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Divest? Think Twice

By Jonathan Z. Zhou

Last week, Harvard students passed a referendum on the Undergraduate Council election ballot that calls on Harvard to divest its endowment from the fossil fuel industry by an overwhelming margin.

For the resounding success of Referendum 1, we should applaud Harvard students for taking a stance on what is arguably the most important issue of this century. However, divestment from fossil fuel represents an admirable but regrettably bad “bang for the buck” approach to the climate change challenge.

The main practical argument for divestment is that if Harvard divests from fossil fuels, other colleges and investors will follow suit. The collective boycott of fossil fuel stocks will cause a drop in stock price. This possibility forces fossil fuel companies’ CEOs to consider more climate conscious decisions when raising capital for future projects, which will create private sector solutions to a public externality problem.

Although some of Harvard’s educational peers have committed to or are considering divesting, it is completely unclear whether Harvard’s financial peers will make the same move.

More likely than not, Harvard’s financial peers, which include for-profit mutual funds and hedge funds, will not make the same commitment to divest. When Harvard sells its fossil fuel stocks, the fossil fuel companies’ cash flow does not change. Other investors, most of whom do not share Harvard’s environmental values, will notice the drop in stock price without a change in fundamentals and will buy the cheap fossil fuel stocks until they reach the “fair” pre-divestment level.

Contrary to popular belief, Harvard’s unilateral divestment most likely would not decrease the long-term expected return of its endowment. If we rely on historical lessons, a hypothetical divested portfolio may even yield higher returns due to greater emphasis on smaller companies. However, after divestment, Harvard’s portfolio will necessarily be less diversified than before, which exposes Harvard to new financial risks. Whether making a statement with no impact on the fossil fuel industry is worth accruing such risk to the endowment is a normative question, and one we must answer as a community.

In the unlikely event that Harvard’s initiative finds support in other investors, this will create a new paradigm in pricing fossil fuel stocks. Investors shunning industries for their malicious practices is not a new phenomenon: A wide range of industries such as tobacco, gaming, and alcohol have long been considered “sin industries.” There is empirical data showing that sin industry stocks, which face various institutional, social norm, and legal constraints, have lower prices. In this case, Harvard can claim success in causing noticeable financial stress on fossil fuel companies.

However, the same empirical study also finds that, since the stock prices of sin industries are lower, they are better deals than similar companies in other industries. The authors of the study found that the sin stocks generate an additional 2.5 percent return per year. Assuming that Harvard succeeds in labeling fossil fuel companies as “sin stocks,” Harvard’s divestment will miss out on this sizeable extra return. Even if we suppose that Harvard only invests a meager one percent of its endowment in fossil fuels, a back-of-envelope estimate will show that divestment will cost Harvard about $7.5 million in potential return every year. I believe Harvard could put that $7.5 million to better use advancing environmental causes.

For one, Harvard can contribute to the environmental movement by directing the $7.5 million in endowment return to environmental policy research. The Harvard Environmental Economics Program at the Kennedy School of Government, for example, enlists Professor Eric S. Maskin and Professor Martin L. Weitzman, both of whom won accolades for applying the economic theory of uncertainty to the cost-benefit analyses of environmental policy and climate change.

Admittedly, environmental economics is an extremely complex problem with more unknowns than cost-benefit analyses may be suitable for, but it is precisely such difficult problems that Harvard, as a premier research institution, is positioned to address. Increasing funding in programs like HEEP will not only expand our knowledge in these areas, but it will also inform our future political and civic leaders on these critical issues. While campus environmental activism may galvanize student awareness and affirm Harvard’s commitment to the environment in the short term, an economic, cost-benefit analytical approach will prepare the campus and the nation for a sensible discourse on environmental policy that will create long-term solutions. It is from this perspective, rather than from a normative stance on the moral cause of environmentalism, that I urge my fellow students to reconsider the costs and benefits of the divestment movement.

Jonathan Z. Zhou ’14 is an applied mathematics concentrator in Eliot House.

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