Discussing divestment: Developing an approach when pursuing sustainability outcomes in listed equities

For listed equity investors, the decision to engage with or divest from ESG laggards depends on the ESG issues concerned as well as the (sustainability) objectives of their clients and beneficiaries.

The two are not mutually exclusive – many investors favour a stewardship-first approach that includes divestment as the final step in an escalation strategy. Yet divestment may be more effective in some contexts than others.

The role of divestment in shaping sustainability outcomes

Investors increasingly recognise that the real-world sustainability outcomes and systemic issues they contribute to shaping through their investment activities will feed into the financial risks they face and are considering the role divestment can play in pursuing these outcomes.

Divestment reduces investors’ ability to directly influence the sustainability performance of investees. Evidence suggests that its financial impact on investees is unlikely to alter corporate behaviour. It may have more far-reaching consequences for public and market perceptions of an industry or company, though this is speculative.

Current trends such as the growth in passive investing, acquisitions of apparently undervalued assets by short-term investors, and improvements in investor stewardship may further weaken the case for divestment going forward.

Key factors when considering divestment

There are different considerations that may lead divestment or engagement to be more effective in shaping sustainability outcomes:

Factors favouring divestment	Factors favouring engagement
Investor is seeking value-alignment	Investor is seeking real-world impact
Poor opportunities to transition to a more sustainable business model	Issue is systemic and non-diversifiable
Investors have low leverage, e.g. a controlled company, lack of legal recourse	Investors have or can improve leverage by working collaboratively
Other escalation measures have already been exhausted	Alternative escalation measures remain open to investors
	Fiduciary constraints on use of divestment

Divestment and net-zero commitments

The growing number of investors that have made commitments to achieve net-zero emissions in their portfolio by 2050 are likely to face increased pressure to divest high-emitting holdings. There is then a risk that the net-zero movement results in a subset of leading investors with greener portfolios, while the broader economy remains largely unchanged.

Advocating for and supporting the acceleration of high-emitting companies’ transition plans through stewardship activities will be among the most impactful actions that investors can take. However, not all companies will have viable options to transition to a low-carbon economy.

Investors in such companies will need to consider whether a managed decline of assets or public policy change are more likely to lead to decarbonisation aligned with the Paris Agreement.

Addressing greenwashing concerns

Demonstrating their commitment to sustainability outcomes can be difficult for listed equity investors, with both divestment and engagement approaches raising potential concerns of greenwashing.

Investors can mitigate these by embedding a range of levers and escalation measures in their stewardship policies and practices and reporting publicly on progress. They can:

• Engage directly with the company to address the relevant issue
• Join or form a collaborative stewardship initiative that includes the company as an engagement target
• File, co-file or support a shareholder proposal^[1] setting expectations for sustainability performance improvements
• Vote against relevant members of the board of directors and disclose the rationale for doing so
• Consider shareholder litigation in respect of the company’s failure to address the issue

If divesting, investors can strengthen the signalling effect of such a move, and thus engage in responsible divestment, by publicly communicating (i) the reasons for doing so and (ii) the sustainability performance criteria which, if met by the company, may lead to re-investment.

Deploying broader influence

Proponents of divestment and engagement agree that using one approach in isolation will not be enough to eliminate systemic risks and to achieve ambitious sustainability goals such as the Paris Agreement or the Sustainable Development Goals.

Investors will need to go beyond direct stewardship of their investees to influence the market in which they operate, including by:

• considering whether and how policy change can support progress on ESG issues and incorporating policy engagement into their stewardship approach;
• considering engagement with index providers and stock exchanges to delist or exclude companies that fail to achieve minimum sustainability performance thresholds.

Introduction

One of the longest-running debates in responsible investment has been whether listed equity investors pursuing sustainability objectives should engage with ESG laggards in which they are invested or divest their holdings.

There is of course no straightforward answer to this question. Much will depend on the issues concerned and the objectives of investors, their clients and beneficiaries.

Nor are these mutually exclusive strategies; many investors favour a stewardship-first approach that includes divestment as the final step in an escalation strategy.

