Engagement on ESG produces real results

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This article highlights a recent study – called ‘The Real Effects of Environmental Activist Investing’ – that found that the NYC Comptroller’s “Boardroom Accountability Project” impacted how the targeted companies reduced their total toxic chemical releases, production-related air emissions, and greenhouse gas emissions. They found that the results were not driven by shifting pollution offsite, but by on-site reduction.

Here’s an excerpt with talking points from one of the authors, Lakshmi Naaraayanan, assistant professor at London Business School:

“This research provides empirical evidence on the positive effects of shareholder campaigns and how they contribute to responsible business practices,” Naaraayanan said in a statement about the research. “Importantly,” he added, “our results demonstrate that co-ordinated action by large institutional shareholders, adopting a firm-specific mandate on sustainability, can bring about positive change by influencing board level decisions so companies mitigate their environmental impact.”

He continued: “To be successful, campaigns require investors to monitor each target firm’s environmental behaviour and combine this with the threat of discipline.”

This blog by TheCorporateCounsel.net’s Liz Dunshee seems to back up that it’s better to engage than divest:

We’ve blogged several times about investor divestment initiatives – and pressure on big asset managers to eliminate fossil fuel companies from their portfolios. That’s a pretty blunt tool to use to effect social change – and recent research says it might not be as effective as engagement. Here’s an excerpt:

This paper is an attempt to analyze the welfare implications of two traditional strategies aimed at shaping corporate outcomes: exit and voice. To make the problem tractable we have made a number of simplifying assumptions: identical firms with zero marginal cost up to a capacity constraint, a linear demand curve, constant absolute risk aversion, normal distribution, etc. We have also studied the three principal socially responsible strategies, divestment, boycotting and engagement, separately, without considering how they might interact with each other.

Subject to these limitations, we find that in a competitive world exit is less effective than voice in pushing firms to act in a socially responsible manner. Our conclusion is consistent with Kruger et al.’s (2020) survey of institutional investors, which finds that such investors consider engagement, rather than divestment, to be the better approach for addressing an externality such as climate risk. Furthermore, we show that individual incentives to join an exit strategy are not necessarily aligned with the social incentive, while they are when investors are allowed to express their voice.

We have derived these results under the best possible scenario for the exit strategies: investors and consumers who can announce their strategies to the world and commit to them. If we relax these assumptions, exit becomes even less effective.

The authors go on to note that company-by-company engagement is also a better alternative than regulatory efforts – because it’s more flexible, cost-effective and “less prone to capture than political voice.” The authors note, however, that the US proxy system tends to limit shareholders’ ability to influence corporate policy and makes engagement less effective – and of course, engagement isn’t very effective at controlled and privately held companies.

The author of that “Exit vs. Voice” study, Oliver Hart, talks about his writing in a video embedded in this CorpGov.net blog by Jim McRitchie. Here is an excerpt from Jim’s blog:

Below are a few of their points (and a few of my takeaways concerning exit vs voice):

  • When making decisions, an individual puts weight on the welfare of those affected by the decision to the degree they value social responsibility.
  • If the cost of avoiding pollution is bigger than the cost of pollution itself, planners will want all firms to use dirty technology. If the cost of avoiding pollution is less than the cost of polluting, planners will want all firms to become clean.
  • Clean firms are less profitable but as expensive to operate, so divestment won’t be economic for most investors. (Isn’t this often be a fallacy since the cost of renewable energy is already less than fossil fuels in many cases. Why did renewables become so cheap so fast? And what can we do to use this global opportunity for green growth?)
  • Re voting. If investors are diversified, capital losses at any one firm to become clean are shared equally. Each individual’s capital loss will converge on something approaching zero. The impact of a proxy vote on each investor’s personal utility (wealth) is negligible.
  • As long as the majority of investors are somewhat socially responsible, voting will deliver the social optimum. If the majority of investors are purely selfish, however, and a vote requires majority support to be effective, engagement by socially responsible shareholders will have no impact. (Again, it is often less expensive over the long-term to use clean energy. Conversion costs are short-term, so at least in those instances being selfish in the long run may lead to positive results.)
  • “Putting proposals up for a proxy vote is expensive. It will not be in the interest of atomistic investors to incur the cost of doing so, and management is unlikely to take the lead.” However, a Green Fund can sell its ability to put ESG proposals on ballots as a feature and pay the cost out of the management fee. “The presence of intermediaries greatly relaxes the informational burden that the voice option imposes on investors.” (This could also be a role taken on by @PatrioticMills, foundations, and family offices #CREOSyndicatemore concerned with preservation than enrichment.
  • Less diversified investors may vote dirty when this is socially inefficient due to the drop in profitability of the clean firm. (My guess is that most investors don’t see voting as a cost, other than the time and effort to decide and execute votes.)
  • In the value-maximizing approach to corporate governance, large shareholders are often thought to reduce agency costs, since ownership and control are closely linked. In contrast, in the socially responsible approach to corporate governance, selfish large shareholders reduce the level of provision of public goods by firms, because they are more adversely impacted.  To that extent, large ownership is undesirable. (Of course, many socially responsible measures also increase profitability.)
  • The authors explain how takeovers can undermine social action to turn companies clean. Even socially responsible investors are incentivized to accept a tender offer when a company moving back to dirty will be more profitable. (Again, this assumes dirty is less expensive to operate than clean. Hopefully, the future will see more efforts like Engine No. 1 at Exxon focused on the long-term.)
  • If workers are shielded from the costs of reducing pollution, they will rationally vote as a benevolent planner would. However, if they have to absorb part or all of the cost of abating pollution, will not, since they are not well diversified. (However, workers may have overexposure to pollution due to proximity, so might support reducing pollution even if it reduces wages.)