The “Frictional Costs Of Fossil Fuel Divestment” report, authored by Prof. Bessembinder of the W.P. Carey School of Business at Arizona State University, looks at the financial impacts of divestment from fossil fuels on endowments and pension funds. Prof. Bessembinder, who also serves as managing editor of the Journal of Financial and Quantitative Analysis, looks at the costs related to executing often-complicated transactions and then actively managing an endowment to ensure it remains compliant with ever-changing definitions of what it means to actually be “fossil-free.”
Here are some key findings from the report:
- That transaction and management costs related to divestment – what he refers to as “frictional costs” – have the potential to rob endowment funds of as much as 12 percent of their total value over a 20-year timeframe. This includes the onetime immediate transactions costs an endowment must endure, as well as ongoing annual management fees to stay in line with the changing definition of “fossil free.”
- Focusing on a sample of 30 universities, including large, medium-sized, and small endowments, conservative estimates of these transaction costs range between 60 basis points and 269 basis points for large endowments, between 25 basis points and 180 basis points for medium endowments, and between nine basis points and 124 basis points for small endowments. Meanwhile, conservative estimates of ongoing annual compliance costs range between 8 basis points and 58 basis points.
- For a typical large endowment growing at a historically reasonable rate, this would translate into a loss in value of as much as $7.4 billion over 20 years. For medium and small endowments the loss is equal to between $52 million and $298 million, and $17 million and $89 million respectively.
- Since many endowments hold assets in structures such as mutual funds, commingled funds, and private equity funds, divestment of fossil fuel assets generally requires the sale of an entire fund – leading to “collateral damage” and imposing substantial transaction costs for a fund.
- The top 10 actively managed funds with an environmental focus charge management fees 10 basis points higher than peers in the active management space, and 73 basis points higher than the passively-managed funds that long-term investors tend to favor.
Frictional Costs Of Fossil Fuel Divestment
Arizona State University,
University of Washington and Compass Lexecon
May 11, 2016
Advocacy for fossil fuel divestment has been growing on college campuses nationwide in recent years. In contrast with prior literature, which focuses on the impact of divestment on returns, I investigate the “frictional” costs that college and university endowments incur in implementing fossil fuel divestment, including transaction costs and ongoing monitoring and active management costs. I find that these costs are likely to be substantial, for the following reasons. First, endowments are long-term investors that tend to hold illiquid assets that are costly to sell. Second, endowments frequently invest in mutual funds or commingled funds, which requires them to sell more than just fossil-fuel-related assets in order to divest. Third, since there is no well-defined and agreed-upon list of assets that are fossil-fuel-related, investment managers must undertake a degree of active management in order to maintain compliance with divestment goals. Overall, I estimate a total cost to endowments over 20 years due to the frictional costs of divestment that range between approximately 2 and 12 percent of the endowment’s value, which, for a typical large university endowment, would translate to a decline in value of between $1.4 billion and $7.4 billion.
Frictional Costs Of Fossil Fuel Divestment – Introduction
Fossil fuel divestment refers to the sale of assets, such as stocks and bonds, associated with companies whose activities related to fossil-fuel extraction and/or distribution are claimed to contribute to climate change. Advocacy in support of fossil fuel divestment came to public prominence with environmental activist Bill McKibben’s 2012 article in Rolling Stone, and has grown modestly since then. McKibben’s campaign recently announced that more than 500 institutions, representing $3.4 trillion in total assets under management, have committed to some form of divestment. The amount of assets actually divested to date appears to be relatively small, though, in part because many institutions that have announced adherence to divestment goals apparently owned few fossil fuel-related assets to begin with. Advocates argue that, by divesting, investors can “take the fossil fuel industry to task for its culpability in the climate crisis” and “help break the hold that the fossil fuel industry has on our economy and our governments.”
Colleges and universities, religious institutions, and public pension funds are frequently the focus of divestment activists’ efforts, and appear to constitute a sizeable share of the institutions that have divested to date. However, a number of prominent institutions have considered, but rejected, divestment as well. In particular a number of prominent universities, including the University of Michigan, Columbia University, Cornell University, Vassar College, and the University of British Columbia, have recently rejected broad-based fossil fuel divestment for their endowment funds. Other major universities, including Harvard University, Brown University, and Yale University had previously rejected calls for divestment, while Stanford University and Georgetown University have indicated a desire to divest from coal-related assets, but explicitly not those in the oil and gas sector. In some cases universities that chose to divest assets on the basis of other concerns, such as human rights in Sudan, have nevertheless elected to not divest in the case of fossil fuels.
