Can Engine No.1 lead Wall Street to ‘beyond investment as usual’?

This textual content was initially printed on Native climate & Capital Media. Study it proper right here.

A yr up to now, an unknown San Francisco hedge fund with an odd-sounding establish hit paydirt. To the delight of the shareholder activist crowd, Engine No. 1 dramatically succeeded the place others had fallen fast: Humble the mighty ExxonMobil, the Twentieth-century oil and gasoline baron. Inside the 2021 proxy season, a majority of its shareholders supported dissident proxy resolutions to elect three directors nominated by Engine No. 1. 

Inside the heaven of inexperienced, birds sang and a claxon rang

It was a stunningly well-orchestrated proxy advertising and marketing marketing campaign and public relations coup by the very best from Wall Highway 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 yr later, Time journal beatified Engine No. 1 as certainly one of many 100 most admired firms of 2021. GreenBiz knighted its CEO, Jennifer Grancio, the earlier COO of BlackRock’s enormous iShares ETF enterprise, as one amongst eight badass women shaping the way in which ahead for finance and ESG.

The conquering heroes from San Francisco are seen as a result of the de facto face of edgy stakeholder native climate activism and impression investing. Engine No. 1 seeks to take native climate stewardship to the next diploma of transparency whereas offering the identical outdated combination of energetic and passive index funding administration.

Nonetheless, as a model new proxy season begins, Engine No. 1’s advertising and marketing marketing campaign in opposition to ExxonMobil and its enterprise model keep 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 factors to launch itself as a company with invaluable PR?

Or was it a watershed second for stakeholder capitalism — a daring occasion of “previous funding as customary” that challenges the foundational cornerstones of asset administration: portfolio growth, security alternative and trendy long-term investing?

Engine No. 1 finds itself within the midst of a fast-moving debate on the roles and duties of latest money managers in a world in catastrophe.

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 money managing commerce the place rising social, geopolitical, environmental and properly being tendencies are inflicting a profound rethink by the world’s largest holders of capital on the precise strategy to most interesting develop and deal with that capital  in a sustainable method inside the a few years to return. 

And like it or not, Engine No. 1, possibly on account of it has obtained such a disproportionate amount of publicity, finds itself within the midst of a fast-moving debate on the roles and duties of latest money managers in a world in catastrophe. That’s whatever the small amount of money Engine No. 1 manages.

Fashionable Portfolio Idea beneath fireplace

On the center of the discuss is the precise strategy to understand and deal with the possibility of the rapidly escalating impression of native climate change and ESG elements on investor portfolios.

Whereas it could possibly be exhausting to think about proper now, these exogenous elements weren’t considered — native climate change didn’t even exist as a problem — in Nobel Prize-winning Harry Moskowitz’s Fashionable Portfolio Idea when it was first printed 70 years up to now inside the Journal of Finance

This points on account of Fashionable Portfolio Idea is the near-universal investing orthodoxy for the world’s largest institutional consumers. Little acknowledged previous the world of lecturers {{and professional}} consumers, Fashionable Portfolio Idea (MPT) has guided generations of funding alternatives by the world’s largest stewards of capital — the big institutional pension, insurance coverage protection and sovereign wealth funds. 

Moskowitz’s good contribution to wealth administration was his notion on the character and significance of portfolio diversification to maximise funding return and scale back funding hazard. 

The rise of systematic hazard and beta activism

Nonetheless, a rising chorus of beta activists argue that there are dangerous flaws in Moskowitz’s precept. In MPT, the benefits of diversification apply solely to explicit, idiosyncratic hazard elements in single firms or express belongings in an funding portfolio. 

Nonetheless, missing from the equation is hazard arising from broader systematic risks. Systematic hazard is market hazard in investments often. It’s non-diversifiable and contributes to systemic hazard, the possibility to or arising from environmental, social or financial applications. It’s high-order stuff like native climate hazard or financial contagion. It impacts everyone inside the monetary system. You cannot run. You cannot cowl.

As beta activists, Engine No. 1 went previous a normal proxy battle and joined the rising movement amongst institutional consumers who think about there’s far more hazard than assumed in MPT.

Take into account the Good Despair of the Thirties or the Good Financial Catastrophe of 2007-2009 that virtually launched down the world’s banking system. The rules and guidelines after these crises — the U.S. SEC was created in 1934 — had been made to buffer the world’s monetary and financial applications from the sorts of world systemic and systematic risks that you just can’t diversify away from.

