Externalities and the Common Owner

Madison Condon is a Legal Fellow at the Institute for Policy Integrity at the New York University School of Law. This post is based on her recent article, forthcoming in the Washington Law Review. Related research from the Program on Corporate Governance includes Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); Horizontal Shareholding by Einer Elhauge (discussed on the Forum here); and New Evidence, Proofs, and Legal Theories on Horizontal Shareholding by Einer Elhauge (discussed on the Forum here).

Most of the stock market is controlled by institutional investors holding broadly diversified economy-mirroring portfolios. In an article recently posted on SSRN, Externalities and the Common Owner, I argue that diversified investors should rationally be motivated to internalize intra-portfolio negative externalities. This portfolio perspective can explain the increasing climate change related activism of institutional investors: I present a rough cost-benefit analysis to show that forcing marginal emissions reductions at individual firms can in fact reap portfolio-wide benefits that outweigh the loss in value of the targeted companies.

In December 2018, Royal Dutch Shell announced that it was setting emissions reduction targets, aiming to reduce its net carbon footprint (including emissions from the sale of its products) 20% by 2035, and 50% by 2050. According to The Wall Street Journal, Shell executives were initially opposed to these goals—the CEO had described them as “onerous and cumbersome” just six months before—but they eventually capitulated “to months of investor pressure.” The announcement was jointly made with Climate Action 100+, a coalition made up of more than 300 institutional investors that control $33 trillion in assets, or 40% of global GDP. In a press release, Climate Action 100+ stated that its success at Shell “demonstrates the power of collective global investor engagement” and that the coalition planned to “use the commitment to raise the bar for the oil and gas industry as a whole.”

Shell is just one of several recent successes investors have achieved in pressuring companies to commit to emissions-reduction targets. Two other oil and gas majors, Equinor and BP, as well as the multinational mining company Glencore, made similar announcements this year as a result of engagements with Climate Action 100+. Each of the companies have agreed to investor demands that their climate targets be linked to executive remuneration.

My article argues that these investor initiatives can only be explained by accounting for investor motivations at a portfolio rather than a firm level. These institutional investors are broadly diversified across the entire economy. The economic impacts of climate change will occur so broadly across their portfolios that they are systemic and cannot be diversified away. One asset manager predicts that “global economic losses could build to $23 trillion over the next 80 years; equal to permanent damage three to four times the scale of the 2008 financial crisis.” Investors are aware that the cause of this economic loss originates from the oil and gas companies held within their own portfolios. The Climate Action 100+ coalition released a list of 100 public companies to target for engagement that are responsible for a combined two-thirds of all industrial emissions.

This insight on the portfolio-perspective of institutional investors engages with scholarship on the anti-competitive effects of common ownership. A growing number of empirical studies show that in concentrated industries, where many of the key players are owned by the same large shareholders, common ownership leads to anti-competitive price increases. That is, the increasing prevalence of institutional investors owning sizable shares of competing firms has resulted in these firms behaving more like oligopolies. These findings suggest that diversified shareholders are able to influence corporate managers into making firm-level decisions for the benefit of the broader investment portfolio.

In response to inquiry over common ownership’s anti-competitive effects, institutional investors have been careful to deny their ability to have any control over product pricing decisions. However, they are considerably more willing to advertise their success persuading companies to commit to environmental and social objectives. My article shows that these objectives can have a direct relationship to product supply and pricing, disputing institutional investors’ general claims to powerlessness. Further, in the climate context, some institutional investors have admitted that the motivation for their firm-specific interventions originates from their portfolio perspective. A group of 74 investors controlling $4.5 trillion in assets recently outlined their expectation that portfolio companies refrain from anti-carbon regulation lobbying, in service to “the long-term value in our portfolios across all sectors and asset classes.” My article contributes to the ongoing debate over common ownership by identifying the causal mechanisms by which institutional investors influence corporate directors into deviating from profit-maximizing objectives.

This argument requires the amendment of the traditional view that diversified investors are “rationally reticent” and lack the incentive to engage in monitoring of firm behavior. It additionally challenges a fundamental norm of corporate governance law: the theory of shareholder primacy rests on the premise that shareholders homogeneously seek to maximize corporate profits and share value. This article shows that in certain circumstances a majority of minority shareholders may direct the firm away from a profit-maximizing objective.

The complete article is available for download here.

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One Comment

  1. Michell Hilton
    Posted Sunday, May 26, 2019 at 9:52 am | Permalink

    What forces are actually behind the markets going up and down; large institutions buying and selling or individual investors?