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A 12 months in the past, an unknown San Francisco hedge fund with an odd-sounding title hit paydirt. To the delight of the shareholder activist crowd, Engine No. 1 dramatically succeeded the place others had fallen quick: Humble the mighty ExxonMobil, the Twentieth-century oil and gasoline baron. Within the 2021 proxy season, a majority of its shareholders supported dissident proxy resolutions to elect three directors nominated by Engine No. 1.
Within the heaven of inexperienced, birds sang and a claxon rang
It was a stunningly well-orchestrated proxy marketing campaign and public relations coup by the best from Wall Avenue and Madison Avenue, backed by a cadre of refined asset homeowners and managers, notably CALSTRS, the second-largest U.S. retirement fund and the Church Commissioners for England. A 12 months later, Time journal beatified Engine No. 1 as one of many 100 most admired firms of 2021. GreenBiz knighted its CEO, Jennifer Grancio, the previous COO of BlackRock’s huge iShares ETF enterprise, as one in every of eight badass women shaping the future of finance and ESG.
The conquering heroes from San Francisco are seen because the de facto face of edgy stakeholder local weather activism and affect investing. Engine No. 1 seeks to take local weather stewardship to the subsequent degree of transparency whereas providing the same old mixture of lively and passive index funding administration.
Nevertheless, as a brand new proxy season begins, Engine No. 1’s marketing campaign in opposition to ExxonMobil and its enterprise mannequin stay a riddle. Was its burst of activism a cynical try to greenmail ExxonMobil? And did it exploit booming media curiosity in environmental, social and governance points to launch itself as an organization with invaluable PR?
Or was it a watershed second for stakeholder capitalism — a daring instance of “past funding as common” that challenges the foundational cornerstones of asset administration: portfolio development, safety choice and trendy long-term investing?
Engine No. 1 finds itself in the midst of a fast-moving debate on the roles and tasks of contemporary cash managers in a world in disaster.
The reply is neither. As an rising asset administration startup, Engine No. 1 stays a high-profile work in progress. It enters a $100 trillion world cash managing trade the place rising social, geopolitical, environmental and well being tendencies are inflicting a profound rethink by the world’s largest holders of capital on learn how to finest develop and handle that capital in a sustainable method within the many years to come back.
And prefer it or not, Engine No. 1, maybe as a result of it has obtained such a disproportionate quantity of publicity, finds itself in the midst of a fast-moving debate on the roles and tasks of contemporary cash managers in a world in disaster. That is regardless of the small amount of cash Engine No. 1 manages.
Fashionable Portfolio Idea beneath hearth
On the middle of the talk is learn how to perceive and handle the chance of the quickly escalating affect of local weather change and ESG components on investor portfolios.
Whereas it might be onerous to consider at this time, these exogenous components weren’t thought-about — local weather change didn’t even exist as a difficulty — in Nobel Prize-winning Harry Moskowitz’s Fashionable Portfolio Idea when it was first revealed 70 years in the past within the Journal of Finance.
This issues as a result of Fashionable Portfolio Idea is the near-universal investing orthodoxy for the world’s largest institutional traders. Little identified past the world of lecturers {and professional} traders, Fashionable Portfolio Idea (MPT) has guided generations of funding selections by the world’s largest stewards of capital — the enormous institutional pension, insurance coverage and sovereign wealth funds.
Moskowitz’s nice contribution to wealth administration was his perception on the character and significance of portfolio diversification to maximise funding return and decrease funding danger.
The rise of systematic risk and beta activism
Nevertheless, a rising refrain of beta activists argue that there are harmful flaws in Moskowitz’s principle. In MPT, the advantages of diversification apply solely to particular, idiosyncratic danger components in single firms or specific belongings in an funding portfolio.
Nevertheless, lacking from the equation is danger arising from broader systematic dangers. Systematic risk is market danger in investments on the whole. It’s non-diversifiable and contributes to systemic risk, the chance to or arising from environmental, social or monetary programs. It’s high-order stuff like local weather danger or monetary contagion. It impacts everybody within the financial system. You can not run. You can not cover.
As beta activists, Engine No. 1 went past a standard proxy combat and joined the rising motion amongst institutional traders who consider there may be way more danger than assumed in MPT.
