How divestment works (in simple words)

You have probably heard or read the word "divestment" in the news, especially in relation to the oil industry or movements like Defund the Police. In plain words, divesting simply means taking your money out of something. In the case of the fossil fuel industry (coal, oil and gas...), many major financial organisations have announced their intention to divest in the next few years. Let's explore what it means, and how this works, without drowning you in technical jargon.

In this post, we will focus on the example of the oil industry, but the same logic would apply to pretty much any company or industry.

To divest, you first need to be invested

Banks and other financial organisations (like your 401k provider and the funds that hold your savings) often have investments in the oil industry. Really, it usually means they either have bought (and own) shares in oil companies (for instance Chevron or ExxonMobil) or they have leant these companies money (just like you can borrow money to buy a new car or house, an oil company can borrow money to build a new oil rig or refinery).

This links back to you, because the money they lend, or buy shares with, is often coming from you (through your savings, your retirement plan, or just the deposits on your current bank account).

What it means when the NewYork state pension fund announces it will divest from the oil industry

In December 2020, NewYork State's pension fund announced it would divest from fossil fuel companies. In practice, they will sell all the shares they own in oil companies that don't improve their climate related practices, by 2040. How and when this happens is not completely clear, but most likely over the next few years, someone who works there will place orders on various stock exchanges to sell shares and loans they own. This will happen once the fund has concluded that the company in question is not doing well enough from a climate point of view (how they will decide this is not exactly clear, but is a difficulat exercise).

The consequences of divestment actions, or "why does it work?"

In the context of divestment, the goal is to weaken the companies you're divesting from, or cut any financial ties you have with it (for instance because you think you will lose money by staying invested, or because of moral considerations). Looking at how oil companies argue against divesting, it's fair to think that it does indeed weaken them. To take a specific example, the coal company Peabody mentioned in their 2014 annual filing to shareholders that "divestment efforts [...] could significantly affect demand for our products or our securities" before they went bankrupt in 2016.

So how does it work?

There are 3 main consequences to divestment, that we will explore in more or less chronological order.

Share value

The first visible impact of divestments is on the company's share price. As investors sell shares, the price mechanically falls (by virtue of the laws of supply and demand). There is much debate about whether that fall is significant or not. Realistically, if you sell the few shares you own, particularly in a company worth dozens of billions of dollars, nobody will notice. If NewYork State's pension fund sold all of its 2+ billion dollars of oil and gas shares in one go, you would expect some sort of drop in price (which may only be temporary). Just to be clear, their divestment announcement is not this, they only said they would sell in the future under certain conditions.

Why does this matter? Share price acts as an indicator of a company's health, and top management compensation is often directly linked to their share price.

Signaling to other market players

The second effect when some organisation announces their intention to divest is that other investors take notice. Again, this is a matter of scale. If you tweet that you'll sell your 10 shares in ExxonMobil, don't expect anyone to follow you. But when NY state's pension fund said they might, it got quite a bit of media attention, and most likely started a number of conversations among professional investors. As multiple sizeable funds have annouced similar moves over the past years, the conversation is gradually turning towards how and when to sell these fossil fuel related shares before their value drops too much.

From a solid profit making investment a few years ago, oil and gas is becoming a risky asset that investors are less and less excited about. Trust in their financial value drops, which leads us to our third point.

Cost of capital

Oil companies are constantly borrowing money, to build a new refinery, a new oil rig, buy new equipment, and so on.

If you wanted to borrow money to buy a new car, you would typically go to your bank, and ask to borrow, say, $20,000. Your banker would look at your current income, your credit rating, and based on this decide if they lend you the money and at what interest rate. If you have a high salary on a long term contract, they'll be happy to lend you at a low interest rate, because it's quite likely that you'll be able to repay the loan. On the other hand, if you asked for the same loan while on a short term contract ending in a few months with low pay, you might need to try with several banks, and end up paying a much higher interest rate. Overall, the total cost of your car would be higher in the second case.

Back to our oil company, when they go to the bank or try to borrow money from the wider stock market ("issue corporate bonds" in financial terms), they often have to borrow from multiple banks (because the amounts are so big). Here is an example of Chevron borrowing $4 billion from a group of banks to repay over the next 30 years. As they negotiate the loan, the banks will look at Chevron's "credit rating", and a part of this is how its share price is evolving on the stock market (or expected to evolve). As we just discussed, divestment has a negative impact on this, and impacts the interest rate they will end up paying. And just like for the cost of your car, this impacts the cost of their operations. Ultimately, this impacts how much it costs them to produce oil. There is debate around how impactful this actually is in the case of oil & gas, though this might only be due to the fact that oil & gas companies represent so much money, that it will take a lot of divestment to actually produce an impact.

The increase in operating costs ends up impacting the cost of many things, for instance a fossil fueled power plant versus a renewable one.

The negative aspects of divestment

If a company is genuinely trying to clean up its work and shift to be a clean energy provider (like Ørsted did between 2009 and 2017), divestment can make it harder for them to implement this strategy, for all the reasons above, but mainly because capital is more expensive.

Looking at it from the perspective of the investor, some argue that if you divest from a company that shifts to more sustainable practices, you might also miss out on the value increase it will enjoy.

Should you divest?

We will post a separate article in which we will discuss the reasons why you might want to divest, or not, from fossil fuel related companies.