This spring, a small hedge fund called Engine No. 1 led a shareholder revolt against Exxon, one of the biggest oil companies in the world. Despite being a new firm with relatively meager assets, they shocked the world by rallying shareholders to eject existing Exxon directors who have ignored the threat of climate change and replace them with clean energy experts.
This signature victory signaled a new era for shareholder engagement, a core activity of investment stewardship which can be key to sustainable investing strategies.
As sustainable investing has grown from a niche interest to headline trend reaching an all-time high of $21.5 billion added to sustainable funds in the first quarter of 2021, investment strategies that prioritize investment stewardship activities, including shareholder engagement and proxy voting, are propelling its influence. Indeed, shareholder engagement is gaining steam as a tactic to move businesses toward more climate-friendly practices.
But what is investment stewardship? How do shareholders engage with companies to improve returns and sustainability? How have these strategies evolved, and how can they help reshape the finance world? Here, we lay out the basics.
Who are shareholders?
Publicly held companies are generally run by a chief executive — but that chief executive reports to a board of directors, who are elected by shareholders.
These shareholders own equity (stock) in the company. Shareholders want the company to do well —and some would argue that the whole point of the company is to do well by them, too.
Thanks to the rise of 401ks and other low-cost investment formats, there are more types of shareholders than in the past. At the same time, the incredible turn toward so-called passive investing, where an individual puts money in an intermediary fund that tracks an index rather than actively trying to pick winning stocks, has led to a few investment management firms owning huge chunks of the market. The “Big Three” asset managers of Vanguard, BlackRock and State Street all mainly follow a “passive” strategy. Taken together, they constitute the largest shareholder in 88% of all S&P 500 companies.
Institutional investors, such as universities and state and city pension funds, also hold enormous amounts of stock: some 80% of the public equities market, much of which is invested through the Big Three.
How can shareholders advance sustainability through investment stewardship?
The UN Principles of Responsible Investment (PRI) define investment stewardship as “the use of influence by institutional investors to maximize overall long-term value including the value of common economic, social and environmental assets, on which returns and clients’ and beneficiaries’ interests depend.”
Shareholders concerned about these issues have several inroads to address concerns about corporate performance. They can influence corporate management via earnings calls, elect the board of directors who can replace executives and, depending on how much stock they own, they have the ability to file and vote on shareholder resolutions.
Shareholder resolutions indicate the direction that shareholders want the company to take. They are considered the most serious investment stewardship tactic and a last resort for when conversations haven’t led to desired changes. They are voted on during companies’ annual meetings where shareholders are updated on business activities.
Shareholders use these tools to express concerns about all matters of corporate strategy, but in recent years more and more shareholders have used them to push companies they believe are exposed to or creating climate risks. Climate risks — both physical risks from the impacts of climate change and transition risks from the switch to a low-carbon economy — are present for nearly every company, but investors generally believe these risks are not being acted on fast enough.
A growing movement argues that environmental, social and governance, or ESG, risks are “material” or “relevant” to future performance. That’s why shareholder resolutions are increasingly pushing companies to improve or remedy their actions as the externalities affect ESG-related issues such as to avoid slave labor, hire more women executives, reduce their carbon emissions, and improve environmental and social outcomes and avoid risks.
Who organizes shareholder resolutions?
Shareholder resolutions take a lot of resources and time to coordinate. As a result, they are typically organized by large institutional investors. It would be hard for a small investor to navigate the bureaucratic process, and passive managers historically don’t bother initiating them, preferring to charge lower fees rather than chase a marginal edge on their investments through engagement.
However, even these large investors still need to coordinate their proxy voting activities in order to result in positive stewardship results. In order for a shareholder resolution to pass, investors who hold the company’s stock will vote on the resolution and it must receive at least 51% of votes in support of the resolution. Even large asset owners and managers cannot reach the 51% mark alone, which is why collective engagement efforts for ESG-related shareholder resolutions are increasing and key to positive stewardship outcomes.
Why hasn’t shareholder engagement worked well in the past?
The more shares you hold, the more attention management pays to your concerns. And for decades, big asset owners and managers simply didn’t take climate change and other ESG issues as seriously as they needed to.
Shareholder resolutions on climate change were sometimes filed, but often didn’t get the votes they needed. This contributed to the fossil fuel divestment movement, which posited that it was better to sell off stocks with climate-negative impacts than try to change fossil fuel companies’ business models (and the threat of selling alone may be enough to change some companies’ minds). Additionally, shareholder engagement only works for public companies. Many private companies — including state-owned enterprises who contribute to the use of fossil fuels — don’t have many shareholders or the transparency that empowers them to push for change.
Due to the bureaucratic nature of proxy voting, unless you had lots of money and the time to coordinate among many different investors, few shareholder resolutions for the planet went anywhere. The success rate for shareholder resolutions related to the environment was less than 20% just 10 years ago.
Why is shareholder engagement gaining steam today?
If investors with enough capital come along and make demands, companies are more likely to listen. In recent years, that’s exactly what has happened, with big investment managers — including the Big Three — increasingly concerned about climate risk.
Before the last few years, active managers were more involved in investment stewardship than their passive peers due to taking a more involved investment approach in general. Yet recently, passive managers are becoming more active stewards of capital. Since passive managers are “permanent, universal owners” of the market, they are particularly exposed to growing, systemic risks like climate change, which threaten financial stability writ large, as a US Commodity Futures Trading Commission report concluded last year.
In the case of Engine No. 1, they successfully courted some of the largest American pension funds. In turn, the “Big Three” supported its resolution at Exxon, resulting in a successful outcome where Engine No. 1 itself only owned 0.02% of shares. The coordinated effort ousted existing directors and replaced them with new directors with experience in renewables — a far cry from an actual pivot to the oil giant’s outdated business model, but a start toward what Morningstar called “shareholder-driven climate governance.” But it wasn’t just Engine No. 1 at Exxon — the 26 climate resolutions in the 2021 voting season received an average of 51% support.
Other examples this year show that sometimes shareholder resolutions don’t need to go to a vote to get the goods. Proposals asked Costco, Sysco and Wendy’s to measure and reduce their total contributions to climate change. Each was withdrawn due to “substantial implementation,” evidence that investor pressure caused management to devise tangible plans to improve its sustainability behavior before a shareholder resolution came to a vote.
What’s next in shareholder engagement?
Passive giants cannot carry the torch alone to the 51% support mark. Despite being the largest owners of S&P 500 companies, they are rarely a majority owner, and therefore can only influence so much on their own. However, collective engagement efforts among asset managers and large institutional asset owners have gained traction.
Even individual investors can join the effort. For example, Engine No. 1 recently launched a low-cost exchange-traded fund, $VOTE, which allows individuals to invest in a diversified fund where corporate engagement is key to the investment strategy. For both large and small investors, passive investing is evolving to take an active role in stewardship efforts.
All this takes place against the backdrop of swelling interest in sustainable investing, creating what CERES president Mindy Lubber called a “sea change” in support for ESG shareholder resolutions. Approximately half of sustainable funds supported ESG shareholder proposals over 75% of the time, while only 6% of non-sustainable funds voted their support at the same levels, according to Morningstar. As more and more managers market their funds as savvy to environmental risks, investors will check to see which ones really follow through on their rhetoric by supporting ESG shareholder resolutions.
Successful stewardship outcomes require the collaboration of all types of investors. Climate change will continue to be paramount in upcoming proxy voting seasons as investors and companies recognize the materiality of climate-related financial risks.