Yet even after an asset is divested, the ESG issues associated with it can have a negative financial impact on an investor’s broader portfolio, particularly as listed companies’ global footprints tend to be larger and divestments rarely directly impact their financial position.

Under its Active Ownership 2.0  programme, the PRI has put forward the case for a stewardship approach that is much more focused on sustainability outcomes, whereby investors consider:

• systemic issues and the interdependencies of portfolio assets to a greater extent; and
• how their influence can be deployed to achieve global goals such as the Paris Agreement and the Sustainable Development Goals.

Investors wanting to pursue such sustainability outcomes may need to adjust how they make a divestment decision or formulate an overall approach to divestment, as this paper sets out.

We define divestment as a complete exit from the shareholding of a company. However, many of the considerations set out here apply equally to partial divestments, or the underweighting of stocks based on ESG criteria.

Where this paper refers to an engagement approach, this is intended to encapsulate the broad array of direct stewardship tools that are used in parallel with robust engagement, such as voting and escalation measures.

The role of divestment in shaping sustainability outcomes

The rise of divestment as a strategy 

The practice of divesting from companies involved in activities seen as incompatible with a set of beliefs or values has a long history within responsible investment.

Yet it was not until the 1970s and 1980s that a divestment campaign sought to affect real-world outcomes, with some institutional investors divesting from companies with operations in apartheid South Africa, and multinational companies spinning off their South African divisions.

Today, institutional investors face greater expectations from their stakeholders to divest from companies associated with a range of issues, including tobacco, weaponry and private prisons.

Yet the area where divestment has become most widespread is fossil fuel-related assets. There are now estimated to be 1,500 institutions with almost US$40 trillion in assets that have publicly committed to some form of fossil fuel divestment (though the scope of assets excluded varies significantly).^[2]

As the number of investors that have committed to achieving net-zero emissions in their portfolio by 2050 rapidly grows, consideration of divestment as a strategy to realise that goal is likely to come to the forefront.

Divestment and sustainability outcomes

Investors are increasingly recognising that the real-world sustainability outcomes and systemic issues they contribute to shaping through their investment activities will feed into the financial risks they face. This is reflected in the PRI’s recent work on active ownership and investing with SDG outcomes.

The PRI defines systemic issues  as “issues that have effects across multiple companies, sectors, markets and/or economies. Impacts caused by one market participant can lead to consequences across the system, including the common economic, environmental and social assets on which returns, and beneficiary interests depend.”

An investor will generally have a legal obligation to consider what, if anything, it can do to mitigate such risks where material (through a combination of capital allocation and stewardship) and to act accordingly, as explored in A Legal Framework for Impact: Sustainability impact in decision-making, a report published in 2021 by the PRI, UNEP FI and The Generational Foundation.

In the case of climate change, a minority of publicly listed companies are outsized contributors to excessive carbon emissions that will lead to increases in natural disasters, abrupt policy changes and volatility, thus threatening portfolio-wide value.

Divesting from such companies may reduce investors’ exposure to the risk of stranded assets. However, it is unlikely to have a discernible impact on their portfolio-wide exposure to physical climate risk, nor to the broader consequences of climate-induced societal upheaval. In such cases, divestment reduces investors’ ability to mitigate the risks and negative outcomes posed to their portfolios and beneficiaries.

Other ESG exposures are similarly difficult for investors to diversify away from. For example, economic inequality (including the poor working conditions that factor into this issue) contributes to political and economic instability, reduced consumer demand and rent-seeking.^[3]

Yet these effects are not limited to companies with poor ESG practices; they are borne by companies and assets across entire economies.

Where the poor sustainability performance of a subset of companies exacerbates the risks faced in their broader portfolios, investors should not view divestment as a way to eliminate those risks. The key question then becomes whether engagement or divestment is a more effective tool to encourage change at those companies.

