2016 56% of oil and gas companies paid dividends to their shareholders and in 2021 this number increased to 76% (Banerjea, 2022). Harvard Management Company due to its divestment strategy has forgone such opportunities by no longer pursu - ing fossil fuel investments. Disparity between the FY21 and FY22 stems from Harvard Management Company’s long-term vision on generating returns from non-fossil fuel assets. Lack of diversification is potentially another rea - son Harvard’s endowment fund underperformed especially when the fossil fuel stocks received a boost from the growing demand for fossil fuels (EIA, 2023). This was associated with the end of the COVID-19 global pandemic restrictions when the low demand for fossil fuels depressed the fossil fuel companies’ stock valuations (Badruldeen, 2021). While it would have been advantageous for Harvard to participate in the growth of the energy sector Harvard Management Company did not participate in such investment op - portunities because of Harvard University’s commitment to reducing its expo - sure to fossil fuel investments and working toward honoring climate pledge to achieving net zero status by 2050 (Narvekar, 2022). Lastly one of the major drawbacks of divestment is the risk of political and legal reprisals from the A.G. Buks, K. Sobański, Divest or engage? Ee ff ctive paths to net zero … 81 pro-fossil fuels industry politicians and lobbyists (Nosek, 2022). In the case of Harvard the university was criticized for its stance on climate change placing its tax-exempt status in peril. In 2017 the U.S. Congress passed the Tax Cuts and Jobs Act which introduced a tax on university endowment income. The Section of 13701 of the Tax Cuts and Jobs Act introduces a 1.4% tax on uni- versity endowments’ income and given the enormous FY21 $53-billion size of the Harvard University’s endowment it could result in significant financial consequences regarding the source of its operating income (Salam, 2018; The United States Congress, 2017). B) Engagement Engine No. 1 hedge fund was founded by Christopher James who deployed his personal capital to invest in ExxonMobil in December of 2020 (Saijel, 2020). James’ $38-million investment represented only a small fraction (about 0.02%) of ExxonMobil’s shares (Phillips, 2020). Considering Engine No. 1 is an activist investor such a small investment could hardly result in an impact on the oil and gas giant’s business strategy especially when considering ExxonMobil’s role as a major contributor to climate change (Chen et al., 2022). Impact in- vesting has grown in popularity over the last ten years and it has been es - timated that by 2020 around $1 trillion has been invested in impact funds across private equity and venture capital investment funds (Kramer et al., 2021) . Furthermore, impact investing is meant to accomplish two of the fol - lowing goals: deliver risk-adjusted returns to investors and generate positive social or environmental impact (Cole et al., 2020). Typically, hedge funds, if they employ sustainable investing strategies, adhere to ESG-based investing. However, Engine No. 1, decided to explore impact investing in publicly traded companies to improve their ESG performance through shareholder activism. James believed that by changing the composition of ExxonMobil’s Board of Directors he would be able to influence ExxonMobil’s management and steer it towards transition to renewable sources of energy. James also believed that by engaging ExxonMobil’s management he would be able to improve its ESG ratings, financial performance and, thus, improve its shareholder re - turns (Kramer et al., 2021). Engine No. 1’s ownership of 0.02% equity stake in ExxonMobil would not allow for such an insurmountable task without at- tracting the support of other large ExxonMobil’s shareholders including the so-called Big 3: Vanguard, BlackRock, and State Street Global Advisors who collectively made-up the largest block of ExxonMobil’s shareholders owning 7.96%, 4.97% and 4.88% respectively (Phillips, 2020) (see Table 2). Dalal (2022) analyses the existing literature on country-level venture capital and points out that technological opportunities, macroeconomic conditions and financial market devel - opment are key determinants of this investment activity. 