Mechanisms to Incentivise Fossil Fuel Divestment and Implications on Portfolio Risk and Returns

Mechanisms to develop divestment strategies are an essential component of carbon reduction strategies. The rate at which investors should divest has become a critical aspect of effective divestment, which has shifted from the periphery to a movement of over a thousand major investors, totaling more than $40.43 trillion in committed funds. We use a comprehensive approach and various asset allocation methodologies to address and assess this impact overtime on S&P 500 portfolios and global ETFs. For the S&P 500 portfolios, instantaneous divestment provides an advantage in terms of management structure, and when including ESG reporting considerations, faster divestment rates are preferable however these are shown to come at the expense of higher portfolio tracking errors. Rapid divestment by shorting may induce higher management fees, and also higher tracking error than slow divestment. Furthermore, we find slower divestment provides a greater stability in the portfolio with regard to the tracking error.Once a portfolio is fully divested from fossil fuels, divestment from secondary sectors utilising fossil fuels or those producing significant carbon outputs can further reduce a portfolios carbon footprint. For example, divesting from both energy and utility sectors offers a reduced carbon footprint of up to 7%, while ETFs' divesting offers substantially greater portfolio carbon footprint reductions. However, this comes at a cost since we find that investing in low carbon footprint funds results in lower dividend returns and attracts lower management fees. A study on ETFs with varying concentrations on carbon-intensive assets reveals that even though the return profile of the ETFs is insensitive to divestment strategies, their risk profile is proportionally (to their carbon intensity) affected by divestment strategies. Our study underscores the importance of considering the investors' demographics, such as retirees seeking dividend cash flows, management structure and carbon reduction targets on divestment strategies for ESG targets