It’s not easy to be green: the cost of fossil fuels divestments to the New Zealand superannuation fund

The Green Party of New Zealand wants the New Zealand superannuation fund to sell its $676 million in fossil fuel investments. For those not in the know, this government investment fund is worth about $25 billion and is funded by present taxes to pay for the universal old age pension in New Zealand. Its current investment strategy seems to rely heavily on index linked funds that minimise management and trading costs.

The Government uses the Fund to save now in order to help pay for the future cost of providing universal superannuation.

In this way the Fund helps smooth the cost of superannuation between today’s taxpayers and future generations.

In common with the endowment funds of the American universities, that $676 million is about 2% of the total New Zealand superannuation portfolio of about NZ$25 billion.

Any portfolio manager risks considerable fees if she must monitor the entire portfolio because 2% is of dubious moral stature.

The main cost of divestiture is compliance costs to prevent fossil fuel investments drifting back into the portfolio through the routine day to day investments of other companies within their portfolios as these other firms expand into new businesses or diversified. The entire portfolio must be monitored for this risk.

American universities found that fossil fuels divestment rules out indexed linked funds as a class, along with their low management and trading fees. Ethical investors must move to actively managed investment funds which are perhaps a third more expensive in management fees.

If a move to a fossil fuel free portfolio rules out  passive indexed linked funds, that is a major risk to future returns of the New Zealand superannuation fund. Would this fossil fuels disinvestment including selling the recently acquired Z petrol station network  by the New Zealand superannuation fund?

Z Energy now owns and manages these businesses, which include:

  • a 15.4 per cent stake in Refining NZ who runs New Zealand’s only oil refinery.
  • a 25 per cent stake in Loyalty New Zealand who run Fly Buys
  • over 200 service stations
  • about 90 truck stops
  • pipelines, terminals and bulk storage

As usual, in the course of argument for disinvestment by the government investment fund, the Green Party makes an excellent argument for the privatisation not only of state owned enterprises but of the New Zealand superannuation fund.

Rather than have one victory at a time, the  Greens want the NZ superannuation fund to use the funds from the disinvestment to reinvest in pet projects of politicians. The green party co-leader said:

Money released from divestment can be reinvested in the rapidly growing renewable energy and energy efficiency sectors, helping to hasten the transition of our economy to a low-carbon future.

This makes government investment funds the playthings of politicians so they can never match the returns of a genuinely privately owned investment fund.

I, Pencil versus Global Disinvestment Day in fossil fuels

I, Pencil is a 1958 classic economics polemic by Leonard Read explaining about how nobody knows how even the most basic items in a consumer society are made and more importantly, they don’t need to know.

The relevance of I, Pencil to environmental activists on Global Disinvestment Day is they pretend to know enough about the vast number of products made by the many companies within the average share portfolio to be out of work out whether these companies are investing in fossil fuels so they can sell their shares in them.

I, Pencil made the point that people simply don’t know how the most basic products are made, much less who made them, and with what. Even if they did know, this information would become rapidly out of date. The marvel of the market is the remarkably small amount of information that people need to go about their business. Prices summarise much of what people need to know.

The whole point of the separation of ownership and control in modern corporations such as those listed on share markets is shareholders simply have no chance of monitoring the day to day affairs of companies in which they invest.

Many shareholders have too small a stake to gain from monitoring managerial effort, employee performance, capital budgets, the control of costs and investment policies (Manne 1965; Fama 1980; Fama and Jensen 1983a, 1983b; Williamson 1985; Jensen and Meckling 1976). This lack of interest by small and diversified investors does not undo the status of the firm as a competitive investment.

Day-to-day management and risk bearing are split into separate tasks with various governance structures developed to ensure that the professional management teams serve the interests of the owners who invested in the company, along with their many other investments that compete for their attention. Large firms are run by managers hired by diversified owners because this outcome is the most profitable form of organisation to raise capital and then find the managerial talent to put this pool of capital to its most profitable uses (Fama and Jensen 1983a, 1983b, 1985; Demsetz and Lehn 1985; Alchian and Woodward 1987, 1988).

