The Agency Costs of Sustainable Capitalism

At the World Economic Forum in Davos in January 2020, Larry Fink – the chief executive of the world’s largest asset manager, BlackRock – wore a climate change-themed scarf. It featured the “warming stripes” visual, where the color of the stripes represented the annual average temperatures of planet earth from 1850 to 2019. The scarf served to emphasize Fink’s – and BlackRock’s – professed commitment to putting sustainability at the center of the firm’s investment approach. Yet, in a new paper, I argue that, when it comes to climate change, there are significant gaps between the interests of BlackRock and the other Big Three asset managers – Vanguard and State Street – and the diversified index investors they represent.

In the absence of regulation to break up the Big Three, their future dominance is largely assured – as is the persistence of climate change as an urgent global problem. With great power, however, comes great responsibility. Calls for asset managers to exercise greater social and environmental responsibility have led the Big Three to increasingly assume what I call the role of “sustainable capitalists.” Namely, because governments have failed to take swift and effective action in the global effort to combat issues such as climate change, there has been increased pressure not only on companies but also on institutional investors to provide market‑driven solutions.

Gilson and Gordon (2013) developed an “agency capitalism” framework where they considered the problems that arose from the divergence of interests between institutional investors and ultimate beneficial owners. In my new working paper, I develop a “sustainable capitalism” framework for analyzing the gaps between the interests of the Big Three and the diversified index investors they represent. The passive investors whose money the Big Three manage typically invest in fully diversified index portfolios, or they have explicitly chosen to prioritize social and environmental values by investing in bespoke environmental, social, and governance (“ESG”) funds.

Gilson and Gordon described institutional investors in the agency capitalism framework as “rationally reticent,” as they would only respond to the proposals of other investors rather than pursue an activist role themselves. I argue that a dual-monitoring shortfall arises in the sustainable capitalism framework. Rational reticence likely still persists. While there is perhaps some scope for the Big Three to initiate portfolio‑wide sustainability improvements, they don’t have an incentive to pursue firm‑specific sustainability activism at portfolio companies.

Examining the wide gulf between the Big Three’s rhetoric on sustainability and their actions also exposes a second problem in the sustainable capitalism framework. This is the risk of the Big Three exhibiting what I call “rational hypocrisy.” Similar to the phenomenon of corporate greenwashing, the Big Three may have strong incentives to claim that they uphold a higher commitment to sustainability than is actually the case in practice.

The dual problems of “rational reticence” and “rational hypocrisy” on the part of the Big Three give rise to what I call “the agency costs of sustainable capitalism.” There is a divergence between the Big Three’s actions in the climate context and the rational preferences of diversified index investors who are generally thought of as a proxy for society as a whole.

In Gilson and Gordon’s agency capitalism framework, the proposed solution was for specialist activist hedge funds to fill the monitoring shortfall by initiating firm-specific activist campaigns at target companies. Hedge fund activists would present their proposals to institutional investors who would then decide whether to lend their support to campaigns. In the agency capitalism framework, the combination of activist shareholders (as initiators) and institutional investors (as arbiters) arguably proved to be a successful means of mitigating the agency costs of agency capitalism.

In the sustainable capitalism framework, two different categories of activists are potential candidates for an analogous intermediary role. First, a vocal minority of activist hedge funds already specialize in ESG activism. These ESG hedge funds focus on highly tailored firm-specific activism at target companies. Second, other responsible activists – such as non‑governmental organizations, pension funds, and religious organizations – concentrate more on portfolio‑wide sustainability initiatives, often submitting relatively standardized shareholder proposals to a large number of companies.

ESG hedge funds may play a role in the sustainable capitalism framework by emulating the successful techniques of their predecessor activist hedge funds. These can include appointing specialist directors to company boards who have renewable energy or climate transition expertise and presenting companies with detailed alternative business plans aimed at promoting corporate success in a low‑carbon economy. An ambitious campaign of this nature was launched at ExxonMobil in December 2020 by a new ESG hedge fund, Engine No. 1. The activist has nominated four independent director candidates to the board of the world’s largest listed oil company, which has reportedly also led ExxonMobil to consider appointing another former activist hedge fund manager, Jeffrey Ubben, to its board.

Despite their potential to mitigate the problem of rational reticence, there is a real risk that ESG hedge funds may exacerbate the problem of rational hypocrisy. ESG hedge funds will ultimately only intervene when they can pursue strategies that generate significant profits as well as being environmentally or socially beneficial. If those dual motives do not align, intervention by the hedge fund would not be rational.

Other responsible activists ordinarily have incentives different from those of activist hedge funds, as their primary focus will usually be on mitigating climate risk. However, such organizations may lack the reputation, clout, expertise, and funding that the most formidable hedge funds have amassed in order to effectively challenge some of the world’s most economically significant corporations. Moreover, some of the strategies these organizations pursue may, in some instances, conflict with the preferred strategies of the Big Three. For example, the Big Three have historically prioritized engagement with target companies, rather than voting against corporate management in support of environmental shareholder proposals.

In summary, because of the dual problem, neither group of activists may be well positioned to eliminate the agency costs of sustainable capitalism entirely. ESG hedge funds may successfully mitigate firm-specific rational reticence but could exacerbate rational hypocrisy. Responsible activists may mitigate portfolio-wide rational reticence but generally lack the financing to take on companies to the same extent that wealthy and formidable activist hedge funds do.

Finally, I contend that mitigating the problem of rational hypocrisy may require a different approach. Appealing to, and appeasing, the Big Three as the pivotal arbiters of activist campaigns is unlikely to address the problem of rational hypocrisy. Instead, inspiration may be found in the former U.S. Supreme Court Justice Louis Brandeis’ famous maxim that “sunlight is said to be the best of disinfectants.” Ultimately, a key role that responsible activists can play is to target the Big Three themselves by exposing discrepancies between their words and actions in order to hold them accountable and ensure that hypocrisy does not remain rational in future. Only then may the agency costs of sustainable capitalism be fully mitigated.

This post comes to us from Anna Christie, assistant professor of banking, corporate, and financial law at the University of Edinburgh. It is based on her recent paper, “The Agency Costs of Sustainable Capitalism” available here.