Will Systematic Stewardship Save the Planet?

The convergence of environmental urgency and the rising power of “universal owners” – asset managers with broad-based portfolios, such as BlackRock – has kindled the hope among academics and activists that universal owners will leverage their power to push companies in their portfolio to reduce carbon emissions. Emissions are an especially promising target of systematic stewardship. Global warming undoubtedly poses a systematic risk, and greenhouse gas (GHG) emissions can be measured and quantified.

In a new paper, we argue that, regrettably, the stewardship of universal owners will be ineffective in reducing emissions due to their lack of incentives and competence. Universal owners are incapable of driving the firm-specific decarbonization strategies required for effective emissions reduction. And their incentives may lead them to push transition strategies that are not optimal for the planet. We show that no other champion will emerge to fill this gap, and legal reforms, such as climate-risk disclosure, will not solve the issue.

Consider universal owners’ incentives. Demand for ESG investments is one of the driving forces of universal owners’ pressure on companies to reduce emissions. Fund managers attract investors into ESG funds by promising to advance ESG goals, while also insisting that the funds’ commitment to ESG goals will not come at the expense of investor returns. “Doing well while doing good,” is the mantra. Thus, to attract investors, ESG funds must produce returns on par with competing ESG funds and the benchmark, non-ESG index.

These commitments, we argue, undermine the universal owners’ incentives in exercising their two main levers to control their portfolio companies: exit (divest) and voice (vote and engage). On the exit front, fund managers that divest from environmentally unfriendly or ‘brown’ companies, for example, lose the benefit of the returns these companies produce. For instance, in 2022 the oil and gas industry outperformed all other sectors of the S&P index, posting a 57 percent increase, while the overall index declined by 19 percent. And, on the voice front, these commitments might lead universal owners to support management in pursuing decarbonization strategies that are unlikely to benefit investors or the planet.

This distortion of incentives becomes evident in the crucial challenge facing major polluters: determining the optimal corporate structure for transitioning to net-zero emissions. Oil majors and other heavy polluters must decide whether to adopt a “pure play” strategy, where the polluting activity and the clean activity are separately owned and managed, or an “integrated play,” where the revenues from the polluting activity are essentially financing the investment in clean energy. Leaving management to decide on firms’ decarbonization strategies creates a fertile ground for management agency costs and greenwashing. Specifically, self-interest is likely to lead management to adopt integrated play strategies under which the company produces some green alternative, regardless of whether it is optimal strategy for the firm or the planet.

Profit-driven activists might be expected to prevent managers from adopting inefficient (and self-serving) strategies in response to investors’ demand to reduce emissions. For example, activists who recognize that an integrated play is an inefficient way for an oil producer to cut emissions could lead a campaign to force it to divest its investment in clean energy. Indeed, leading hedge fund activists have launched campaigns calling on oil companies to adopt pure-play strategies. Activist hedge funds, however, rely on the support of universal owners and other asset managers. We argue that asset managers might support managers’ refusal to divest “dirty” assets because a corporate structure that combines clean and dirty activities allows asset managers to enjoy the returns of the fossil fuel business while treating it as a clean investment. A pure play strategy would require managers of ESG funds to sell the “dirty” business. In contrast, an integrated play strategy allows asset managers to enjoy the returns of the fossil fuel business while treating it as a clean investment they can continue to hold in their funds.

Thus, managers’ agency costs and universal owners’ distorted incentives might push polluters to increase investment in renewable energies even when both the planet and investors would benefit from pure play strategies. Moreover, the pressure to offer green alternatives might push public companies toward known alternatives such as wind and solar energy and carbon capture and storage, while emerging technologies such as geothermal drilling that might be more directly related to the expertise of the legacy corporation are not explored.

Similarly, problems abound due to universal owners’ lack of competence. The systematic risk of climate change cannot be adequately addressed solely through systematic measures, such as climate risk disclosure, industry-specific emission targets, or climate-based compensation. An effective decarbonization strategy requires firm-specific emission targets, strategies to meet these targets, and effective means to monitor management. Given their business model and regulatory constraints, universal owners will not initiate firm-specific policies for reducing emissions. We argue that, unfortunately, no other actor has the incentive and competence to provide the firm-specific expertise required to reduce emissions.

Capital markets rely on activist hedge funds to devise firm-specific strategies and challenge management to implement them. But these funds are unlikely to launch firm-specific campaigns to cut emissions. They will launch campaigns only if they expect them to increase the corporation’s value (some argue only in the short term). Second, activists motivated by a genuine concern for the environment are unlikely to succeed in using the profit-driven activists’ playbook and spearhead the effort to determine firm-specific carbon policies. Finally, neither ESG directors nor investor coalitions can lead firm-specific decarbonization efforts.

Pushing companies to take meaningful steps to cut emissions requires investors to devise firm-specific strategies. Without an actor that could drive firm-specific changes, universal owners’ stewardship will have, at best, a limited effect on emissions. And universal owners’ incentives could lead to large-scale distortions in the much-needed development of green energy. Moreover, legal reforms, such as requiring extensive disclosure from public companies on climate risks or requiring ESG funds to be more transparent about their investment policies, will not address the concerns that we have identified. Activists and academics should therefore recognize the significant limitations of universal owners as a driving force in the fight against carbon emissions. Investors’ stewardship is a very poor substitute for environmental regulation.

This post comes to us from Zohar Goshen, the Jerome L. Greene Professor of Transactional Law at Columbia Law School and a professor at Ono Academic College Faculty of Law, and from Assaf Hamdani, a professor at Tel Aviv University’s Buchman Faculty of Law and Coller School of Management and a visiting professor at Columbia Law School. It is based on their recent article, “Will Systematic Stewardship Save the Planet?” available here.