With the arguments about whether or not ESG ratings give useful guidance to investors about which companies are taking action on climate change, it’s important to talk about how investors with climate or net zero targets should react. Should they divest (sell stakes in poor-performing companies), or encourage them to improve performance through strong stewardship?
When Tesla released its 2021 impact report in May 2022, Elon Musk attacked the structure of current ESG ratings, saying the focus on governance and box ticking enables oil and gas companies to game the system, ignoring the overall impact of their operations.
That may be the case but the row has once again raised the question of what investors should do with high-carbon companies or poor ESG-performing businesses. One of the core questions for today’s investors is whether divestment or stewardship is the right way to go?
While investors can divest, the financial system can’t
Traditionally this has been an ‘either/or’ question, with opinion divided as to the efficiency of either approach. Stay invested in climate and ESG laggards and the markets fail to send a signal to corporates, but divest and run the risk that stakes simply change hands, often into the ownership of investors with potentially no interest or capacity to effect change.
Sarah Breeden, an executive director at the Bank of England, warned recently in a speech that “while individual investors can divest, the financial system as a whole cannot.” The argument for divestment has been that if enough investors commit to divestment, the cost of capital for those companies goes up, driving a focus on alternatives.
$40 trillion is committed to divestment
Divestment has been a particular issue in terms of social licence to operate, as activists have driven many successful divestment campaigns over the years. Today over 1,500 institutions are committed to fossil fuel divestment, with over $40 trillion in value of those institutions.
The 350.org report Invest-Divest 2021: A Decade of Progress Towards a Just Climate Future, made the argument that the divestment movement has succeeded in making fossil fuels accountable for the externalities created by unregulated carbon emissions.
Despite these commitments, however, and reports suggesting that up to 80% of fossil fuels will need to stay in the ground if the world is to meet 2050 targets (from groups as diverse as think-tank Carbon Tracker and the International Energy Agency (IEA), investment continues in new oil and gas. In fact, the energy crisis is seeing a return to such investment by states and financial institutions.
Bank resolutions to halt fossil fuel finance fail
Many still argue that rapid transition away from fossil fuels is not economically viable. Resolutions to prevent further financing of fossil fuels failed in April 2022 at Citi, Wells Fargo and Bank of America, despite their membership of the Net Zero Banking Alliance (NZBA). Such proposals are also forthcoming at JP Morgan, Goldman Sachs and Morgan Stanley.
There is widespread expectation that 2050 will see roughly 20% of the world’s remaining energy-related emissions and embodied carbon driven by fossil fuels. That means every operator wants the right to a piece of that pie, however impossible it might be that all will succeed.
There is also the challenge that while the oil majors may be susceptible to capital concerns and shareholder pressure, state-owned companies reportedly own over three quarters of today’s crude oil production and divestment will not effect them.
Growing support for environmental and social action at board level
There is an increasingly strong argument to be made for stewardship, as the media is full of demands for action on environmental concerns, animal welfare, and the financing of fossil fuel expansion.
The latest research from Bloomberg Intelligence reports a growth in support for environmental and social resolutions, with an average of 33%, up from 22% five years ago.
While most shareholder resolutions are not requirements, research suggests that support of over 50% usually results in action, so there is movement in the right direction.
And there are a growing number of stories of successful intervention: from a shareholder call for Apple to undergo a civil rights audit, to the imposition of climate-friendly directors to ExxonMobil’s board. And in order to balance between shareholder activism and the impact of sudden market shifts, new approaches are also being tried.
AXA proposes divestment only if stewardship fails
One of these is from global asset management firm AXA Investment Managers. It recently released its 2021 Stewardship Report highlighting a new approach that seems to split the difference.
Borrowing from baseball, AXA’s 2022 strategy is, according to Gilles Moëc AXA Group chief economist and AXA IM core head of research, “three strikes and you’re out.”
A review of its engagement areas in 2021 showed that climate issues took up over a third of its stewardship engagements, alongside issues such as corporate governance, human capital and resources and ecosystems – a breakdown by goal showed that while not all goals were reflected (nothing for 1, 16 or 17), over 80% of AXA’s interventions were related to specific Sustainable Development Goals.
AXA IM says it will regularly engage with companies it has identified as slow to act, to steer them to achieve progress on climate objectives, with a special focus on construction, oil and gas and financial services. The idea is to use escalation techniques when necessary (e.g. voting against management) to force management to take shareholder concerns seriously.
From 2022, the company says it will concentrate on a selection of companies which do not have net zero commitments or whose quantified emissions reduction targets are insufficiently demanding or not credible, in view of AXA IM.
This list will include issuers in different sectors and different geographies and, If the objectives have not been achieved after three years, AXA IM will divest. The manager says that it sees biodiversity as a systematic risk and plans to increase its engagement around that just transition and human rights.
Engagement followed by divestment may be the most effective path to change
This approach will certainly highlight the performance of selected companies – no longer a question if they’re simply not yet ready but rather shining a spotlight on their willingness to act (or not) over a three-year period. That’s a lot harder to argue away.
What’s particularly interesting in AXA’s explanation of its engagement plans is the importance it is placing on the measurement and management of Scope 3 emissions and the importance of integrating climate policy at board level.
Divestment versus stewardship may prove too binary an approach overall, especially as banks continue to argue that they need to work with their clients on transition rather than abruptly end finance. With so little time to achieve the 2050 (let alone the 2030) goals, it seems as if engagement may well be the best way forward.