Missing from MPT movement: 75 p.c of all portfolio hazard

Of their seminal and smart e-book “Transferring Previous Fashionable Portfolio Idea: Investing That Points,” Jon Lukomnik and James Hawley argue that the exact hazard in a single agency or express asset has develop into quite a bit a lot much less very important than beforehand thought. They’re saying 75 p.c of all hazard to an funding portfolio return arises from broader systematic risks that aren’t built-in into MPT. “In impression, MPT tells us you might affect what points least,” says Lukomnik. 

Lukomnik and Hawley ambitiously and convincingly synthesize current contemplating spherical what is known as “applications investing.” Their work and others resembling The Shareholder Commons and The Funding Integration Endeavor are arguing the investor ought to focus on a beta over alpha methodology. 

The model new beta activist

That is the rationale Engine No. 1’s battle with ExxonMobil is so instructive. As beta activists, Engine No. 1 went previous a normal proxy battle and joined the rising movement amongst institutional consumers who think about there’s far more hazard than assumed in MPT. 

Beta activists aim systematic risks at firms nonetheless further critically at clusters of firms and sectors in transition, in a quest for larger outcomes for all firms and stakeholders. Beta activism is about influencing the effectivity of the overall funding market. It lasers in on the externalized costs — suppose carbon air air pollution or the results of smoking tobacco — which firms foist upon us all. Lastly, it moreover intentionally targets the options loops and the impression of our investments on firms and the true monetary system.

Beta activism pulls all this collectively and, by doing so, challenges the unthinkable: the holy e-book of MPT. 

Wall Highway’s new masters of the universe

The world’s largest asset homeowners are driving this profound shift in funding contemplating. They’re diversified Widespread Householders uncovered to your complete monetary system — its good and harmful fortunes. These consumers unequivocally help stakeholder capitalism. They ask firms to maneuver previous enterprise as customary and help a model new previous funding as customary.

What makes these homeowners so completely completely different is the sheer measurement of their portfolios and that they private the “complete market” — or about $61 trillion in institutional belongings worldwide. That’s, they’re most inside the normal outcomes. They care about broader beta on account of they’re further involved with systematic risks than in one-off agency hazard. Not by various, nonetheless by definition, they develop into “good residents,” urging actions that do no harm and revenue all stakeholders.

The ExxonMobil proxy battle was not the first. Nonetheless, it was undoubtedly the highest-profile occasion of how a model new expertise of consumers is incorporating the following order of exterior risks — additionally known as “applications investing” — into consideration when managing funding portfolios. 

The rise of Engine No. 1

Engine No. 1 is solely a very shiny occasion of beta activism at work. The company is the brainchild of veteran Silicon Valley consumers Chris James and Charlie Penner, who, with Gancio, did what no environmental activists had succeeded at doing: Rock the inside sanctum of ExxonMobil’s boardroom. And they also did so by collaborating in Wall Highway hardball. 

Armed with Wall Highway’s coin of the commerce — an 80-page PowerPoint investor deck, modern capital and years of experience in activism (Penner), hedge funds (James) and institutional investing (Grancio) — the company strategically decided to sort out target-rich ExxonMobil, and by doing so, turbocharged the as quickly as practically apostolic world of earnest funding stewardship.

Chugging into uncharted funding and stewardship territory, Engine No. 1 check out drove a model new model of engaged possession and funding that spoke the language of Wall Highway, not the vicarage, nonetheless with a heavy inexperienced accent. 

ExxonMobil was a aim to not end fossil fuels or save the world nonetheless on account of it lacked a “worthwhile and transformative vitality experience on the Board.” Most damaging for long-term consumers was that the ExxonMobil board had didn’t “place the company for long-term price creation in a altering commerce and world, and to create price in a decarbonizing world.” 

Engine No. 1 is solely a very shiny occasion of beta activism at work.

To the shock and shock of just about everyone, notably ExxonMobil, the beta activist advertising and marketing marketing campaign labored. The upstart gained three seats on the board. It gained, partially, by using the similar brass-knuckled methods of the marauding firm raiders of the Eighties, solely this time in order so as to add a model new inexperienced agenda. 

Once more then, a “inexperienced” — as in money — premium was paid by a company to the raider for its shares, coupled with an settlement to go away. This was derisively commonly known as “greenmail,” a method utilized by infamous Eighties hedge fund consumers resembling  T. Boone Pickens and Carl Icahn. Others would observe, storming America’s firm citadels to squeeze return and capitalist effectivity out of sleepy American icons.

