‘Wolf pack’ win opens the door for more turmoil

The success of the activist shareholder assault on the Exxon board last week, along with a court ruling ordering Royal Dutch Shell to cut its carbon emissions faster than planned and a majority of Chevron shareholders voting for a reduction in its “scope three” emissions have been depicted as victories for climate activists.

While the Shell decision clearly fits into that category (although it will appeal) and Chevron probably also squeezes in, the Exxon experience isn’t quite as clear cut and illustrates the confusion and conflict, for companies and investors, that flow from the increasing aggression and impact of environmental, social and governance (ESG) funds.

Larry Fink’s BlackRock, the world’s biggest money manager, lent its considerable weight to the Exxon push.Credit:Bloomberg

Exxon was targeted, ultimately successfully, by a small hedge fund with ESG credentials, Engine No.1, which campaigned on a mix of Exxon’s poor financial performance and its response – or the lack of a coherent one – to climate change.

Exxon’s financial record and its view that it could reduce emissions while increasing its oil and gas production made it a soft target for climate change activists.

It is the combination of an ESG issue and more conventional concerns about its returns to shareholders that makes the Exxon contest particularly interesting.

With the support of some of the world’s largest investors – BlackRock, Calpers, Calstrs, the New York Common Retirement Fund, Legal & General, the Anglican Church, and others – and armed with recommendations from the two most influential proxy advisers, Engine No. 1 succeeded in having two of its four nominees elected to the Exxon board.

BlackRock is the world’s largest investment manager, with about $US7.5 trillion ($9.7 trillion) of funds under management.

Last year it declared it would avoid investing in companies with high sustainability risks, exit investments in coal companies, launch funds that excluded fossil fuels and vote against managements that weren’t making progress on fighting climate change.

More than half the funds it manages are, however, passive or index-related funds that would have an exposure to their total market, including companies that fail key ESG criteria.

The Exxon vote brought together a coalition of investors who are concerned about ESG issues, and climate change in particular, with more traditional activists who were galvanised by the oil major’s lengthy track record of poor performance. Engine No. 1 cleverly exploited those two strands of discontent.

The outcome, however, doesn’t resolve the tensions – particularly visible in an oil major – between the ESG issues and near-and-medium term financial performance. It wouldn’t have been even if a majority of the Exxon board had been displaced, which it wasn’t.

Exxon’s financial record and its view that it could reduce emissions while increasing its oil and gas production made it a soft target for climate change activists.Credit:AP

In the long run, of course, Exxon may have to reinvent itself or be doomed but in the near term its profitability will be driven by its oil and gas output.

That highlights a dilemma for company boards and managements.

While even the US Business Roundtable has backed away from its long-standing commitment to the Friedmanite conviction that their primary responsibility, apart from obeying the law, is to make money for shareholders, their new pledge to manage in the long-term interests of all stakeholders and take issue of diversity, social inclusion and the environment into account doesn’t exactly provide a neat formula for marrying financial imperatives with ESG outcomes.

The growth in ESG funds – there’s an estimated $US3 trillion-plus now managed by funds with an ESG or sustainable investments label – and increasing shareholder and consumer activism means that companies have no choice but to take notice of the changing investment environment.

It’s a complicated world when companies are being pressured to reduce their customers’ emissions, or protest changes to voting laws, or join campaigns against racial or gender discrimination. It is, however, the world that companies and their boards and executives now have to manage within.

It’s also a complicated world for fund managers and their investors.

The Exxon contest highlighted the conflicts facing some fund managers. BlackRock’s activist stance and its ESG funds will, if they vote in line with founder Larry Fink’s convictions and their label, damage the interests of investors in the passive funds the group also manages which will inevitably hold stocks that don’t have ESG-positive credentials.

The same dilemma would confront other big passive funds like Vanguard and State Street that, with BlackRock, increasingly dominate the share registers of the larger companies. Between them the three funds held about 21 per cent of Exxon.

Where in the past companies might have been able to see of the threat from environmental activists by appealing to shareholders more focused on financial returns, any company with ESG vulnerabilities that doesn’t have a good financial track record and isn’t performing strongly in the present could be susceptible to a pack attack.

There’s also confusion about what an ESG-impact fund actually looks like, given that there is no consensus and no definitions to guide end-investors.

Companies engaged in industries that one fund might find abhorrent might well have ESG fund shareholders because, for instance, they are actively taking steps to shrink their carbon footprint. It is quite conceivable that there could be ESG-labelled funds on both sides of proxy fight on ESG issues.

The ESG funds are growing in popularity and funds under management because they combine a “feel good” factor – a belief that the investor is investing in line with their own values and helping to drive positive change for the environment and communities – with an expectation of superior returns.

While the first might hold true the second isn’t as clear-cut. In recent years any fund that avoided carbon-intensive companies and invested in tech, whether they were an ESG fund or not, would have produced superior returns because of the remarkable performance of the tech sector.

With no clear definition or guidelines for what constitutes an ESG fund or portfolio – the label is self-awarded – and poor disclosure of voting records, it isn’t easy for investors to know whether their expectations are actually being met, although the Securities and Exchange Commission is seeking to improve ESG fund disclosures and measurement and validation of their claims.

The lack of clarity around ESG investment has created an opportunity – which Engine No.1 took – for traditional profit-driven activist investors to cloak themselves in green and enlist ESG funds and investors in what has been termed “wolf pack activism” that is far more threatening to incumbent boards and managements but may not necessarily deliver what the ESG investors expect.

Where in the past companies might have been able to see of the threat from environmental activists by appealing to shareholders more focused on financial returns, any company with ESG vulnerabilities that doesn’t have a good financial track record and isn’t performing strongly in the present could be susceptible to a pack attack.

Distinguishing between genuine ESG concerns and genuine ESG-impact funds and hedge fund opportunism is going to be a challenge for companies, shareholders and ESG funds alike.

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