Firms who are not alert enough to develop cost effective solutions to incentive conflicts and misalignments will not grow to displace rival forms of corporate organisation and methods of raising equity capital and loans, allocating legal liability, diversifying risk, organising production, replacing less able management teams, and monitoring and rewarding employees (Fama and Jensen 1983a, 1983b; Fama 1980; Alchian 1950).

Indeed, our friends on the Left do go on about the power of boards of directors to set their own exorbitant salaries because shareholders lack of control them because they know so little about what they do.

That is, according to our friends on the Green Left, shareholders are not supposed to know enough about company performance and operations to work out if the salaries of top executives are justified. Top executive pay is always published in annual reports of companies.

Activist shareholders concerned about fossil fuel use nonetheless will be able to work out what the companies in their share portfolios are investing in and whether these investments are in fossil fuels. Details of these investments are much less public than the pay of top executives.

This continuous monitoring of corporate investment policies and associated buying and selling of shares will make investing in small parcels of shares in smaller companies listed on the share market rather expensive. Diversified share portfolios in index linked funds can have hundreds of companies in them. Some of these companies receive next to no media coverage that will simplify the cost to activist shareholders of monitoring their investments in fossil fuels.

Is fossil fuels disinvestment a cheap or expensive futile gesture?

It is actually expensive to divest from fossil fuels both from the trading costs of selling, and more particularly, continuously monitoring your portfolio to make sure that fossil fuel companies have not entered surreptitiously in the course of companies in your portfolio buying shares in other companies that have subsidiaries in the fossil fuel industry.

Fischel’s study bases its conclusions on a historical comparison of two hypothetical, diversified, value-weighted stock indices for the period 1965-2014. One index included typical fossil fuel stocks, the other did not. The result: The fund that excluded the fossil fuel investments performed worse than the one that included them. Adding in a variety of other factors — attitudes toward risk, compliance and transaction costs — the analysis suggests that the climate-friendly fund would have earned 23 percent less over the last 50 years.

The Guardian quotes studies that argue the following:

Here are some studies, not funded by the oil industry, which indicate recent divestment would, if anything, have had a positive impact on returns and can reduce investment risk

That actually makes their arguments a wee suspicious. Too good to be true. It’s too much of a happy coincidence that moral choices such as disinvestments are also profitable.

image

Indeed, if disinvestment was profitable, actively managed portfolios would already have disinvested or marked down the returns and exposure from those shares already to account for the risks of fossil fuel and the temporary profits of peak oil.

The environmental movement manages to believe in both peak oil – oil will run out in the next two decades or so – and global warming based on runaway carbon emissions for the rest of the century burning the increasingly expensive and increasingly scarce crude oil that had ran out a long time ago previously. Global warming will solve itself as long as we are willing to accept that the environmental movement is genuine in its predictions about peak oil.

At bottom, the Guardian is trying to argue that an actively managed portfolio offers superior returns to an index linked passive portfolio that minimises trading costs. Furthermore, that form of active management requires detailed monitoring of the entire portfolio to ensure that fossil fuel investments do not inadvertently re-enter through the investment decisions of each company in that portfolio.

I can’t remember whether its 70% or 80% of actively managed share portfolios fail to beat the market in any one year. The Guardian’s previously warned in its business pages about actively managed share portfolios swallowing up to 1/3rd of investment returns as management fees.

Figure 1: Who Routinely Trounces the Stock Market?

Actively managed portfolios fail to beat a passively managed portfolio with the same composition and diversification as the whole share market itself which trades in shares only for liquidity and to rebalance the portfolio to match new compositions of the share market. Just 2 out of 2,862 actively managed funds managed to beat the market five years a row in the US stock market.

Divestiture from fossil fuels is not a one-off act. There are continual compliance costs and an investment strategy that forecloses using a whole range of low-cost index linked passive investment share portfolio managers. That cannot be denied. . American University said that divesting from these companies would require that AU investments be withdrawn from index funds and commingled funds in favour of more actively managed funds [and] estimated this withdrawal would cause management fees to double.

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