This article examines the tobacco industry’s investment returns, external societal costs and how investors are engaging with or divesting from the industry.
The tobacco industry has been a very profitable investment, but some investors may be concerned with how the externalized costs of tobacco use may be undermining economic growth and investors’ wider portfolios, particularly in emerging markets. Due to these negative impacts, and the potential for governments to strengthen regulations in line with the World Health Organisation (WHO) Convention on Tobacco Control, some investors may decide to engage with the industry and governments, even if they also choose to divest.
Research from Oxford University (Smith School, Oct 2013) on divestment campaigns has found that ‘success’ requires cooperation with ‘neutral’ investors and policy-makers. Divestment alone is unlikely to change the tobacco industryand the prevalence of smoking. Those investors who have divested their tobacco holdings could look to governments to enact stronger anti-tobacco regulations along with other tobacco investors who may have concerns about the industry’s negative externalities, but who remain invested in tobacco stocks.
Since September 1989, the S&P500 Tobacco Index rose 1,510% compared to the S&P500 which rose 509%. However, six million people die each year of smoking related illnesses. Health costs and lost productivity due to premature death and disability make smoking one of the greatest economic burdens on society, rivalling armed violence: 3.0% of global GDP or USD 2.1 tn according to McKinsey Global Institute, WHO and literature review studies.
This does not include other costs such as the economic opportunity cost of cigarettes. For instance, WHO (2004a) cites evidence from several countries where the addictive nature of tobacco causes poor people in developing countries to spend 2-10x more on cigarettes than on food or education. As well, smokers’ often have lower day to day productivity; there are significant environmental and social impacts of tobacco crop production including the prevalence of child labor; cigarette-caused fire/smoke damage, injury and death, which leads to higher insurance costs. Cigarette litter also damages the environment (i.e. the chemicals and heavy metals in cigarette filters—BMJ May 2011) as well as being a costly and unsightly waste for cities to collect.
Using available evidence, we estimate that the industry creates at least 5 times more societal costs than benefits (as measured by investment returns, taxes paid, staff salaries, donations and the U.S. Food and Drug Administration’s estimate of potential ‘lost utility’ from anti-tobacco regulations). However, this does not include the controversial ‘benefit’ that premature death caused by smoking reduces pension liabilities. We were unable to find any data on this ‘benefit’.
While some listed tobacco companies may be trying to expand the sale of ‘harm reduction’ products and improving tobacco crop production practices in parts of their supply chain, only 20% of major listed companies audit their suppliers’ practices and often exclude farm level assessments (MSCI 2015).
Just as investors have become more concerned with climate change risks, investors with a global and long-term investment horizon may be concerned with how the tobacco industry’s cost externalisation affects economic growth and by extension, the financial performance of other assets.
There appears to be a strong parallel between the UN Paris Climate Agreement and the WHO Tobacco Convention: their ultimate goals are supported by the vast majority of countries and both call for a near complete elimination of carbon emissions and tobacco use. In both areas, the question is the rate of change and if companies and investors are adequately assessing risks. As companies and investors develop climate risk stress-testing methodologies, there may be lessons that can be learned from and by the tobacco industry and its investors and analysts. While some tobacco sell-side analysts in the past have stress-tested the impact of particular national tobacco regulations, it may be useful for equity analysts and investors to stress-test the impact of stronger regulations in line with the WHO Tobacco Convention and the 2013 world health ministers’ goal to reduce tobacco use to 30% by 2025 (WHO 2013).
Improved disclosure and stress-testing may be necessary as Allianz Global Investors concluded that the market appears to be discounting the impact of new anti-smoking regulations. Tobacco companies’ consensus sales growth, earnings and operating margin all show steady growth over the next several years. The industry has remained profitable in the face of declining smoking rates by increasing prices, expanding This information is intended for informational purposes only and does not constitute investment advice, a recommendation, an offer or solicitation. Past performance may not be indicative of future results. 4 cigarette sales in emerging markets and with industry consolidation. However, AGI concludes that despite tobacco’s addictive nature (inelasticity of demand) the ability to raise prices may reach limits creating profit and growth challenges. “With young populations around the world increasingly uninterested in tobacco, this may be sooner than expected” (AGI Aug 2016).
