Divestment doesn’t go far enough

“There is no such thing as liquidity of investment for the community as a whole,” John Maynard Keynes wrote.

Let’s examine how this applies to tobacco and carbon divestment. I’ll address this macro-position at the end of this article. First, I want to lay out the groundwork.

Arguably, the movement to divest tobacco holdings from institutional portfolios can be traced to an individual. (That makes for a better story; multiple influences within a complex system make for a poor narrative.)

Dr Bronwyn King is an Australian radiation oncologist who was once treating lung cancer sufferers and is now chief executive of Tobacco Free Portfolios.

“It was only during a meeting with a representative of her superannuation fund in 2010 that Bronwyn learnt some of her money was flowing to tobacco companies through the default option of her superannuation fund,” the Tobacco Free Portfolios website states. (Source: http://www.tobaccofreeportfolios.org/who-we-are-2).

This is a flaw in the narrative, but a perfectly forgivable one. No money was flowing to the tobacco companies. Existing ownership rights were being shuffled between willing buyers and sellers, that’s all.

Nevertheless, King saw a problem.

“In recognition of the profound death and disease caused by tobacco, there are 181 parties to the UN Tobacco Treaty, vowing to implement robust tobacco control regulations,” she wrote. “In contrast, the global finance industry still invests in, and profits from tobacco. But this is changing…”

The tobacco industry causes harm, therefore there is an ethical case against it. But most of the global finance industry operates under a fiduciary duty, which comes from a history of ethics-free, finance-only decisions. So what does the financial case for divestment from tobacco look like?

History shows that tobacco companies have been extraordinarily successful investments; if customers are compelled to buy a product (because of a physiological addiction), it shouldn’t be too hard to make super-normal profits. To build a financial case against holding such assets, one must argue that future returns will be different.

To me, there are two relatively clear aspects to the industry’s future returns: an attractive stream of cash flows from an existing business model supported by tied-in customers; and a very unattractive set of ‘externalities’ (essentially litigation or regulation) that could take most, if not all of those cash flows away.

It would take a brighter mind than mine to combine those two elements into an expected value. My thinking is more simplistic.

If I know that a tobacco asset has a positive probability of going to zero over my investment horizon (and the cumulative likelihood grows ever larger as the horizon lengthens) why hold it? Part of compounding wealth is about avoiding drawdown, and there are many other assets I could hold instead, so why take the risk?

Given that, I believe I can construct a valid, financial-sounding (but in reality, ethics-infused) case for divestment.

That brings us back to Keynes. Applying the idea there is no such thing as liquidity of investment for the community as a whole, I can remove tobacco from my portfolio but society can’t.

If I sell my securities, I can do so only if there is a willing buyer on the other side, and so the tobacco business model continues largely unimpeded. It’s just that the returns and the risks now affect someone else’s portfolio.

As a bit of an aside, King’s super fund contributions were not funding this industry. But a previous generation of financial industry participants did fund it. Back then, there were credible claims that smoking could even be good for you. This history shows the importance of genuine long-term thinking. It is better not to fund an industry that causes harm than to try to shut it down after it exists (and can lobby). But this would represent incredible foresight.

So there’s a shuffling of ownership but tobacco company operations continue. I presume that is not the result that King desires.

It can be argued that if enough people decide to divest, there is an impact on the cost of capital to tobacco companies. But will that affect them? They are no longer allowed to give money to advertising agencies, and there is no point in capital expenditure to expand production. In short, they don’t need capital and are unlikely to be bothered by a higher cost of capital.

The truth is, tobacco is a dead business, and everyone knows it.

You can, in fact, make a case that tobacco’s returns went from merely excellent to extraordinary at the time it became generally recognised that it was a dead business. This is because the industry had no other use for the cash thrown off by continuing operations than to return it to shareholders.

So, for me, divestment doesn’t achieve what it aims for – the ending of tobacco-influenced human suffering. The answer is to shut down the business model, which would entail a deliberate choice by brave shareholders to strand financially attractive short-term assets.

That is, unless we could persuade governments to nationalise the tobacco companies.

This would give society the liquidity, the out that is otherwise achievable only by stranding. It would also allow a government to manage the asset-liability problem as it saw fit, over the time horizon it deemed practical.

Apply this to fossil fuels. Tobacco is a $517 billion problem (the global market cap of tobacco companies). To me, fossil fuels are the same type of problem but at an order of magnitude much bigger ($5 trillion).

If fossil fuels equally cause human suffering (or are about to), then they pose exactly the same private divestment versus public externality problem.

Therefore, we should probably start thinking about engaging with governments to nationalise fossil fuels under a mandate to wind them down as well. The private capital windfall could then be applied to funding new industries – hopefully with greater knowledge of potential future externalities.


Tim Hodgson is head of the Thinking Ahead Group, an independent research team at Willis Towers Watson and executive to the Thinking Ahead Institute.