82 Economics and Business Review, Vol. 9 (1), 2023 Table 2. Top 5 Shareholders of ExxonMobil as of end June 2020 Shareholders Stake Shares owned Total value ($) The Vanguard Group 7.96% 336 million 15.6 billion BlackRock Fund Advisors 4.97% 210 million 9.8 billion State Street Global Advisors 4.88% 206 million 9.6 billion Geode Capital Management 1.49% 62 million 2.9 billion Fidelity Management & Research Co. 1.32% 55 million 2.6 billion Source: Own compilation based on data provided by Bloomberg. In James’ view ExxonMobil’s poor financial performance stemmed from inadequate capital allocation associated with climate change denialism which was threatening its future returns (Eccles & Mayer, 2021). To address this prob- lem Engine No. 1 started Reenergize XOM campaign making the following four recommendations through an open leer tt to ExxonMobil’s board of directors and its shareholders: (1) refresh the board; (2) impose greater long-term capi- tal allocation discipline; (3) implement a strategic plan for sustainable value creation in a changing world; and (4) realign management incentives (Engine No. 1, 2021). ExxonMobil refused to address Engine No. 1’s recommendations making it clear for Engine No. 1 that the only way to change ExxonMobil’s business strategy was to change the makeup of its Board of Directors through a proxy contest in the upcoming 2021 annual shareholder meeting. To do so Engine No. 1, through a rigorous search process, created its own slate of four candidates for the ExxonMobil’s Board of Directors consisting of individ - uals with an extensive experience in the oil and gas industry as well as with experience in energy transition (Kramer et al., 2022). Reactions to Engine No. 1’s proxy campaign were encouraging. The proxy advisors, Institutional Shareholder Services and Glass Lewis which represent the largest institu - tional investors endorsed three out of four Engine No. 1’s candidates for the ExxonMobil’s Board of Directors (Brower, 2021). Furthermore, with the sup- port of other large shareholders including the Big 3 (BlackRock, Vanguard and State Street Global Advisors) Engine No. 1’s slate of independent candidates to the Board of Directors was elected (Kramer et al., 2022). While this was a clear victory for the newly formed activist and impact investing hedge fund and ESG investors, the question remains how the new makeup of the board would be able to influence ExxonMobil’s business strategy to make it climate change-friendly and help deliver improved financial returns for the share - holders? Did Engine No. 1’s proxy move improve ExxonMobil’s stock price? In the case of Engine No.1 and ExxonMobil there are clear advantages for corporate board engagements considering the changes that took place at ExxonMobil in 2021. In May of 2022 Engine No. 1 published a list of actions A.G. Buks, K. Sobański, Divest or engage? Ee ff ctive paths to net zero … 83 undertaken by ExxonMobil following its Reenergize Exxon campaign. These include a multitude of strategic initiatives undertaken by ExxonMobil aimed at reduction of Scope 1 and 2 carbon emissions, its commitment of $15 billion over a span of six years to reduction of carbon emissions, to hiring a senior- level executive to lead the Low Carbon Solutions (new core business unit add - ed to ExxonMobil), to adhering to transparency by publishing all of its political contributions and lobbying eorts ff and by committing to become net zero by 2050 (Engine No. 1, 2022a). Another set of accomplishments which Engine No. 1 takes credit for includes ExxonMobil’s commitment to exercise a bee tt r long- term capital allocation discipline. ExxonMobil decreased in 2021 its planned capital expenditures from $30–$35 billion to $20–$25 billion and increased its market capitalization from $174 billion at the end of 2020 to $259 billion at the end of 2021 (ExxonMobil, 2022). Furthermore, while Engine No. 1 spent $12 million dollars on its proxy fight campaign it still generated substantial profits from its $38 million investment in ExxonMobil which was trading at $38.50 per share on December 1, 2020 and was trading at $61.19 per share on December 31, 2021 (ExxonMobil, 2022) (see Figure 4). Lastly Engine No. 1 stunned and generated significant aen tt tion from the investment manage - ment community following its victory in the proxy fight. Such publicity was particularly helpful when Engine No. 1 launched its r fi st ETF (exchange traded fund) Engine No. 1 The Transform 500 ETF in 2021 (Sharfman, 2020) and in 2022 when Engine No. 1 launched another ETF—Engine No. 1 The Transform WTI crude oil price ExxonMobil stock price Figure 4. ExxonMobil stock price and WTI oil price from December 1, 2020 to March 20, 2023 ($ per share and barrel, respectively) Notes: Stock price adjusted for splits, dividend payouts and other corporate events. Source: Based on data provided by the U.S Energy Information Administration and Stooq. 