Improved, more comparable and more widespread tobacco regulation scenario stress-testing would match the recommendations of the Financial Stability Board (FSB) Task Force on Climate-related Financial Disclosure, which is recommending companies and investors improve their carbon risk management and transparency, including with climate related stress-tests.
While global smoking prevalence fell from 23% to 21% between 2007 and 2013, according to WHO (2015) only ~10% of the world’s population is covered by a tobacco tax that is judged by the WHO to be sufficiently high (more than 75% of cigarettes’ retail price). The proportion of tax in cigarette prices is also much lower in emerging markets, where 80% of the world’s 1.1 bn smokers live. Without stronger polices, an additional 700 million people could be smokers by 2030. This is based on WHO estimates, which assumes prevalence rates remaining relatively unchanged and current projected population growth rates.
The world’s health ministers have agreed a target to reduce tobacco use 30% by 2025. From 2008-14, more than 53m people in 88 countries stopped smoking due to tobacco control regulations, including in countries with high smoking rates, indicating that regulations are expanding (Levy et al Dec 2016). Cigarette sales appear to be declining, even in China, the world’s largest market (AGI Aug 2016). Reducing the rate of smoking will also help meet the UN Sustainable Development Goals.
An increasing number of investors are divesting their tobacco stocks and/or bonds, though this is still small compared to the industry’s market capitalisation. Notably, CalPERS decided to expand its tobacco divestment policy to its external managers despite their financial advisors recommending tobacco re-investment.
The UK Law Commission concluded that investors may divest from companies if underlying beneficiaries share the concern and if a reasonable test of potential financial detriment is used. Trustees may also account for an industry’s wider negative economic impacts (such as those described in this article) in their decision.
One French pension fund which recently announced their tobacco divestment decision stated “Progress will not be achieved by dialogue with these companies, because the whole purpose of engagement would be to demand that they should stop their activities altogether” (FRR Dec 2016).
While a similar argument is being made by some commentators regarding fossil fuel companies today, investor engagement is helping lead European oil and gas companies to increase investment in low-carbon technologies and to climate stress-test their portfolios (CDP 2016). As well, one major U.S. oil and gas company appointed a climate scientist to their board after investor pressure. In May 2017, investors voted in favor of climate risk stress-testing at two major US oil and gas companies. Divestment and engagement strategies both have complementary roles to play in helping to reduce climate risks, the negative impacts of tobacco use and other sustainability challenges.
The high negative externalities of the industry suggest that investors who are not able to or willing to currently divest, could attempt a multi-year engagement initiative, encouraging listed companies to improve performance on Environmental, Social and Governance (ESG) issues, aiming to reduce the negative impacts of tobacco use as far as possible.
Caution is however necessary given the industry’s history, such as the 2006 U.S. court finding that the industry engaged in a 50-year violation of the U.S. racketeering act. WHO has also warned that the tobacco industry just uses engagement to improve their image.
Electronic cigarettes and other ‘harm reducing products’ could be creating a different future for the industry. One industry chief executive declared a desire to phase out conventional cigarettes. Whether this is genuine remains to be seen but investors could call for firm business timelines and targets towards such a goal. ‘Harm reducing’ products could be monitored and further developed to reduce remaining negative impacts, particularly concerns that they could introduce children to other tobacco products and thus to life-time addiction.
Just as investors played a key role in encouraging the finalization of the Paris Climate Agreement, investors are starting to become more active in encouraging governments to implement the WHO Convention on Tobacco Control. On “World No Tobacco Day” (31 May 2017) 53 investors with USD 3.8 trn in assets called on governments to support stronger regulation on tobacco control (PRI May 2017). This could accelerate regulations that reduce tobacco’s negative impacts.
A new agenda for investors regarding tobacco could include: creating and using tobacco regulation stress-testing methodologies, stronger disclosure requirements (regarding marketing practices; ‘harm-reducing’ product business strategy, R&D levels and product volumes; fines, legal costs and lobbying policies/practices), expanding and improving tobacco crop production sustainability standards, supporting the use of such standards as a condition for bank loans to the sector, supporting the creation of an Economics of Tobacco report modelled on the climate change Stern Review and considering how investors could support governments in enacting new and strengthening existing tobacco laws.