Why investor engagement with “dirty” companies is preferable to divestment
Investors who adhere to environmental, social and governance (ESG) principles won’t get much by selling their shares in non-ESG-friendly companies, according to a new research paper titled “The Impact of Investing ‘impact’ by finance professors Jonathan B. Berk at Stanford University and Jules H. van Binsbergen at Wharton. Instead, investors may be more successful if they buy these so-called “dirty” stocks and then engage with the management of those companies to adopt ESG-friendly policies, the newspaper said.
When ESG investors sell stocks in non-ESG-friendly companies, they hope to lower those stock prices and thus make it more difficult and costly to raise capital for those companies. But “the impact [of divestment] on the cost of capital is too low to significantly affect actual investment decisions, ”the document said. “To have an impact, instead of letting go, socially conscious investors who want to have an impact should invest and exercise their controlling rights to change company policy.”
Socially conscious investors who walk away from ESG-disrespectful companies often say they have two goals, van Binsbergen says. The first is “to feel good that they are not investing in dirty companies,” he said. “It’s more like a placebo effect. If it makes them feel good, it may have some use. Second, ESG investors want their divestment to “change the way companies do business” and become more ESG-friendly, he added.
But divestment is a misguided strategy, van Binsbergen and Berk found in their study. Suppose your divestment has a significant effect. In this case, investors end up getting poorer when they sell dirty stocks and buy “clean” stocks. “With that, you are driving up the stock prices of clean companies and lowering those of dirty companies,” van Binsbergen said. “But it does mean that in the future clean companies will have lower returns. You will make less money by investing in green stocks, and you will make more money by investing in dirty stocks. as a green investor you get lower returns, but on top of that you reward investors who don’t care about being green with higher returns.
“If you sell shares in a dirty company, someone else will buy them.” – Jules H. van Binsbergen
More importantly, from a quantitative point of view, the effect will not be large enough. In other words, non-ESG-friendly companies are not penalized enough if investors abandon them and turn to clean companies, van Binsbergen continued. Building on his previous point, he noted that lower returns for clean firms will imply a lower cost of capital for clean firms compared to so-called dirty firms, but the main question is how much.
The high bar for effective disinvestment
“Using the most optimistic estimates, we show that to effect a change of more than 1% in the cost of capital, impact investors would have to represent more than 80% of all investable wealth,” the document said. “Given the low probability of achieving such a high turnout, the results of this article call into question the effectiveness of divestment. Van Binsbergen explained that with the analogy of a loan where the interest rate for a dirty business is 1% higher than that for a clean business: “You need 85% of the market to be with it. you before you can achieve that 1% effect. “
To determine this change in the cost of capital, Berk and van Binsbergen studied the FTSE 4Good USA index, which has 491 companies including Microsoft, Apple and Amazon and is part of a larger FTSE 4Good index that measures the performance of companies with strong ESG practices around the world.
For the study, the authors created a model with clean and dirty stocks and weighted the impact of four factors on the cost of capital. One was the equity risk premium, which measures how well stocks outperform bonds. The second looked at the shares of clean and dirty firms in the makeup of the US economy. The third factor is the amount of capital controlled by green and non-green investors. The fourth factor was a measure of the substitutability of green and dirty stocks.
“We see in the data that the correlation between green and ‘dirty’ is so high that some investors are willing to hold more dirty stocks for almost no incentive,” van Binsbergen said. “Therefore, you don’t have to give them a much higher return at all to get them to hold more of those dirty stocks.” With this strong correlation between green and dirty businesses, “the overall effect [of ESG investing] simply disappears; it just doesn’t matter, ”he added.
“The reason the divestiture has so little impact is that stocks are highly substitutable and socially expensive stocks represent less than half of the economy,” the newspaper explains. “Even with the growing popularity of impact investing over the past 10 years, we find no detectable difference in the cost of capital between companies targeted for their social or environmental costs and companies that are not. “
The document notes that the Vanguard FTSE Social Index Fund, which tracks the FTSE 4Good Index, is the largest social index fund in the world. But this Vanguard fund only manages $ 12 billion in assets, which is a small fraction of the US market cap of around $ 50 trillion, noted van Binsbergen.
Van Binsbergen pointed out other reasons why divestment doesn’t always help the ESG cause, and in some cases it could make matters worse. “If you sell shares in a dirty company, someone else will buy them,” he said. “This person clearly doesn’t care about the ESG aspect, which makes it less likely that pressure from investors can force changes in the company. The question in this case is: did you do something right?
“If you want to convince companies to do the right thing, then go to the shareholders’ meeting and vote on the proposals that are the right thing to do. ” – Jules H. van Binsbergen
In an extreme scenario imagined by van Binsbergen, a divestment could lower the price of a dirty stock to a level where “other investors who don’t care” about ESG principles could end up taking full control. “Suppose you can get the price of a dirty stock to reach, say, a dollar,” he said. “The CEO of the company could then buy the whole company for that low share price. You are giving the person who cares the least about ESG the opportunity to buy the entire profit stream almost for free. “
Why Escrow is a Better Option
On the flip side, socially responsible funds could buy stocks in non-ESG-friendly companies, and they would need far less than 50% shareholder participation to make changes, the newspaper pointed out.
Van Binsbergen explained how this works with an example of a shareholders’ meeting of a company where 51% of the votes are against a green initiative. If socially conscious investors control the remaining 49% in favor of the initiative, it would take a little over 1% more to win the vote.
“If you, as a socially conscious investor, make sure you’re on the margin, then with little investment you can tip the vote and potentially have a big impact,” he said. “If you want to convince companies to do the right thing, then go to the shareholders’ meeting and vote on the proposals that are the right thing to do. Introduce yourself and make your point.
Over the past year, a few activist and institutional investors have adopted Berk and van Binsbergen’s approach of engaging with companies they perceive as hostile to ESGs.
- Earlier in October, BlackRock announced that starting in 2022, this would allow some institutional clients to have more say in voting on their investments. He said the move is in line with his policy of “engaging” with businesses “by advocating for sound corporate governance and sustainable business models to support long-term financial returns.”
- In June 2021, activist hedge fund investor Engine No. 1 won three seats on the board of ExxonMobil with the backing of the “big three” institutional investment firms BlackRock, Vanguard and State Street. The No.1 engine had launched a campaign that called for “repositioning ExxonMobil for long-term value creation”.
- At the end of October, Third Point LLC, an activist investment firm headed by Daniel Loeb, asked Royal Dutch Shell to split into two stand-alone companies, The Wall Street Journal reported. Third Point’s plan is for one company to own the legacy activities of Royal Dutch Shell, such as refining, which would provide stable cash flow, and another company for its renewables and other units that require substantial investment.