Consider the Nice Melancholy of the Nineteen Thirties or the Nice Monetary Disaster of 2007-2009 that nearly introduced down the world’s banking system. The foundations and rules after these crises — the U.S. SEC was created in 1934 — have been made to buffer the world’s financial and monetary programs from the varieties of world systemic and systematic dangers that you just can not diversify away from.
Lacking from MPT motion: 75 p.c of all portfolio danger
Of their seminal and good e book “Moving Beyond Modern Portfolio Theory: Investing That Matters,” Jon Lukomnik and James Hawley argue that the precise danger in a single firm or specific asset has develop into a lot much less essential than beforehand thought. They are saying 75 p.c of all danger to an funding portfolio return arises from broader systematic dangers that aren’t included into MPT. “In impact, MPT tells us which you could have an effect on what issues least,” says Lukomnik.
Lukomnik and Hawley ambitiously and convincingly synthesize present considering round what is named “programs investing.” Their work and others comparable to The Shareholder Commons and The Investment Integration Project are arguing the investor ought to give attention to a beta over alpha strategy.
The brand new beta activist
For this reason Engine No. 1’s combat with ExxonMobil is so instructive. As beta activists, Engine No. 1 went past a standard proxy combat and joined the rising motion amongst institutional traders who consider there may be way more danger than assumed in MPT.
Beta activists goal systematic dangers at firms however extra critically at clusters of firms and sectors in transition, in a quest for higher outcomes for all firms and stakeholders. Beta activism is about influencing the efficiency of the general funding market. It lasers in on the externalized prices — assume carbon air pollution or the results of smoking tobacco — which firms foist upon us all. Lastly, it additionally deliberately targets the suggestions loops and the affect of our investments on firms and the actual financial system.
Beta activism pulls all this collectively and, by doing so, challenges the unthinkable: the holy e book of MPT.
Wall Avenue’s new masters of the universe
The world’s largest asset homeowners are driving this profound shift in funding considering. They’re diversified Universal Owners uncovered to the entire financial system — its good and unhealthy fortunes. These traders unequivocally assist stakeholder capitalism. They ask firms to maneuver past enterprise as common and assist a brand new past funding as common.
What makes these homeowners so totally different is the sheer measurement of their portfolios and that they personal the “complete market” — or about $61 trillion in institutional belongings worldwide. That’s, they’re most within the total outcomes. They care about broader beta as a result of they’re extra involved in systematic dangers than in one-off firm danger. Not by alternative, however by definition, they develop into “good residents,” urging actions that do no hurt and profit all stakeholders.
The ExxonMobil proxy combat was not the primary. Nonetheless, it was undoubtedly the highest-profile instance of how a brand new technology of traders is incorporating the next order of exterior dangers — also called “programs investing” — into consideration when managing funding portfolios.
The rise of Engine No. 1
Engine No. 1 is just a really shiny instance of beta activism at work. The agency is the brainchild of veteran Silicon Valley traders Chris James and Charlie Penner, who, with Gancio, did what no environmental activists had succeeded at doing: Rock the internal sanctum of ExxonMobil’s boardroom. And so they did so by taking part in Wall Avenue hardball.
Armed with Wall Avenue’s coin of the commerce — an 80-page PowerPoint investor deck, recent capital and years of expertise in activism (Penner), hedge funds (James) and institutional investing (Grancio) — the corporate strategically determined to tackle target-rich ExxonMobil, and by doing so, turbocharged the as soon as virtually apostolic world of earnest funding stewardship.
Chugging into uncharted funding and stewardship territory, Engine No. 1 take a look at drove a brand new mannequin of engaged possession and funding that spoke the language of Wall Avenue, not the vicarage, however with a heavy inexperienced accent.
ExxonMobil was a goal to not finish fossil fuels or save the world however as a result of it lacked a “profitable and transformative power expertise on the Board.” Most damaging for long-term traders was that the ExxonMobil board had did not “position the company for long-term worth creation in a altering trade and world, and to create worth in a decarbonizing world.”
Engine No. 1 is just a really shiny instance of beta activism at work.
To the shock and shock of just about everybody, notably ExxonMobil, the beta activist marketing campaign labored. The upstart received three seats on the board. It received, partly, through the use of the identical brass-knuckled ways of the marauding company raiders of the Eighties, solely this time so as to add a brand new inexperienced agenda.