Impact of divestment on corporate behaviour

The evidence on whether divestment has led companies to adopt more sustainable practices is mixed. Particularly when compared with engagement, many academics have found divestment has a limited effect – if any – on shaping target companies’ decision making.^[4]

The impact of divestment on companies’ cost of capital has been considered insufficient to affect their internal investment decisions. Yet exceptions to this view exist^[5]  and other researchers have found only limited improvements in sustainability performance resulting from institutional investor ownership.^[6]

Many investors consider divestment to be an escalation method or ultimate sanction when investee companies are unresponsive to engagement efforts.^[7]  Under these circumstances, divestment can communicate to the wider market that the investor believes the targeted company’s long-term strategy is likely to remain misaligned with relevant sustainability performance thresholds.

The threat of divestment may be necessary to ensure some companies are receptive to engagement. Yet for others, the knowledge that vocal shareholders may eventually divest could also disincentivise them from acting on shareholder concerns, believing they can wait these shareholders out.

It is possible that even if divestment has little direct effect on individual companies’ decision making, it may contribute to broader normative shifts that shape public perceptions of a given industry and increase the likelihood of public policy interventions targeting that industry. Many proponents of divestment believe this is the key impact of such a strategy, though its effectiveness is speculative and difficult to measure.

Current trends could lead to a further weakening of divestment as a strategy for influencing corporate behaviour.

With continued asset growth from passive investors tracking broad-based indices, there will likely be long-term institutional demand for a substantial portion of large-cap companies’ securities, unless exclusions are considered for existing indices or there is a significant change in the uptake of alternative indices (see Engage stock exchanges and index providers).

Furthermore, should divestments succeed in increasing a company’s cost of capital, this may increase their attractiveness for some hedge funds and private equity investors with shorter-term investment horizons.^[8]

Improving ESG incorporation and stewardship practices among investors may also improve the prospects of engagement compared with divestment.

Many jurisdictions have introduced or strengthened stewardship regulations or soft law; over 20 jurisdictions now have stewardship codes, as highlighted in the PRI regulation database. Investors also face increased scrutiny from other stakeholders of how they exercise stewardship. This has contributed to a rise in support for ESG-related shareholder proposals in recent years.^[9]

The Ukrainian crisis and divestment of Russian assets

Key factors when considering divestment

Table 1: Deciding whether to divest or engage

Factors favouring divestment	Factors favouring engagement
Investor is seeking value-alignment	Investor is seeking real-world impact
Poor opportunities to transition to a more sustainable business model	Issue is systemic and non-diversifiable
Investors have low leverage, e.g. a controlled company, lack of legal recourse	Investors have or can improve their leverage by working collaboratively
Other escalation measures have already been exhausted	Alternative escalation measures remain open to investors
	Fiduciary constraints on use of divestment

Client and/or beneficiary preferences

Nature of ESG issue

Transition opportunities

Fiduciary implications

Influence

Divestment and net-zero commitments

Since the launch of the UN-convened Net-Zero Asset Owner Alliance (NZAOA) in early 2020, the number of investors committing to achieve net-zero emissions in their portfolios by 2050 has grown massively – as of November 2021 an estimated  450 firms in the financial sector across 45 countries had done so.

Such investors are likely to face increased pressure to divest holdings that are not aligned with a net-zero-by-2050 trajectory, in order to achieve interim decarbonisation targets and to demonstrate the seriousness of their commitments.

A key risk is that the net-zero movement results in a subset of leading investors with greener portfolios, while the broader economy remains largely unchanged. AP2, for example, points out that of the 70% drop in the carbon footprint of its portfolio between 2019 and 2020, less than 4% came from changes to companies’ footprints, with the rest coming from changes in portfolio holdings.^[18]

As noted by the NZAOA in the second edition of its Target Setting Protocol, each time an investor adopts a net-zero emissions target while the global economy does not move in conjunction, the gap between the two widens:

“Eventually […] this will force members to divest from entire sectors to bring their portfolios in line with the set target range and reduce the flow of capital to those highly capital-intensive sectors which require financing to transition (such as aviation, transport, and materials).

