Systemic Stewardship with Tradeoffs

Marcel Kahan is George T. Lowy Professor of Law and Edward B. Rock is Martin Lipton Professor of Law at NYU School of Law. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here); Index Funds and the Future of Corporate Governance: Theory, Evidence, and Policy by Lucian Bebchuk and Scott Hirst (discussed on the forum here); The Specter of the Giant Three by Lucian Bebchuk and Scott Hirst (discussed on the Forum here); and The Limits of Portfolio Primacy by Roberto Tallarita (discussed on the Forum here).

Many have started to look to the corporate sector to control carbon emissions and mitigate climate change. But any serious effort to control carbon emissions will have winners and losers: companies that will benefit from reduction; and companies that will bear the brunt of mitigation efforts. In particular, concentrated carbon emitters such as oil exploration and production companies are likely to suffer. If so, who will force the carbon emitters to cut their carbon output? Who will be the agents of change in the corporate sector?

In recent years, the proponents of a corporate focused strategy have started to look to “universal owners”—the asset managers and owners that hold a significant swath of many public companies. As a group, they hold a significant percentage of the shares of public companies, often with substantial holdings in individual portfolio firms. Given their “universal” holdings, some commentators have argued that these universal owners should use their influence in portfolio companies to benefit their overall portfolios (and society), rather than focusing on the value of any particular company. According to some, universal owners should adopt “systemic stewardship” and push for market wide initiatives to reduce environmental externalities and control systemic risk (e.g., standardized climate risk disclosure). According to others, universal owners should pursue a more ambitious agenda and take affirmative steps to mitigate the risks of climate change to the long-term value of the portfolio by, for example, pushing carbon emitters to cut output, whether or not that promotes firm value. For example, consider the recent suggestion that BlackRock should pressure ExxonMobil and Chevron to reduce their carbon emissions substantially because the decline in the share value of these companies would be more than offset by an increase in the value of other BlackRock portfolio holdings.

But shareholders, even universal owners, do not manage companies. Rather, the business and affairs of a corporation are managed by full time senior management teams under the general oversight of a board of directors, within a framework created by corporate law. In this article, we analyze the extent to which universal owners can and should be expected to sacrifice single firm value even when doing so increases the value of the overall portfolio. We are quite pessimistic about the potential of systemic stewardship that entails substantial tradeoffs among portfolio companies.

This is for three principal reasons. First, universal owners would have to take into account the possibility that inducing some firms to reduce environmental externalities and mitigate risk will generate a competitive response that will eliminate a substantial portion of the benefits from these actions for their other portfolio companies. If BlackRock were to pressure ExxonMobil and Chevron to reduce their output substantially, would it be profitable on a portfolio basis? A huge share of the world’s petroleum reserves is controlled by exploration and production companies beyond the reach of universal owners’ influence including companies that are state-owned or held by less diversified investors (e.g., Saudi Aramco, Russia’s Rosneft and Gazprom, Kuwait Petroleum Corporation, Petróleos de Venezuela S.A., the Nigerian National Petroleum Corporation and China’s Sinopec). Even within the U.S., about 9,000 independent oil producers develop 91 percent of the wells and account for 83 percent of U.S. oil and 90 percent of U.S. natural gas production. If ExxonMobil and Chevron decided to cut production, some significant supply response by state-owned or independent oil producers is likely—the only question is the size of the response. If that were to happen, universal owners would be stuck with the losses while receiving only a portion of the gains. This is a substantial risk that greatly complicates the task of deciding whether a production cut would in the interest of a universal owner.

Second, corporate law, as it currently stands, has a strong “single firm focus” (“SFF”) that stands in sharp contrast to the potential “multi-firm focus” (“MFF”) of large portfolio investors. Directors owe fiduciary duties to their corporation for the benefit of that corporation’s shareholders. Were universal owners to work individually or together to protect their overall portfolios from systemic risk by imposing a “tradeoff” strategy that inflicted significant costs on carbon-emitting portfolio companies, it would clash with fundamental principles of corporate law and could create significant risks of liability. Although boards of directors have substantial discretion under the business judgment rule to reduce emissions when they believe in good faith that doing so is in the long-term interests of the corporation, this discretion falls far short of justifying the sort of significant tradeoffs that are necessary to mitigate climate change.

Third, universal owners typically manage a wide variety of different portfolios for different clients each of whom is owed fiduciary duties. A “tradeoff” strategy that would benefit some portfolios at the expense of other portfolios would conflict with these fiduciary duties as well as with the core multi-client multi-portfolio business model. Assume, for example, that BlackRock concluded that pressuring ExxonMobil and Chevron to reduce their carbon emissions would indeed increase the value of its other portfolio holdings by more than it would reduce the value of its stakes in ExxonMobil and Chevron and decided to give it a try. While such a “low carbon” strategy might be optimal for the investors in a broad-based index fund, it would not be optimal for investors in an energy ETF or in an active fund heavily invested in ExxonMobil and Chevron. How would BlackRock explain to these investors why it supported a strategy that sacrificed ExxonMobil and Chevron for the benefit of their index fund investors? Indeed, a business model that prioritized the interests of index fund investors over other funds would likely doom those other funds, as competitors would offer competing products that pledged loyalty to fund investors. This sort of tradeoff strategy would also conflict directly with Trust law’s (and ERISA’s) “sole interest” rule according to which a trustee must “administer the trust solely in the interest of the beneficiaries.”

As a result, we are skeptical about the prospects of universal owner systemic stewardship. To the extent that they act, we expect that they will act unilaterally and under the cloak of promoting single firm value. But because controlling systemic risks of all sorts involves serious tradeoffs that cannot be ignored while pretending to further single firm value, we do not expect systemic stewardship by universal owners to have much impact.

The complete paper is available for download here.

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