84 Economics and Business Review, Vol. 9 (1), 2023 Climate ETF, with assets totaling $392 million and $92 million respectively as of January 25, 2022 (Engine No. 1, 2022b). There is, of course, a downside to Engine No. 1 and ExxonMobil engage- ment story. When Engine No. 1 made an investment in ExxonMobil the global oil prices were at historical lows hurting revenues of the oil produc - ing sector especially because of the global COVID-19 pandemic (Badruldeen, 2021). However, as of January 2021 the demand for oil started growing lead - ing to higher oil prices and, thus, boosting revenues of the oil sector includ - ing ExxonMobil (see Figure 4). This allowed Engine No. 1 to capitalize on changes in the macroeconomic trends and particularly rising oil prices (EIA, 2023). The growth in Exxon’s valuation in this period might have come about because of the macroeconomic trends and not as a result of the changes to its Board of Directors make-up following Engine No. 1’s Reenergize XOM campaign (Engine No. 1, 2021). The divergent development of oil prices and Exxon’s stock price starting in the second half of 2022, contradicts though this assertion. Furthermore, engagement through proxy fights can be risky to investors and expensive. Engine No. 1 embarked on its proxy fight with ExxonMobil with a war chest of $30 million, spending $12 million whereas ExxonMobil spent $35 million to deflect the activist hedge fund’s eorts ff (Deveau, 2021). Lastly does shareholder activism help address the challenges associated with cli - mate change or does it promote greenwashing? One could argue that Engine No. 1 investment served as a catalyst for a major change at one of the big- gest climate change offenders in the world (Chen et al., 2022). At the same time ExxonMobil despite its commitment to become net zero by 2050 con - tinues to be a major producer of fossil fuels. A brief look at ExxonMobil’s of- ficial statements may make one believe that ExxonMobil is fully committed to sustainability despite being a member of the fossil fuel industry which is re- sponsible for contributing to global warming (Chen et al., 2022). Considering that in May of 2022 the pioneer of electric vehicles, Tesla was removed from the S&P 500 ESG Index whereas ExxonMobil was rated as one of the top ESG- -rated companies by the same index (Kerber & Jīn, 2022; S&P, 2023). This may mislead investors to think that ExxonMobil due to its corporate governance, ESG-related overhaul and financial commitments to becoming net zero by 2050 had become a green company leading the charge in actions on climate change. Whether ExxonMobil can live up to its climate commitments remains to be seen. Climate change is a commons problem and it will take collective action to solve it. More eort ff than a small activist hedge fund like Engine No. 1 or the Big 3 asset managers is needed and it will take considerable coop- eration at intergovernmental and international levels to adequately address the issue. Otherwise, sincere eorts ff of activist investors such as Engine No. 1 may be perceived as a distraction and mislead one into thinking that the private sector may provide the efficient answer. A.G. Buks, K. Sobański, Divest or engage? Ee ff ctive paths to net zero … 85 Conclusions and policy recommendations Developed economies like the United States are facing significant decar - bonization challenges imposed by the public, investor community and policy - makers who introduce pro-climate policies or anti-ESG measures depending on the side of the political aisle. A fundamental maer tt is the need for more robust response at the corporate board level to acknowledge climate change and to introduce mig ti ao ti n measures to transio ti n to net zero. For this reason shareholder activism through shareholder engagement, as per Engine No. 1’s example can lead to more promising and robust results by engaging fossil fuel companies at the board of directors’ level, appointing climate-friendly board members and gathering support of other shareholders to take meaningful steps to mitigate the causes of climate change. It can also produce more im - mediate results than divestment. Furthermore, engagement is getting more traction as divestment appears to yield little to no eects ff on changing cor - porate behavior and appears to have no financial impact on fossil fuel com - panies while exposing endowment funds to financial losses as per Harvard Management Company’s