Consumer and investor power have come to be seen as key drivers of ethical conduct over the past couple of decades. Notable campaigns have included the Shell boycott of 1995 (objecting to the dumping of the Brent Spar platform at sea), “Mitsubishi: Don’t Buy It” in 2000 (objecting to Mitsubishi’s involvement in an industrial salt project in Mexico), Greenpeace’s spoof Kit-Kat advert of 2010 (to put pressure on Nestlé to adopt a zero deforestation policy in its palm oil supply chain), “Don’t buy Sodastream” in 2014 (objecting to Sodastream’s of production facilities in the West Bank), the United Methodist Church investment boycott of five Israeli banks, or the “Fossil Free” campaign (encouraging pension funds and other investors to commit to divesting themselves of assets in the top 200 fossil fuel companies).

One interesting question regarding such campaigns is how much it costs to participate in them. For example, how much does it cost to refuse to put money into “unethical” investments? Those buying pensions or other financial products are obviously free to invest or not invest in whatever products they choose, and if such products advertise themselves as not putting funds into this or that, that can be seen at one level as simply offering a range of options to investors. However, investment funds are also obliged to report their financial performance. Is there not a case that, for the same transparency reasons the implications of other decisions must be reported, funds with a policy of not investing in this or that asset should be obliged to report how much that policy costs investors?

One objection to requiring such reports is that it’s not straightforward to assess how much investors lose. If the boycott is of the stocks of just one company, losses may seem fairly straightforward to assess – that company will be either outperforming or underperforming its market peers, so the question of gains or losses is quite specific. But what if what is boycotted is a whole asset class, like alcohol companies, or the whole supply chain of high salt, sugar and fat products, or fossil fuel companies, or all companies using Russian suppliers?

There have been a number of empirical studies attempting to assess how much broad asset class “ethical investing” really costs. Until recently, the standard form such studies took was to measure the risk-adjusted returns with and without potentially-boycotted shares. The results are ambiguous. Although those studies that find an impact do typically find a loss of 25-200 basis points (i.e. a loss of 0.25 to 2 per cent in annual returns) in normal times, many studies find no significant impact at all.

One problem with these traditional studies was that they accounted for risk using standard models which simply assume that investors are able to completely diversify their risks (any risks they take are a choice, a trade-off for higher returns), whereas a reduced ability to “diversify” is probably the main problem facing an investor attempting to avoid “unethical” investments that run across significant asset classes.

“Diversification” is a familiar concept from homely proverbs such as “don’t put all your eggs in one basket” or “what you gain on the swings, you lose on the roundabouts”. In finance, an investor diversifies by purchasing portfolios (groups of assets) where higher-return scenarios for some of the assets are likely to be correlated with (i.e. occur, fairly often, at the same time as) lower-return scenarios for other assets, so that losses tend to be cancelled out by gains elsewhere and the overall risk of the portfolio is reduced.

An investor excluding certain stocks that would otherwise be important for diversification might

* end up with more risk but with no increase in expected return
* end up with less return but no reduction in risk
* end up with more return but also with more additional risk than would have been necessary to secure that extra return if those excluded stocks had been used instead

Using this insight, a couple of years ago Europe Economics developed a new way to assess the costs of broad asset class “ethical investment”. Our research focused on the costs to investors of fossil fuel divestment, but the basic principles would apply to any asset class. We constructed two sets of stocks: one a broad tracker based on the stocks in the FTSE All Share Index and the other with the biggest listed fossil fuel firms excluded. Within those two sets, we established the set of “efficient portfolios”, i.e. those for which there was no way to enjoy greater returns without facing more risk. The difference would come down to the extent to which some assets were not correlated with one another and it was therefore possible to enjoy higher returns without higher risk by hedging your bets more completely.

That empirical excise produced an unambiguous result. The oil sector does face different risks to the wider economy (its returns are less than perfectly correlated with those on the wider market) and therefore any investor who wants to exclude them will need to accept lower returns, or face more risk. Specifically, we found that investors following the recommendation of the fossil fuel divestment campaign to exclude fossil fuels would, from 2002 to mid-2015, have sacrificed the equivalent of an annual return of 0.68 percentage points (68 bps) or, if they did not want to accept lower returns, would have had to take more than 20 per cent extra risk on their investments.

This principle would apply equally to other investment boycotts. Funds should of course be free to advertise that they refuse to invest in this stock or that. But shouldn’t those considering putting money into such “ethical” funds be given some indication as to what those “ethical” policies cost?