Divestment won’t work, but debt denial might

Written by Rebecca O'Connor on 1st Dec 2015

Some financial economists are getting a little frustrated. They can see the divestment movement gathering more and more momentum among environmental campaigners, and the chorus asking institutions to divest growing louder.

The argument of divestment is that if investors, institutional and private, who disagree with the business models of fossil fuel companies, sell their shares, then these companies will be forced to reconsider what they do. It is a seductive theory to environmentalists seeking a way to speak the language of a financial industry that funds some of the most world-destroying activities.

The campaign has gained huge momentum and has claimed various successes.

But some academics claim it is seriously flawed and at risk of undermining what are noble aims.

They don’t argue that using money and the threat of removal of finance is the wrong approach – rather, it is the type of finance being withdrawn that is wrong.

Here is where it gets a bit technical. Instead of selling shares in fossil fuel companies, campaigners and the trusts, funds and individuals that sympathise with them need to instead refuse to renew high-yield corporate bonds to the fossil fuel industry. Or, in layman’s terms, debt denial.

According to Andreas Hoepner, a senior academic fellow at the UN Principles of Responsible Investment (UNPRI) and Associate Professor of Finance at the ICMA Centre at Henley Business School, debt denial would involve the non-renewal of high-yield corporate bonds to fossil fuel industries.

“The problem with the divestment campaign, however well-meaning, is that it has not fully understood the way oil companies are financed. While it sounds on the face of it to be an effective strategy, selling shares, apart from in making a statement, is actually pretty ineffective. What you want to do, as an investor, is refuse to renew a high yield corporate bond at the end of the term, in effect starving the company of cash flow immediately. But this message is perhaps not quite as easy to translate to the masses, or for campaigners to understand.”

High-yield corporate bonds are essentially loans to companies that are considered by rating agencies to be high risk.

Fossil fuel companies, like any other large corporations, tend to be fairly reliant upon the corporate bond market for cash.

This is how it works:

  • The company issues a bond. The yield offered to investors who buy this bond (like an interest rate on savings) will be determined by the level of risk and the term of the bond. They can be for a range of durations from 1 year, with the longest terms and the highest risk usually attracting the highest yields (as there is more risk over a long term that investors will not get their money back.)
  • Investors buy the bonds. These are usually institutions looking for greater certainty of return for their portfolios. Although there is a risk that the company will not be able to repay the loan with interest, the return is more visible than returns on equity shares in a company, which can go up and down dramatically.
  • The company pays the yield, usually annually, half-yearly or quarterly, and then pays the investors back their capital at the end of the term.

Corporate bonds involve significant sums of money and large global organisations can issue a bond worth millions, if not billions.

High yield corporate bonds are those rated BBB or below by credit ratings agencies – in other words, they are considered high risk. Or put another way, sub-prime.

It is usual practice to continue to recycle debt – repaying old debt with new debt – over time. It is assumed that investors will always be willing to renew bonds, or if they aren’t, that it will be easy enough to find another buyer for a new bond.

In this way, large companies, just like homeowners with mortgages to renew every couple of years, are debt-dependent, both for cash flow, and for their ability to repay current debt.

Imagine, then, if an institutional investor, instead of renewing a high yield bond to an oil company, chose instead to call it in (demand full repayment at the end of the term). This would create a headache for the company, which would have to find another buyer for the debt it was unexpectedly saddled with. Then imagine if a range of institutions chose not to renew their loans to oil and gas companies.

What would happen to cash flow? It would be severely compromised, and would have to be dealt with by the company in a number of ways, but the first option would usually be cost-cutting: Cancelling planned explorations in the case of oil companies, or shedding jobs. If fresh finance could not be found, the last course of action a company would choose would be to cut the dividend.

The dividend is a payment to shareholders – a kind of bonus, thank you payment for continuing to hold on to the shares. Cutting the dividend is a ginormous deal for any company, but for oil companies, it is the biggest possible deal, as it is primarily the dividend that has kept legions of investors – with billions of pounds worth of shares – loyal.

In this way, debt denial could also lead to divestment of shareholders who, in the face of dividend cuts, decide to abandon ship. A double whammy, if you like.

“It’s a much more immediately effective strategy as these loans come up for renewal all the time,” says Hoepner. All the bondholder has to do is refuse to renew it – there are other corporate bonds with similar yields they can choose instead. It is less of a deal for the bondholder, but a problem for the oil company, which is probably already suffering from a lack of cash because of low oil prices and high exploration costs.

Incidentally, debt denial was one of the ways that global financial markets brought down apartheid in South Africa. Other governments stopped renewing their loans to the South African Government in protest. And it was this approach – starving the nation of the cash  it needed to survive rather than lobbying – that some credit as the reason for regime change.

Given the urgency over the matter of keeping the world’s temperature rises as low as possible, it’s a position some would like to see oil companies, which have so far remained relatively unmoved by the divestment campaign, facing too.

Could debt denial be the answer?