The three types of climate divestment.
Climate change also poses a direct risk to investors. The International Renewable Energy Agency (IRENA) estimates that $11 trillion in assets will be left “stranded” by climate change by 2030.
Fossil fuel divestment seeks to balance an investors values on climate change with their financial goals. The key trade-off investors face is diversification risk: the more assets an investor changes out, the farther away from the market allocation they get.
In general, there are three broad strands of climate divestment approaches.
Here’s how to choose which one is best for you:
1. "Subtractive" Divestment
In a subtractive approach, investors divest from climate-sensitive firms and leave their remaining investments intact. Its relatively easy to change your allocation this way, but can expose you to hidden costs associated with tracking error and loss of diversification.
- Relatively easy to do yourself with the right tools
- Doable with low-cost ETFs
- Some climate-friendly ETFs exist
- Can lead to tracking error with the S&P 500
- Exposes your portfolio to inflation risk
- Can be hard to manage divestment across large or complex portfolios
- Some climate-conscious funds are terrible for the environment
2. "Analogous" Divestment
In an “analogous” approach, an investor chooses to swap out stakes in climate-sensitive firms with investments in renewable energy firms. Investors tend to choose this approach when they want to maximize the climate impact of their investments or if they believe renewable energies make good investments.
- “Feel good” value of investing in renewable energy
- Maintain exposure to energy & utilities sectors (~12% of the S&P 500)
- Possibility for greater climate impact
- Greater tracking error with the S&P 500
- Renewable energy funds tend to be actively-managed, leading to higher fees
- Some of the largest renewable energy operators are oil companies, so many funds invest in them
- Little direct control over what companies you want to divest from
At the end of the day, “social impact” is highly subjective. Your values and financial priorities may not line up with those of the person(s) managing the “climate-driven” fund of your choosing. Truly climate-friendly investing is time-consuming, so you’ll likely end up paying higher fees.
3. "Neutral" Divestment
A “neutral” approach looks at the impact that divestment has on the risk & performance profile of your whole investment portfolio. An investor will take their fossil fuel investments and funnel them into a custom asset or group of assets that, together, mimic the performance and risk profile of the divested assets without contributing to climate change.
- Minimizes tracking error
- Uses low-cost index funds
- Limits portfolio exposure to inflation
- Hard to identify which investments to use
- Difficult to set up and maintain