example. Engagement has also become a maer tt of recommended policy by the Glasgow Financial Alliance for Net Zero (GFANZ, 2022). GFANZ indicates that the global financial sector can accelerate the transition to net zero by pursuing engagement strategies through engaging with clients and portfolio companies, financial sector peers and industry as - sociations and engaging with governments and the public sector. Aside from engagement strategies GFANZ guidance provides a specific set of metrics and targets which provide quantitative and measurable goals to achieve net zero transition goals. GFANZ provides several examples of successfully implement - ed engagement strategies by major financial services organizations like Aviva, Robeco, HSBC, BlackRock, Goldman Sachs, Dai-ichi Life, Citi, Bank of America, Barclays and other leading financial institutions (GFANZ, 2022). While divestment certainly draws positive ae tt ntion to climate change and helps shift investment away from polluting industries towards more sustain - able ones, it does not translate into an immediate behavior alteration of the climate polluters. It is rather engagement that encourages polluting companies to adopt more sustainable practices in a timely manner. Nevertheless both divestment and engagement can play mutually supportive roles in addressing climate change by the corporate sector. Policy makers in the US should, how- ever, support businesses by creating regulatory frameworks on the state and federal levels to encourage sustainable investment and sustainable business practices. Whilst the 2022 Inflation Reduction Act has been the most ambi - tious US pro-climate change piece of legislature to date strong implementa - tion policies are needed to create market incentives for companies to reduce 86 Economics and Business Review, Vol. 9 (1), 2023 their carbon footprint and invest in sustainable business practices to make the transition to net zero by 2050 aainable. tt Policy recommendations that could be implemented in the US to promote carbon reductions by the corporate sector include, in particular: (1) imple - ment a carbon tax at a national level: this would place a fee on the amount of carbon emissions produced by businesses and individuals, encouraging them to reduce their emissions and switch to cleaner sources of energy; (2) extend public support for investment in renewable energy sources like wind, solar and hydropower which produce little to no operational carbon emis - sions. This could be achieved through tax incentives, public subsidies for re - search and development of new technologies, and investment in technology to capture carbon emissions from power plants and store them underground; (3) increase fuel efficiency standards: the government should continue to in - crease fuel efficiency standards for vehicles and continue to encourage the use of electric and hybrid vehicles; (4) increase energy efficiency throughout the economy: the government should encourage the use of energy-efficient buildings (Leadership in Energy and Environmental Design or net zero en- ergy building standards) and appliances (ENERGY STAR-rated). Since climate change is a global issue the US should cooperate with other countries to im- plement carbon control measures; (5) implement broad mandatory ESG dis- closure requirements on the federal level for US businesses. The US regula- tors could follow in the footsteps of the European Union where the Corporate Sustainability Reporting Directive (CSRD) will significantly transform ESG re - porting starting in 2024. Under this regulation some 50,000 companies are subject to mandatory sustainability reporting, including subsidiaries of non- EU companies or businesses listed on EU regulated markets (KPMG, 2023). Affected companies will be required to report according to the European Sustainability Reporting Standards which set out rigorous disclosure require - ments, including over hundreds of sustainability metrics. Lastly more research on divestment and engagement is needed. The ma- jority of the published research on ESG-based investing addresses financial performance of stock portfolios or individual stocks and focuses on decar - bonization of stock porolios tf but does not measure physical reduction of car - bon emissions. 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Economics and Business Review – de Gruyter
Published: Apr 1, 2023
Keywords: divestment; engagement; ESG; net zero transition; decarbonization; G10; G11; G15; G24
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