Again then, a “inexperienced” — as in cash — premium was paid by an organization to the raider for its shares, coupled with an settlement to go away. This was derisively referred to as “greenmail,” a technique utilized by notorious Eighties hedge fund traders comparable to T. Boone Pickens and Carl Icahn. Others would comply with, storming America’s company citadels to squeeze return and capitalist effectivity out of sleepy American icons.
Engine No. 1, nevertheless, isn’t greenmailing. They and different Exxon activists are usually not going away. They’re expressing a brand new type of inexperienced investing — name it local weather inexperienced — that believes future investor returns rely much less on jawboning an organization to restructure itself internally and extra on pressuring firms to know and capitalize on exterior inexperienced ESG components, components that, like local weather change, the Ukraine battle or power shocks, develop extra critical by the day.
New-age hero with inexperienced knuckles or conventional activist?
That stinging “cash talks, B.S. walks” funding critique, together with utilizing activist ways hardly ever seen earlier than in sustainability funding stewardship, weaponized stakeholder activism — and received the brand new firm the form of priceless PR protection most startups may solely dream of reaching.
“It was ESG activism, however it was additionally traditional activist exercise,” stated Engine No. 1 authorized counsel Elle Klein, a 2022 Dealmaker of the 12 months. “Engine No. 1 engaged with Exxon as a result of it was an organization that was underperforming. Nevertheless it additionally had an important overlay of ESG points.”
So what actually is Engine No. 1?
Regardless of its massive victory over ExxonMobil, what stays unresolved is simply what sort of inexperienced stakeholder Engine No. 1 desires to be. They aren’t a number of pink-capped local weather activists who stormed BlackRock’s New York headquarters at Park Avenue Plaza a number of years in the past.
Nor are they simply new-age greenmailers with a conscience. They use activist ways comparable to board director campaigns, however these are coupled with local weather stewardship finest practices. They’re additionally hearty capitalists, constructing a contemporary funding platform with passive and lively ETFs, VOTE and NETZ, and a thematic “Perennial Worth” hedge fund.
The founders declare to be forging a new model of active ownership. The agency’s $750 million belongings beneath administration are small in comparison with its affect. It hearkens again to an earlier period of investing when small leveraged buy-out retailers comparable to Henry Kravis and George Roberts’ KKR had a disproportionate affect on enterprise as common relative to the variety of belongings they managed.
So it’s far too early to know if there may be fizzle or sizzle in Engine No. 1’s strategy. Take its enterprise mannequin. There may be little perception into the finer particulars of their “new method of seeing worth” or smart data, magic green investment model. They declare they’ll ship long-term worth within the context of great alternatives in ESG engagement and local weather options. However so does each ESG store on Wall Avenue.
Driving lengthy SRI coattails and investor local weather collaborations
Much more attention-grabbing is a evaluate of whence they got here and what they’re leveraging, not particular person company-focused beta activism.
The agency is browsing the mainstreaming of the unique Socially Accountable Investing (SRI) wave, pioneered by a technology of dogged and numerous activist seers and doers. However it began method earlier than that, within the 1700s, simply as America was rising as a nation and John Wesley first preached “no hurt.”
In that vein, beginning within the Nineteen Sixties, early SRI leaders focused particular environmental and social points, or in finance parlance, idiosyncratic risks, comparable to these from asbestos, smog, aerosols or weapons, at single firms or small clusters of them. Specialty SRI investment managers sprung up, investor networks have been organized and sustainable investing began to the mainstream after the SEC issued its first local weather steerage in 2010.
In 2015, the SRI motion, now rebranded ESG, started to select up steam on Wall Avenue. The Big Three asset managers, BlackRock, Vanguard and State Avenue, began to construct “governance and sustainability” stewardship groups and crank out blueprints and whitepapers and, within the case of BlackRock, investor letters from CEO Larry Fink.
Engine No. 1 seeks ‘to flip the institutionalized inertia of siding with administration on ESG points by setting a coverage that helps a overwhelming majority of local weather and ESG proposals on the proxy poll.’
In 2017 the American pension fund CalPERS performed a primary spark function in convening an much more formidable world engagement effort for the worldwide trigger of commercial greenhouse gasoline emissions discount. The next 12 months, a brand new investor initiative, Climate Action 100+, was shaped and sought to maneuver past idiosyncratic occasions to tackle important industrial sources of public firm emissions. It was a coordinated marketing campaign to deal with the higher-level systematic funding dangers posed by unabated fossil gasoline combustion enterprise fashions.