“This outcome would be highly harmful to the speed of the planetary transition to net zero as the real economy is left behind, hence limiting the real impact on global warming. [Investors] can only de-couple from the real economy benchmark to a certain extent before [their] portfolios no longer reflect the sectors, of which, a net-zero economy would be comprised.”

Investors that divest from high-emitting holdings may free up capital they can reallocate to help bridge the climate financing gap. Yet for allocations that remain within secondary markets, supporting the acceleration of high-emitting companies’ transition plans through stewardship activities will be among the most impactful actions that investors can take.

They can do this individually and through participation in initiatives such as Climate Action 100+. This will be particularly important for companies in hard-to-abate sectors.

Such companies will need shareholders supportive of and forcefully pushing for ambitious decarbonisation timetables.^[19]

Shareholders will need to ensure boards of directors are aligned with their long-term interests, by actively challenging and shaping them to have adequate climate competence and oversight.^[20]

A disengaged shareholder base may lead to slower private sector decarbonisation, frustrated internal company change agents and continued lobbying practices that prevent necessary policy changes.

With respect to interim decarbonisation targets, investors need to be cognisant of the risk of hitting the target but missing the point. For example, some national governments have been criticised for increasing natural gas use to reduce emissions in the short term while locking in long-term emissions.^[21]  Investors should similarly be wary of taking actions today that will enable them to achieve interim targets but reduce the prospects of achieving systemic change.

Not all companies will have viable options to transition to a low-carbon economy. Investors in such companies will need to consider whether a managed decline of assets or public policy change are more likely to lead to decarbonisation aligned with the Paris Agreement.

Where investors have sufficient influence with a company, they may be able to agree on a new capital management plan, where it ceases investment in new fossil fuel projects and instead returns capital to shareholders via increased dividends and invests in a just transition for workers and communities.^[22]

Yet this may be more effectively achieved via policy change, and a policy engagement strategy is an important component of a net-zero commitment. ^[23]

Where an investor does miss an interim net-zero target due to continued ownership of high-polluting companies, it should be able to evidence its ongoing stewardship activities with them, including the metrics used to measure such efforts.

Addressing greenwashing concerns

Demonstrating their commitment to sustainability outcomes can be difficult for listed equity investors, with both divestment and engagement approaches raising potential concerns of greenwashing.

For the former, an investor may improve the sustainability characteristics of its portfolio without any effect on real-world outcomes, which raises concerns where this is framed as having a positive impact.

For the latter, an investor’s purported commitment to engaging on sustainability outcomes may not be reflected in its actual engagement and voting activities.

In both cases, investors can demonstrate their efforts to affect real-world sustainability outcomes by embedding a range of levers and escalation measures in their stewardship policies and practices and reporting publicly on progress.

Where an investor determines that divestment is the most effective way of achieving its objectives, there are steps it can take to improve the chances of affecting sustainability outcomes in the real world, which together could be considered a form of responsible divestment. These include:

• reserving divestment for target companies where other escalation measures have been exhausted (see Figure 3), as this strengthens the signalling effect of that decision;
• publicly disclosing the rationale for a divestment decision;
• where relevant, publishing suggested improvements to a company’s sustainability performance, commitments or governance that would lead to reinvestment and continuing to engage with them post-divestment on that basis; and 
• allocating divestment proceeds to activities that more directly contribute to improving real-world sustainability outcomes, thus contributing to a change in the financing cost or liquidity of such activities.^[26]

Where a divestment campaign has already gained substantial prominence, further divestment announcements may add little to market information or public discourse, and so employing a broader range of stewardship activities will be necessary for an investor to have an impact.

Deploying broader influence

Proponents of divestment and engagement agree on one thing: using one approach in isolation will not be enough to eliminate the risks posed by systemic issues and to achieve ambitious sustainability goals such as the Paris Agreement or the Sustainable Development Goals.

As such, investors wishing to shape sustainability outcomes will need to consider other stewardship levers at their disposal, going beyond direct stewardship of their investees to influencing the market in which they operate.

Engage policy makers

Engage stock exchanges and index providers