How Dual-Class Shares Can Promote Low-Carbon Innovation

To reduce CO2 emissions, the world needs alternatives to fossil fuels. According to the latest estimates by the International Energy Agency, 35 percent of the green energy required to reach net zero by 2050 depends on technologies not yet on the market. The delay undermines governments’ ability to reduce CO2 externalities through traditional means such as taxes and regulation, because starving people of energy is politically difficult and hard to coordinate internationally. What’s more, so long as burning fossil fuels is profitable, the impact of sustainable finance on global CO2 is limited. However, sustainable finance can give controlling shareholders incentives to pursue low-carbon breakthroughs and speed the transition. Supported by dual-class shares, controlling shareholders are better positioned than managers to pursue radical low-carbon innovation because they have vision, tolerance for failure, and indefinite time horizons.

In a recent paper, I argue that dual-class shares, which enable control with less than half of a company’s equity, allow institutional investors to commit to financing low-carbon innovation. Controlling shareholders can tap the funds of climate-conscious investors to scale their vision, while climate-conscious institutional investors commit to supporting the controlling shareholder’s vision by relinquishing control rights conditional on the achievement of an ambitious CO2 target. To support this double commitment, I advocate charter clauses that sunset the dual-class structure on the condition that controlling shareholders reduce their equity (a “divestment sunset”) or sell control before hitting the target (a “target-contingent sunset”).

While dual-class shares allow controlling shareholders to scale their vision, they may also increase agency cost. This concern is often exaggerated. Although controlling shareholders with dual-class shares have more incentive to take advantage of minority shareholders, this problem is less severe in jurisdictions with effective procedural constraints on self-dealing. Still, an excessive wedge between voting rights and the controller’s equity created by dual-class shares could undermine the incentive to acknowledge the vision’s failure as the controller’s stake becomes too small (for example, a 10:1 wedge enables control with 9.1 percent of the equity; 20:1 requires only 4.8 percent).

However, the presence of idiosyncratic private benefits of control (PBC) rules out excessive wedges. Idiosyncratic PBC represent the vision’s subjective value – for instance, the pride of making a negative-emissions vehicle – and motivate controlling shareholders to invest all or most of their wealth in a company to implement their vision. To protect the value of their undiversified investment, controllers stop selling noncontrolling stock when investors require a discount as high as idiosyncratic PBC: Selling stock for less would reduce the value of the controller’s equity. As investors anticipating agency cost require a higher discount the higher the wedge, finite idiosyncratic PBC limit this wedge, setting a lower bound on the controller’s stake. Because controlling shareholders value their vision and may lose everything from failing to acknowledge its failure, the agency cost of dual-class shares is limited.

A target-contingent sunset commits controlling shareholders to pursuing low-carbon innovation to turn idiosyncratic PBC into money. Such a sunset would collapse the dual-class structure into one-share-one-vote if the control block is sold before achieving the decarbonization target. Conversely, the dual-class structure would become permanent when the target is achieved. Although controlling shareholders face no time pressure to deliver innovation, they must wait until they hit the target before they can cash in idiosyncratic PBC as control premium. With a target-contingent sunset, climate-conscious investors may give controlling shareholders an incentive to pursue low-carbon innovation. Importantly, the target must be technologically out of reach in the particular industry. Think, for instance, of a net-zero vehicle (meaning negative CO2 emissions) or low-carbon aviation. Moreover, CO2 targets should be reliable and include measurable upstream and downstream (so-called Scope 3) emissions. In my paper, I show with a numerical example that controlling shareholders prefer to commit to low-carbon innovation if climate-conscious investors buy noncontrolling stock at a smaller discount than financial investors who only care about risk-adjusted returns.

Why would investors offer such a good deal to controlling shareholders? Some institutional investors, particularly mutual fund managers, cater to the preferences of climate-conscious beneficiaries who are willing to forgo short-term return, however little, to improve climate change. This is not just theory; there is evidence that this mechanism affects mutual fund flows, including of large, mainly index-tracking investors such as the Big Three (Blackrock, Vanguard, and State Street). In turn, ownership by the Big Three and comparable asset managers is negatively correlated with CO2 emissions. However, the size of CO2 abatement that can be attributed to institutional investor engagement is much too small compared with the Paris Agreement goals. More disturbingly, a recent study reveals that CO2 emissions are positively correlated with low-carbon innovation, suggesting a Jevons paradox: When burning fossil fuels becomes more efficient, companies – and their institutional owners – prefer cashing in the value of innovation to pursuing further decarbonization. This frustrates the purpose of climate-conscious investors.

To fulfil the mandate of their climate-conscious beneficiaries, institutional investors must become allies of controlling shareholders and commit to them with dual-class shares conditional on low-carbon innovation. If institutional investors retain control, they cannot commit to long-term strategies having more impact than foreseeable government policies.  Large, institutional owners engage with portfolio companies to manage systematic climate risk, which however is mispriced. This is insufficient to fulfil a mandate from climate-conscious beneficiaries to forgo short-term returns for long-term impact. Short of greenwashing, which regulations such as the EU Taxonomy will curb, such a mandate implies subsidizing low-carbon innovation until it will become profitable in a decarbonized world, in the spirit of the delegated philanthropy theory of Bénabou & Tirole.

Large, institutional owners cannot subsidize low-carbon innovation for three reasons: a) they cannot commit to forgoing short-term returns to support low carbon-innovation; b) they are incompetent to judge firm-specific innovation, exposing innovating managers to hedge fund activism; c) they have a conflict of interest with low-carbon breakthroughs because, as argued in the common ownership literature, they prefer less competition. Controlling shareholders facilitate commitments from institutional investors because they face none of these limitations. As large, undiversified shareholders, they are committed to the long term, as controllers, they cannot be ousted by activists unless they underperform severely. and as visionaries, they compete aggressively.

While a target-contingent sunset supports climate-conscious investors’ subsidy to low-carbon innovation (in the form of a smaller discount and higher wedge of dual-class shares), institutional investors could still worry that controlling shareholders increase agency costs ex-post, after getting undisputed control. To overcome this concern, corporate law should feature a divestment sunset as a default rule. A divestment sunset stipulates that a dual-class structure reverts to one-share-one-vote system if the controller’s equity falls below a certain proportion as of the IPO (or the subsequent issuance of dual-class shares). Complementing corporate law restrictions on self-dealing and other safeguards, a divestment sunset would prevent controlling shareholders from increasing agency costs by taking cash out of the company while retaining control.

There are recent examples of controlling shareholders using dual-class shares to support low-carbon innovation rather than to extract cash from the company. Porsche raised €9.4 billion selling non-voting shares, allegedly to foster Volkswagen Group’s global leadership in Electric Vehicles, whereas leveraging on Berkshire Hathaway’s dual-class structure, Warren Buffett has become the largest shareholder of Occidental Petroleum, a market leader in Carbon Capture and Sequestration technology. In both cases, institutional investors have played along. Combining a target-contingent sunset with a divestment sunset aims to mainstream dual-class shares for low-carbon innovation.

This post comes to us from Professor Alessio M. Pacces at the Amsterdam Center for Law & Economics (ACLE) of the University of Amsterdam. It is based on his recent article, “Controlling Shareholders and Sustainable Corporate Governance: The Role of Dual-Class Shares,” available here.