Introduction

Institutional investors are increasingly recognising climate-related financial risks. The traditional energy sector is a significant contributor to climate instability, and despite the growing awareness, many companies in this sector remain resistant to making meaningful changes. Historically, investors have faced two options: exit (divestment) or voice (engagement). However, the report suggests these are not mutually exclusive strategies. A combination of both is necessary to mitigate risk and protect portfolio value.

For many fiduciaries, the engagement vs. divestment debate has evolved into a combined strategy. Engagement is strengthened when divestment remains an option, as it adds credibility and leverage. Divestment, when implemented strategically, can accelerate stewardship goals and address portfolio risks. The report stresses that engagement alone often falls short, especially given fossil fuel companies’ history of rejecting climate-related investor engagement.

Engagement and divestment: Rivals or partners?

While some argue that divestment removes an investor’s influence, the report highlights that divestment is a necessary tool in protecting portfolio value. By keeping divestment on the table, investors retain leverage over companies failing to manage climate risks. Engagement is most effective when combined with the potential of divestment, allowing investors to escalate action if companies fail to respond to softer methods, such as shareholder resolutions or public statements.

Evolving investor practice

Case studies, such as the New York State Common Retirement Fund’s engagement with ExxonMobil, illustrate how engagement and divestment intersect. Initially, the fund sought to change ExxonMobil’s behaviour through engagement, including filing successful shareholder resolutions. However, after repeated failures to shift corporate policy, the fund announced plans to divest from companies in the energy sector that did not meet net-zero transition standards. By 2024, the fund divested from ExxonMobil and similar companies, while increasing investments in climate solutions.

Choosing the right tool

The report suggests that investors need to develop tailored strategies to handle climate risk. There is no one-size-fits-all solution, and each investor should evaluate the most effective tools for their specific needs. Factors to consider include:

• A company’s risk profile: If a company fails to address significant market risks, indefinite engagement might not be in the investor’s best interest. Fossil fuel companies, for instance, have underperformed in recent years.
• Pathways for change: Investors should assess whether credible pathways for change exist within a company. If progress is unlikely, divestment may be the best course of action.
• A company’s willingness to engage: If a company repeatedly resists investor dialogue, investors should question whether the company is positioned to manage long-term shareholder value effectively.
  recommendations

Recommendations

• Engagement must be credible, time-bound, and paired with the option of divestment when needed.
• Investors should develop clear escalation pathways, incorporating divestment as part of broader stewardship efforts.
• A comprehensive, portfolio-wide decarbonisation strategy, like that of the New York fund, should be implemented, combining forceful engagement with divestment for companies unwilling to change.

Quantitative evidence

• Fossil fuel stocks have underperformed the broader market over the past decade, with a significant decline in market weighting within the S&P 500 Index, falling from 30% in 1980 to low single digits by 2024.
• The report references data from initiatives like the Science-Based Targets Initiative (SBTi) and the United Nations’ Net-Zero Asset Owner Alliance, which advocate for clear exit strategies if companies fail to align with net-zero targets.