Big Oil Versus College Kids, Part 2

I got a bunch of responses to my post on divestment last week. It seems worth running through the major arguments and why, even after hearing them, I’m still pretty convinced that divestment won’t work.
Still won't work.

I got a bunch of responses to my post on divestment last week. It seems worth running through the major arguments and why, even after hearing them, I'm still pretty convinced that divestment won't work.

Argument No. 1: Global warming is a major threat to humanity. We have to do something!

It apparently surprised some readers to learn that I am on Team Do Something. The threat of catastrophic outcomes seems small, but even a few percentage points' worth of Catastrophic Possibility seems worth paying to avoid. (This is also why I am on Team Asteroid Detection and Destruction Research Funding.)

However, I'm not on Team Do Anything. Actions to address climate change should, in my opinion, offer a reasonable chance of addressing climate change. Actions that give environmentalists warm and fuzzy feelings while doing nothing to address climate change are a bad idea for two reasons: First, they are a substitute for patiently working on harder problems. Second, they not infrequently alienate the audience you want to convince. In my opinion, the antics at Swarthmore College lost more potential converts than it gained.

Argument No. 2: We're not trying to cost the oil companies money. We're trying to delegitimize them.

Below is the fullest and most coherent version of this argument that I heard:

The divestment campaign shines a spotlight on the industry's destructive "business plan" and its effective control of Congress to do its bidding. By stigmatizing the industry it becomes much more problematic for Congressional representatives to be linked to them -- finally permitting a price to be placed on carbon pollution. Renewable energy and energy efficiency solutions will then emerge on the scale and in the timeframe necessary to limit warming

Leaving aside the almost touching belief that the rest of the public takes its policy cues from the investment officers at a handful of elite colleges, this has a bit of an underpants-gnome business plan feel to me:

  1. Bring down the full wrath of the Harvard faculty on oil companies.
  2. ???
  3. Renewable-energy and energy-efficient solutions emerge on the scale and in the time frame necessary to limit warming.

Yes, I understand that there are intermediate steps named. But these steps so fundamentally misunderstand the politics of a carbon tax, and the actual geopolitical challenges that "drive the stock price of fossil-fuel companies down" seems brilliant in comparison.

First: The major obstacle to carbon pricing in the U.S. is not ExxonMobil. The major obstacle to carbon pricing is states such as Alaska, Louisiana, West Virginia, Texas and North Dakota, where large quantities of fossil fuels are produced, providing some of the best jobs around to a large number of voters, making the politicians in those states inalterably opposed to anything that threatens the gravy train . . . and all the other states where the majority of the population has built their lives around cheap energy to heat and cool their homes, run their giant American-style appliances and drive their cars to their often-distant jobs. They will freak out if you significantly raise the cost of their energy, and politicians know it.

Second: The major obstacle to fixing global warming at this point is not U.S. consumers, who have actually shrunk their carbon footprint in recent years. Rather, it's billions of people in poor countries who are getting richer and using a lot more energy. Just to hold emissions steady in the face of Chinese growth, Americans would have to cut their energy usage by about two-thirds.

Carbon taxes might help lead some investment into lower-carbon technologies, which could help those countries industrialize with lower carbon emissions. However, to really address global warming, the low-carbon technology has to be cheaper than fossil fuels -- not "competitive if you factor in all the negative externalities," but actually cheaper.

Much was made on Twitter of Germany's generating 50 percent of its renewables from solar power, which is not true, but no matter. Germany got to its impressive-but-not-actually transformative level of solar-panel installation through massive subsidies. We cannot ask China to do the same. Well, I guess we can ask, but they'll say no.

Finding cheaper, cleaner energy sources is a worthy goal, which is why I support hog-wild spending on research into renewables, and yes, a carbon tax. But this doesn't seem like the most efficient way to pursue that goal:

a) Get universities to divest their endowments;
b) "Delegitimize" fossil-fuel companies;
c) Force congressmen to stop accepting contributions from said companies;
d) Pass a carbon tax; and
e) Enhance renewables and energy efficiency.

Going straight for the subsidies and the carbon tax seems more efficient, and more likely to work, given that, as mentioned above, ExxonMobil's campaign spending is the very least of the environmental movement's problems.

Argument No. 3: Fossil-fuel companies get all sorts of subsidies from Congress. Divesting will make capital more expensive for them and claw back some of that subsidy.

This argument is a perennial favorite among the environmental movement, though the people who offer it are often rather expansive in their definition of a subsidy to fossil fuels. "Not having a carbon tax to price the externalities" is often cited as a subsidy; so is "war." People also frequently mention somewhat arcane rules about expensing drilling and exploration costs, which aren't a permanent subsidy, and also were stripped from the major oil companies years ago.

Even if we assume arguendo that war is actually a subsidy for oil prices, as mentioned above, the target of those subsidies is less "big oil companies" than "U.S. consumers," meaning that a divestment that costs Big Oil's shareholders a few dollars is unlikely to make much difference in the political calculus. Even more important, divestment and U.S. tax subsidies are largely irrelevant to most of the world's major producers of fossil fuels.

When you look at the list of the world's largest coal companies, you'll see that the majority are in China, India, Russia and other emerging-market economies, many of them state-owned. Those companies do not care about the U.S. tax code. They do not need to come into U.S. capital markets to get money. Divestment will hurt them as much as ... well, as it would hurt you to be told that a group of students at Siberian Federal University thought your summer trip to Europe was destroying the environment.

The list of the biggest oil producers is even more lopsided. Twenty companies produce 88 percent of the world's oil, and two-thirds of those companies are either Russian or state-owned firms in oil-rich nations. Time is too short for me to summarize all the many ways in which these companies fail to care what U.S. universities and public-worker pension funds think of them.

