Fossil fuel divestment activists celebrated on January 10 when Mayor Bill de Blasio announced that the City of New York’s pension funds would divest from fossil fuel companies. Comptroller Scott Stringer mentioned that it had taken two years to arrive at this decision, and that the implementation of a divestment strategy would be “complex”.
The complexity Stringer referred to is driven in part by the laws that govern the behavior of pension fiduciaries. For corporate pensions, the fiduciary standard is articulated in the Department of Labor’s Employee Income Retirement Security Act (ERISA). Under ERISA, the primary responsibility of fiduciaries is to manage plans solely with the interest of participants and beneficiaries in mind, and for the exclusive purpose of providing benefits and paying plan expenses. Fiduciary guidance for public pension plans like New York City’s is not governed by ERISA but by state statutes. Most states including New York, however, have adopted laws and fiduciary standards that are very close to those found in ERISA.
As such, pension trustees must determine that divestment from fossil fuel companies contributes to the exclusive goal of providing promised benefits. Standards of conduct are imposed on trustees to protect beneficiaries, and while we may wish them to be more flexible, it appears that divestment based solely on moral grounds, or on the harm fossil fuel companies are doing to the environment is not, in and of itself, sufficient to satisfy most pension fiduciary standards. During the January 10 press conference, Comptroller Stringer mentioned that the pension trustees had studied the issue divestment issue extensively and that after careful consideration, they believe divestment at a policy level to be consistent with their fiduciary responsibilities. We assume that the risk of stranded fossil fuel assets facing the industry factored strongly in their decision. Trustees, however, are typically charged with making investment policy decisions, not with making security selection decisions. Those decisions are delegated to others, either internal or external portfolio managers, who are given mandates by the trustees to implement the policy. Many investors and market participants (including we at FFI) believe that the economic prospects for fossil fuel companies are dim. However, there is more to implementing a divestment strategy for a pension fund than removing securities of The Carbon Underground 200TM from its portfolio, because, investment (and divestment) decisions need to be made for the exclusive purpose of providing and securing benefits. The Mayor and Comptroller, therefore, face the challenge of developing an implementation strategy that is demonstrably for the exclusive benefit of participants.
To illustrate the implementation challenges, let’s examine hedge fund strategies that involve long and short positions. Large pension funds are typically invested in active quantitative strategies like statistical arbitrage (“stat arb”). Stat arb strategies involve computer algorithms that identify stocks to be long and stocks to be short. These low-beta strategies provide a diversified return stream to most portfolios. Strict divestment criteria that prohibit any ownership of fossil fuel reserve owners might restrict an asset owner from investment in a stat arb strategy, even though the long exposure is a) generated by a computer algorithm, b) likely short term in nature, and c) likely offset by a similar short exposure, thus producing close to zero beta to the fossil fuel industry.
Another example is merger arbitrage. In the oil and gas industry, it would not be unreasonable to expect an increase in the volume of transactions where larger, more cost-efficient companies purchase smaller, less efficient companies. Merger arbitrage involves being long the acquired company and short the acquiring company. If the deal closes, the arbiter realizes the spread between the prices of the two companies (which converge upon closing). Divestment that prohibits the purchase of reserve owners could also restrict pension plans and participants from benefiting from uncorrelated returns via merger arb.
These are just two examples of strategies that involve an investment in a fossil fuel reserve owner where that long investment is part of a broader strategy, one usually involving an offsetting of the short position. In these strategies, the asset manager is not making the long investment because they believe in the management of Exxon Mobil or the prospects of oil exploration activities of Chevron. The asset manager is making a bet on mispricing between two securities and the asset owner, and hence plan participants benefit from the uncorrelated return stream provided by this arbitrage.
To develop a divestment implementation plan that balances the high-level decision that fossil fuel companies are not appropriate investments, with the fiduciary need to act in the best interests of participants (i.e., to generate returns so that their benefits can be paid), pension trustees should consider the following approaches:
Develop a nuanced policy. This policy could exclude strategies that are not simple long investments in reserve owners from the divestment mandate. These strategies (or funds) could include various arbitrage strategies like the two mentioned above. They could also exclude commingled funds where an alternative fossil-fuel-free version does not exist or is too costly to replicate. Funds that invest in private equity or venture capital might also be excluded if high-quality fossil-free alternatives cannot be found.
Consider synthetic divestment. Synthetic divestment refers to the use of a swap to hedge exposure to fossil fuel investments. A swap contract allows an investor to exchange the returns of an asset or reference index for the returns of a different asset or reference index. In 2013, the World Wildlife Fund (WWF) was considering the risk of stranded fossil fuel assets in their portfolio. Rather than instructing their managers to sell holdings, the WWF executed a “stranded asset total return swap,” whereby they would exchange the returns of a basket of coal, oil, and gas stocks with the returns of the S&P500. In effect, the WWF economically divested without having to sell the individual holdings, or change managers or manager mandates.
With the swap, investors avoid profiting (and losing money) from the fossil fuel industry, maintain ownership and a voice as a shareholder, maintain their current asset allocation and manager structure and retain flexibility to adjust the notional (principal) amount of the swap to reflect the actual exposure from fossil fuel holdings. While the transaction costs of the swap will likely exceed the transaction costs of divestment, the additional flexibility to retain access to alpha-generating strategies and retain the voice as a shareholder could for some asset owners, outweigh the costs.
Change the benchmarks. Another divestment strategy could be to simply change the benchmarks (at the plan level and benchmarks for managers) so that they exclude fossil fuel owners (like the CU200 companies). The asset owner is in effect saying to their external managers that the benchmark portfolio upon which they will be measured excludes fossil fuels. They are not prohibiting managers from making investments, they are simply communicating that any investment outside of the benchmark securities should be thoughtfully considered.
Change manager selection criteria. The criteria for changing managers can be amended to select managers that have adopted ESG considerations into their security selection process. Specifically, asset owners can select managers who specifically consider the risks of climate change in constructing portfolios. While this strategy doesn’t mandate that managers cannot hold interests in fossil fuel companies, it likely reduces the probability of having significant holdings in reserve owners.
The issues involved with divesting a public pension fund are complex and the hurdles are high. The implementation may well end up with public pensions having some de minimis allocation to fossil fuel reserve owners. But the point will have been made, that fossil fuels are incongruous with a clean-energy economy.
 The determination of whether a trustee has discharged their fiduciary responsibilities is a matter of facts and circumstances. We can provide no opinion as to whether the trustees of the New York City pension plans have satisfied the Prudent Investor standard as outlined in the New York Prudent Investor Act, or any other standard of conduct prescribed by law. https://www.nysenate.gov/legislation/laws/EPT/11-2.3
 See http://www.intentionalendowments.org/selling_stranded_assets_profit_protection_and_prosperity. For the following two years, the swap was successful as a hedge, returning a reported 55%.