In today's Exponential Investor...- The self-reinforcing cycle of divestment
- Tether's terror
- Institutional adoption is crucial for crypto flows
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As members of Extinction Rebellion (XR) charge merrily around the streets of London, alienating a few people from their cause while raising awareness of the urgency of climate action, the criticism of their methods extends beyond their blocking busy junctions.
Divestment? So what?
XR members have been long-time proponents of something called "divestment". But… does it work?
Divestment, in this context, is taking your money out of fossil fuel stocks. It means selling funds which hold them, and only buying ones which specifically exclude them. Divestment is one of the main strategies that can support environmental, social and governance (ESG) investing.
The theory is that selling lowers the share price and raises the cost of capital to the business.
There is also the non-financial argument that many people realise they don't really want to be profiting from the fossil fuel business.
It's an argument with lots of valid points on either side.
For example – are fossil fuel companies really to blame? Surely, as with the drug trade, it's
demand you need to tackle: Big Oil companies are just meeting that demand?
That is true, but Big Oil lobbied hard against environmental regulation for decades, and knowingly covered up or obscured climate science so they could keep selling their dangerous products.
Okay, but does it really have any effect? For each seller there is always a buyer. And wouldn't you rather an environmentally conscious person owned the shares and engaged the company to improve, than someone who doesn't care and won't push for change?
There's merit to that argument too.
But I think that divestment really does have profound effects.
Firstly, if it's widespread enough it can genuinely make it more difficult for oil companies to obtain funding that they need.
I heard stories that an oil company looking to raise exploration capital found that only one investor was interested... out of four
hundred.
Divestment also leads to something called "social proof". If X isn't investing, then maybe Y shouldn't either. And inversely, if X and now Y aren't investing in oil companies that aren't looking to change, then other oil companies themselves may voluntarily change to meet the new standards of the financial industry.
Social proof encourages change without regulation. Fossil fuel companies are losing their social licence to operate and now consequently losing their financial licence too. That's a real risk.
If divestment is widespread enough, it doesn't just raise the cost of capital, it might block access to any capital at all.
Shale oil in the United States has finally lost the trust of the bankers, who so willingly threw money down their various wells. You might think that the oil price rebound since Covid-19 hit might have encouraged at least some shale drillers to chase the bankers once more. But they have not done so. The onshore rig count in the United States is way below pre-Covid pandemic levels: fewer than half as many drills are active now than were in late 2018.
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Flows not pros
There is another element to this debate though.
"For every seller there is a buyer" is one of those things that sounds as though it must be true.
If it is, it would render divestment pointless – it would have no effect. You are always selling to someone, so the only thing that changes is that people who care about the climate sell to people who care about dividends
more than the climate.
However, take a look at stock buybacks which are pretty much the main source of most investment returns in recent years. A stock buyback involves a price-insensitive buyer with (often) huge amounts of capital. That has sent share prices steadily higher, as companies have bought their own stock on each price dip.
Divestment works in the same way, except it's the sellers who are price insensitive. And the same dynamic works in reverse.
If people start asking for divestment and pulling their money out and directing it in ever greater numbers towards low-carbon funds, this has a series of knock-on effects.
Money is automatically pulled out of oil and gas stocks.
All the growth for fund providers is in low-carbon, sustainable, ESG products, so they start launching those and raising money for them.
And just like how passive investment has boosted the FAANG (big US tech) stocks by funnelling larger and larger sums in their direction through size-weighted index allocation
This accelerating flow of capital out of oil and gas stocks creates a self-reinforcing cycle. As they fall in price, they get ever lower allocations from passive and index funds. Every buyer does not have a seller.
If the amount of capital willing to own fossil fuel shares
at any price falls from $100 billion to $70 billion or $50 billion... that becomes a limiting factor on the market capitalisations of the companies involved.
If there are now so many funds which, by their mandate, are not allowed to allocate towards oil and gas, then the hoped for rebound in stock prices that oil bulls are looking for might never materialise.
That is because there will not be a reallocation towards them in an upcycle. The fund management industry has decreed that a large portion of its funds will not buy oil stocks.
Therefore, in so many ways, divestment has created a number of self-reinforcing cycles which nudge change.
The loss of a large number of buyers leads to various significant knock-on effects, including lack of access to capital and most importantly, social proof which encourages change.
The unwanted crypto divestment
All this reminds me of Tether, the stablecoin which seems to have been lying about being backed by the dollar.
The concern is that the founders of Tether have managed to convince people that each Tether issued is equivalent to a dollar. But as long as people believe that, they can issue a bunch to themselves and use it to buy things even though it's essentially worthless.
If serious fraud is discovered at Tether, there is still an argument about what that means for the bitcoin price.
Some believe that Tether has indeed been fraudulently issuing stablecoins and using them to buy bitcoin, and that this has been a huge factor in bitcoin's price increase.
They point to Tether's market cap rising up $60 billion, and the free float of bitcoin which is anything from $50 billion to $200 billion. If Tether turned out to be a fraud and all the stablecoin "dollars" which were used to buy bitcoin were suddenly worthless, the effect on prices would be immediate and severe.
I am nervous about this Tether thing.
But on the other hand, we are seeing so much news, over the past year especially, of flows being brought to bear on crypto in a positive light.
PayPal recently made it available to trade for UK account holders, and big institutions are getting into crypto too. The institutions are allocating funds towards it or are launching crypto-focused exchange-traded funds (ETFs) and brokerage services.
As crypto goes mainstream at financial institutions, flows are likely to become a much bigger factor in their success. This is especially true for bitcoin where so much of it is held long term by miners or HODLers.
In short, only a fraction of the total coins is traded day to day.
While this means that Tether poses a greater risk, as its share of daily liquidity is larger and if all coins were traded, it works both ways, and the majority of the news around crypto flows is massively positive.
All the best,
Kit Winder
Co-editor,
Exponential Investor
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