Argument No. 4: How can you not think that divestment will affect the stock price of fossil-fuel companies? Supply and demand, baby!

Sure, supply and demand. But outside of economics textbooks, a tiny drop in demand does not translate seamlessly into a decline in price. As noted above, most of the large producers in the two dirtiest fossil-fuel industries aren't in the stock market at all; they're state-owned firms that care a lot about the price they can sell for and not at all about the need to raise capital in U.S. markets or maintain the good opinion of U.S. college students. To be sure, they often produce in partnership with Big Oil. By the same token, these companies are potentially a source of capital for Big Oil even if you did, somehow, miraculously cause capital to dry up in the Western world.

Second, you won't cause capital to dry up in the Western world. To see why, it's worth running through some basic finance. How do you price a stock?

The simple answer they teach you in finance class is "the discounted value of future cash flows." That is, how much money will the stock throw off while you own it, and how much can you expect to sell it for?

Liquidity does matter for the ultimate sale value; people who buy thinly traded small-cap stocks expect to get a discount to cover the risk that they might not be able to sell it. But for nice, big, beefy stock in a company such as ExxonMobil, which has solid profits and a dominant market position, that's not really a factor. Even if you got all the university endowments and all the blue-state public-sector pension funds out of the stock, there would still be plenty of willing buyers. You may change the distribution of who buys the stock, but you're unlikely to change the price, because the price is mostly going to be related to the underlying assets and profits of the company, not the liquidity of the market in the stock.

Let's work it through with a little example. Let's say there's a stock market with $1 million invested in it by 100 investors, each of them with $10,000 in the market. In that market, there are 10 stocks, each of which has a market capitalization of $100,000. All the stocks are priced to yield a risk-adjusted 5 percent a year in some combination of dividends and capital appreciation, which means that everyone's $10,000 portfolio earns $500 per annum, because they are good students of economics and they buy index funds rather than trying to beat the market.

Yes, this is a gross oversimplification, but it's enough to illustrate our point.

Now imagine that one of our 10 stocks makes a controversial product -- call it Evil Sludge. Twenty of our investors -- call them the Moral Minority -- decide that they do not want to be involved in the production of Evil Sludge. Each of them has 10 shares of Big Evil Inc., which they sell, and they use the money to purchase an equally weighted portfolio of all the other shares.

The immediate effect is that the price of Big Evil falls, while the price of all the other shares rise. That's the first-order effect. That seems to be where a lot of people are stopping in their mental model of divestment.

But let's think about the second-order effect. The price of the other nine companies has now risen, so a $1,000 investment buys you fewer shares. What does that mean?

It means that the potential return has fallen. A $1,000 investment in a nonsludge stock used to earn you $50 a year. But now you aren't getting as many shares for your $1,000. So maybe it earns you $45 a year. In financial jargon, the returns are inversely related to the price: All else being equal, the higher the price you pay, the lower the return; the lower the price, the higher the return.

But hey, Evil Sludge is evil, and the Moral Minority is willing to take a little financial hit in order to send a message to Big Evil.

OK, but what about the other investors? They don't care about Big Evil; they care about returns. And just as the returns on other stocks fell when the Moral Minority decided to shift their portfolios, the potential returns on Big Evil Inc. have now risen; a $1,000 investment may now net you $55 or $60 a year. The rest of the investors can make free money by selling some of their other stocks to the Moral Minority and buying up Big Evil. Where does this process stop? When the returns on Big Evil fall to the same level as the returns on all the other stocks.

This is what I was talking about when I said that it's hard to stage a boycott on a fungible commodity. In order to significantly affect the stock price, you'd have to shrink the market for that stock to the point where the majority of people are not willing to hold that stock, and there's a significant risk that you won't be able to sell it if you need to.

There is no chance that the divestment movement will achieve that level of disinvestment. Tobacco companies are actually widely reviled by millions and enjoy a price-to-earnings ratio not much different from the S&P 500 average. That's in a declining industry with a product that most of the public doesn't use, and which is very directly linked to gruesome diseases. Investment managers keep buying them because they have steady, recession-proof cash flows.

If you want to attack the stock price of Big Oil, you need to attack the demand for their product. The issue is not legitimacy. It is not demand for their stock. It is not subsidies. It is the fact that there is so much consumer demand for their product, here and abroad.

One of my e-mailers/commenters said that I was naive and ignorant for pushing demand-side solutions, because decades of trying to shrink consumer demand have failed. Indeed they have, but this is not a very good argument for divestment.

During the run-up to the first debt-ceiling debacle, I had a frustrating conversation with dozens of conservatives in which I pointed out that shutting down the government was not a realistic path to achieving lower government spending, and it would almost certainly hurt the Republican politicians who were pushing it, and thus the prospects for cutting government spending in the future.

The answer I got back was "Well, nothing else worked, so this is all we have left." That is a bad argument, as I am sure the divestment advocates can readily understand. Switching from "not working" to "actively counterproductive" is not an effective strategy -- no, not even if your cause is really, really important.

Ultimately, divestment doesn't matter, except possibly to the undergraduates who get benefits from endowments as currently invested. It won't impact fossil-fuel consumption or politics. It may provide a satisfying focus for frustrated environmental groups that are tired of trying to convince the student body to eat vegan.

But precisely because global warming is a real problem, I think that environmentalists should not waste as much as a second on things that don't matter. Particularly when some of the protests turn actively counterproductive, as the events at Swarthmore did. Even if they succeed in forcing the college to divest, they will have cost the movement more in public-relations terms than it can ever hope to gain by proudly announcing that the Swarthmore endowment is pulling out of fossil fuels. The movement cannot afford many more such victories.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.