Seen by many as essentially the most profitable investor collaboration group globally, Local weather Motion 100+ boasts 700 traders, with $68 trillion in belongings, focusing on 166 firms, representing 80 p.c of world industrial emissions. It stays a work in progress, however like many net zero initiatives, its uncooked variety of traders and route of journey are spectacular.
A real inexperienced engine?
If Local weather Motion 100+ is the brand new local weather gentle inexperienced, Engine No. 1 is presumably a brand new darker inexperienced.
GreenBiz’s personal Grant Harrison, in his article “Can Engine No. 1 help Wall Street overcome finance inactivism?“, gives that Engine No. 1 seeks “to flip the institutionalized inertia of siding with administration on ESG points by setting a coverage that helps a overwhelming majority of local weather and ESG proposals on the proxy poll.”
In contrast to the Massive Three asset managers, Engine No. 1 discloses its proxy votes in real-time and points well timed case research on its voting priorities and rationales. Additional, it engages particular firms on director votes, firm local weather transition plans, greenhouse gasoline target-setting, human capital administration and extra.
Lastly, it has executed what no massive asset managers have tried — to drive a change in route by instantly difficult an organization’s management.
The rise of proprietor alliances
And whereas jaunty little Engine No. 1 has lately hogged the local weather activism limelight, the actual engines of change are usually not hedge funds or Personal Fairness. Influential, self-proclaimed gold-standard organizations such because the U.N.-Convened Net Zero Asset Owners Alliance (NZ-AOA) have emerged over the previous decade, taking a extra world and trade strategy to stakeholder engagement.
Albeit with fewer daring headlines than Engine No. 1, these alphabet alliances are main the cost on systematic/systemic danger, beta activism and local weather stewardship, demanding that each one traders, particularly common homeowners, work collectively, deliberately, collaboratively and urgently, to repurpose capitalism to deal with the three nice problems with our time: local weather change; inequality; and threats to democracy, as outlined in “Reimagining Capitalism in a World on Fire.”
Nobody does this higher at this time than the Internet-Zero Asset Proprietor Alliance. With its $10-plus trillion in belongings, the Proprietor Alliance and supporting refrain climatus of world investor NGOs flash neon inexperienced, turning down goal portfolio temperatures and growing the accountability warmth on its asset managers as world warming intensifies.
Albeit with fewer daring headlines than Engine No. 1, these alphabet alliances are main the cost on systematic/systemic danger, beta activism and local weather stewardship.
Since 2019 they’ve referred to as, with increasing specificity, for web zero GHG emissions by 2050 and funding portfolios aligned with a most temperature rise of 1.5 levels Celsius above pre-industrial ranges. Many agree with this directionality, even when they consider that 1.5 C is already out of reach.
The most recent blast from the Alliance, “The Future of Investor Engagement: A call for systematic stewardship to address systemic climate risk,” launched final month, is a clarion name for asset homeowners and their managers to “change the foundations of the sport” which have guided institutional investing for 70 years.
Now what?
How all this interprets into investor motion stays to be seen. However the 2022 proxy season is already shaping up into what ought to be a season of escalating investor and firm drama.
Oddly, Engine No. 1 is taking a decidedly low-key strategy on this 12 months’s proxy fights.
As a substitute, taking over ExxonMobil is the Dutch NGO activist Follow This. It has filed a proxy resolution that requests Paris-consistent emissions reductions targets. It seeks to stoke a shareholder riot in opposition to ExxonMobil for its “refusal to set Scope 3 targets,” which majorities supported at Chevron, ConocoPhillips and Phillips66 in 2021. Exxon, it says, “particularly rejects accountability for the emissions of its merchandise by calling Scope 3 accounting strategies ‘duplicative and flawed.’”
So why isn’t Engine No. 1 following by on all its hearth and brimstone of final 12 months? Cynics might argue that they’re simply good previous Wall Avenue opportunists wearing inexperienced sheep’s clothes. The worth of their stake in Exxon has surged because the cussed oil Goliath recently predicted report first-quarter income.
Doable, however uncertain. Urged on by long-term considering institutional traders, it’s extra probably that Engine No. 1 is simply the primary of a brand new period of beta-focused funding managers figuring out, partaking and attacking a giant unhealthy bundle of systematic dangers to speed up motion, protect the hard-earned financial savings of hundreds of thousands of pensioners and proceed to outline what’s past funding as common.