A small but growing body of literature on fossil fuel divestment, which I summarize in Appendix A, has focused primarily on the question of whether a divested portfolio could potentially produce lower risk-adjusted returns to investors over time. By contrast, in this paper, I focus entirely on the “frictional” costs associated with fossil fuel divestment, including transaction costs associated with trading securities and ongoing portfolio monitoring costs. While some divestment advocates have argued that divested portfolios may suffer only minimal or no losses in future returns, the existence and impact of frictional costs of the type I describe in this paper cannot be meaningfully disputed. That is, costs of this type will be incurred in virtually every case where an investor divests a material amount of fossil fuel assets, irrespective of the market performance of the underlying assets in question.
My goal in this paper is not to provide commentary or analysis related to the potential environmental benefits of a broad societal shift from fossil fuels, as this important issue has been extensively discussed elsewhere. Rather, my goal is to shed light on the existence of lesser-known frictional costs of divestment – many of which are often excluded from broader discussions about the merits of divestment policy – and to provide reasonable estimates of their magnitude, so that divestment decisions can be evaluated by trustees, administrators, students and interested stakeholders with the most complete information possible.
B. Summary of Conclusions
A brief summary of the key points made in the remainder of this report is as follows:
- Many investors, including university endowments, hold assets in structures such as mutual funds, commingled funds, and private equity funds that themselves house a variety of investments. Divestment by a fund investor of the fossil fuel assets owned by a fund generally requires sale of the entirety of the fund. For this reason, the magnitude of assets that would need to be sold and replaced to achieve fossil fuel divestment is generally larger than the fossil fuel assets themselves.
- Because university endowments are perpetual institutions that make long-term investments, they tend to have disproportionately large holdings in relatively illiquid assets.
- As a consequence of these facts, transaction costs associated with divesting and replacing existing fossil fuel assets in university endowments are likely to be substantial. Focusing on a sample of 30 universities, including large, medium-sized, and small endowments, conservative estimates of these transaction costs range between 60 basis points and 269 basis points for large endowments, between 25 basis points and 180 basis points for medium endowments, and between nine basis points and 124 basis points for small endowments.
- Fossil fuel divestment advocates are not unanimous with respect to identifying which assets should be divested, and there is no objective scorecard of which I am aware to determine this question. Further, as company policies and technologies evolve, the individual investments that comprise an appropriately divested portfolio will likely change. As a consequence, investment managers would need to undertake ongoing research and management costs to maintain compliance with divestment goals. This introduces a costly element of active management into endowment portfolios.
- While some universities may take on this element of active management internally, others will elect to outsource this function to specialized environmental fund managers with appropriate expertise in these issues. A conservative estimate, derived from the difference between expenses charged by mutual funds with an explicit environmental focus and those without such a focus, indicates ongoing annual frictional costs of between approximately eight basis points and 52 basis points for large endowments, and similar or larger annual costs for medium and smaller endowments.
- Combining estimates of transaction costs and ongoing compliance costs, I estimate that endowments would lose between approximately two and 12 percent of value due to these frictional costs of divestment over a 20-year period. For a typical large endowment growing at a historically reasonable rate, this would translate into a loss in value of between $1.4 billion and $7.4 billion by the end of the 20-year period. The equivalent range for medium endowments is between $52 million and $298 million, and the equivalent range for small endowments is between $17 million and $89 million. These frictional costs are in addition to any reduction in investment returns that divestment may impose due to foregone diversification benefits, as discussed in prior literature.
- While the actual frictional costs of divestment will vary depending on the precise holdings of the investor and the particular divestment strategy undertaken, it cannot be meaningfully disputed that frictional costs of the nature discussed in this paper will occur. These frictional costs of divestment are large enough to impose substantial costs on institutions that decide to divest.
C. The finance literature recognizes the importance of frictional costs, and some universities have rejected divestment at least in part on this basis.
The finance literature recognizes the importance of frictional costs when evaluating total returns as well as the choice of investment strategies. Some strategies that appear attractive may be suboptimal once frictional costs are taken into account. For instance, Damadoran (2012) states, “Some investment schemes are more expensive than others because of transaction costs – execution fees, bid-ask spreads, and price impact. A complete test will take these into account before it passes judgment on the strategy.” Pederson (2015) states, “Whereas a high-turnover trading rule (i.e., a rule that implies frequent and/or large trades) may be the best on paper, without taking transaction costs into account, it may be a poor trading strategy in practice. Said differently, even if returns are large gross of transaction costs, net returns may be poor.” Harris (2003) states, “On average, active managers cannot outperform the market. Transaction costs and high management fees ensure that they underperform the market on average.”18 Indeed, even if (as some argue) the reduction in average rates of return from divestment is small, the frictional costs of divestment may nevertheless make a divestment strategy undesirable.
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