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Navigating an Orderly Transition: Considering Divestment and Transition Finance

Global movement towards net-zero targets is promising, and serves as an indication that businesses and investors are taking climate change seriously. At present, over 5,200 companies from transport, technology, manufacturing, retail and finance have joined the UN Race to Zero, with one fifth of the world’s largest corporates setting net-zero targets. Expectations have been set, as 130 countries are now setting or considering the target of reducing emissions to net zero by 2050.

However, beneath commitments and targets lies a crucial question: how exactly will companies and portfolios alike meet net zero? This has been the subject of controversy, with independent assessments finding that whilst companies have technically committed to a net zero strategy, many of the policies in said companies undermine any real change at achieving zero-carbon operations. This may be because they do not count all of their scope 3 emissions – that is, the emissions along their supply chain, or because they depend on strategies to offset their carbon production that are not wholly reliable or functional yet.

One way industries have committed to net zero is transitioning through divestment, away from carbon and fossil fuel heavy industries. Squeezing the flow of investment into fossil fuel companies will either force them to dramatically change their business models, or bring about their collapse. However, the transition from ‘brown’ activity to ‘green’ is far more complex than a case of divesting. If a company decides to quickly cut its carbon footprint through divestment, but that same carbon-intensive activity ends up thriving in the hands of a new owner, then the net impact on the environment does not change, or may even incur negative costs. Whilst transitioning away from ‘brown’ activities is conducive to achieving net-zero, the process must be orderly and manageable, with a clear holistic understanding of the ripple effects that rash divestments may have on sectors, workers and overall net impact. At the crux of understanding the problems of divestment, is the concern that reputable fossil fuel industries will come under pressure from investors to step away from their assets by selling them to smaller, less responsible investors who may not prioritise ESG or climate considerations to the extent that they would have.

Consider the following examples of how divestment may be counterintuitive to reducing carbon emissions.

  • Movements within the coal industry to phase out coal has backfired in some cases. Anglo American’s exit from coal conveys how unintended consequences can occur, as ownership was transferred in a bid to gradually close coal mines. Instead, under new management, ambitions were laid out for coal mine growth. As the economy recovers from the pandemic, demand for electricity and fuels has surged, sending thermal coal prices to the highest on record. This gap in the market was lucrative to both investors and producers to continue expanding the business. Thus, selling the problem to a third party could lead to more coal being produced, with less consideration for key ESG factors, and for longer if not managed properly.
  • One of the greatest targets for divestment are international oil companies (IOCs); as low-hanging fruits, they serve as an emblem for fossil fuels. However, the problem is far more complex, with divestment from IOCs resulting in the transfer of demand for fossil fuel to national oil companies (NOCs) – state owned companies that are subject to less transparency, typically have larger carbon footprints than IOCs, and are less committed to addressing the climate crisis. The result is that the divestment movement, in this instance, does not reduce demand for oil and gas, but instead grants NOCs a market that still heavily demands oil and natural gas for a wide range of products.
  • Divestment has seen rapid flight from fossil fuels, leaving towns and cities reliant on coal for income to suffer the consequences of such decisions. Put simply, environmental considerations do not ensure socio-economic justice for those on the ground.
  • Divestment comes at a cost for direct input. Investors that divest from fossil fuel heavy companies may lose their voice as partial owners of a company. This can prevent key conversations from occurring from within the business itself.

The above considerations point to the need for a more nuanced approach to addressing transition to low or zero carbon for the future. Rash decisions can result in contradictory results. Instead, there is a case for engaging with high-emitting industries to assist an orderly transition.

Transition finance is a key tool that can facilitate this. Transition finance raises capital for high emitting companies seeking to shift to lower carbon emissions. Emission-heavy industries that do not have green alternatives yet are useful for socio-economic growth in a region – or those that do not have enough resource capacity or will significantly reduce their cost-competitiveness if they did adopt green alternatives, can turn to transition finance. Transition finance not only helps aid and find solutions for industries seeking to reduce emissions, but protects industries from transition risks, such as tightening regulation. In other words, transition finance aids the process of becoming green whilst making room for adequate timelines and considering the viability of transitioning to lower emissions. A key feature of transition finance is penalty mechanisms to incentivise industries to be compliant with targets and KPIs linked to material reduction in emissions, in order to avoid ‘transition washing’. Overall, transition finance and its checks-and-balance mechanism can address some of the key issues discussed above, and reduce poorly thought-out divestments, and asset-fleeing by reframing high-emitting industries as dedicated players in the global movement towards net-zero.

Nonetheless, divestment still serves as a strong form of activism in a bid to improve ESG performance globally. Any forms of divestment should be managed closely, and gradually. Sustainability should be framed as taking responsibility for assets – not fleeing from them, which can result in contradictory results, hurt communities and engender potential greenwashing. Both divestment and transition financing can be considered in tandem, in a controlled way to ensure winding down of high-emitting assets, whilst also providing the support that companies, assets and employees will need. Rather than panicking, investors and companies alike must consider how the long-term effects of short-term attempts to reach net zero may be even more detrimental, despite good intentions. It is through careful consideration, forward-thinking, and nuanced analyses that an orderly transition can ensue.