Engine No. 1, nonetheless, is simply not greenmailing. They and completely different Exxon activists shouldn’t going away. They’re expressing a model new sort of inexperienced investing — identify it native climate inexperienced — that believes future investor returns rely a lot much less on jawboning a company to restructure itself internally and additional on pressuring firms to know and capitalize on exterior inexperienced ESG elements, elements that, like native climate change, the Ukraine battle or vitality shocks, develop further vital by the day. 

New-age hero with inexperienced knuckles or typical activist?

That stinging “money talks, B.S. walks” funding critique, along with using activist methods rarely seen sooner than in sustainability funding stewardship, weaponized stakeholder activism — and obtained the model new agency the type of priceless PR safety most startups could solely dream of reaching.

“It was ESG activism, nonetheless it was moreover typical activist train,” talked about Engine No. 1 approved counsel Elle Klein, a 2022 Dealmaker of the Yr. “Engine No. 1 engaged with Exxon on account of it was a company that was underperforming. Nevertheless it moreover had an essential overlay of ESG factors.”

So what really is Engine No. 1?

No matter its huge victory over ExxonMobil, what stays unresolved is just what kind of inexperienced stakeholder Engine No. 1 must be. They aren’t a few pink-capped native climate activists who stormed BlackRock’s New York headquarters at Park Avenue Plaza a few years up to now. 

Nor are they solely new-age greenmailers with a conscience. They use activist methods resembling board director campaigns, nonetheless these are coupled with native climate stewardship most interesting practices. They’re moreover hearty capitalists, establishing a up to date funding platform with passive and energetic ETFs, VOTE and NETZ, and a thematic “Perennial Value” hedge fund.

The founders declare to be forging a new model of energetic possession. The company’s $750 million belongings beneath administration are small compared with its impression. It hearkens once more to an ancient times of investing when small leveraged buy-out retailers resembling Henry Kravis and George Roberts’ KKR had a disproportionate impression on enterprise as customary relative to the number of belongings they managed. 

So it’s far too early to know if there’s fizzle or sizzle in Engine No. 1’s methodology. Take its enterprise model. There could also be little notion into the finer particulars of their “new method of seeing price” or good data, magic inexperienced funding model. They declare they’ll ship long-term price inside the context of significant options in ESG engagement and native climate choices. Nevertheless so does every ESG retailer on Wall Highway. 

Utilizing prolonged SRI coattails and investor native climate collaborations

Far more fascinating is a overview of whence they bought right here and what they’re leveraging, not explicit particular person company-focused beta activism.

The company is shopping the mainstreaming of the distinctive Socially Accountable Investing (SRI) wave, pioneered by a expertise of dogged and quite a few activist seers and doers. Nevertheless it started method sooner than that, inside the 1700s, merely as America was rising as a nation and John Wesley first preached “no harm.” 

In that vein, starting inside the Sixties, early SRI leaders centered explicit environmental and social factors, or in finance parlance, idiosyncratic risks, resembling these from asbestos, smog, aerosols or weapons, at single firms or small clusters of them. Specialty SRI funding managers sprung up, investor networks had been organized and sustainable investing started to the mainstream after the SEC issued its first native climate guidance in 2010. 

In 2015, the SRI movement, now rebranded ESG, began to decide on up steam on Wall Highway. The Massive Three asset managers, BlackRock, Vanguard and State Highway, started to assemble “governance and sustainability” stewardship teams and crank out blueprints and whitepapers and, inside 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 factors by setting a protection that helps a overwhelming majority of native climate and ESG proposals on the proxy ballot.’

In 2017 the American pension fund CalPERS carried out a main spark perform in convening an far more formidable world engagement effort for the worldwide set off of enterprise greenhouse gasoline emissions low cost. The subsequent yr, a model new investor initiative, Native climate Movement 100+, was formed and sought to maneuver previous idiosyncratic events to sort out essential industrial sources of public agency emissions. It was a coordinated advertising and marketing marketing campaign to deal with the higher-level systematic funding risks posed by unabated fossil gasoline combustion enterprise fashions.

Seen by many as in all probability probably the most worthwhile investor collaboration group globally, Native climate Movement 100+ boasts 700 consumers, with $68 trillion in belongings, concentrating on 166 firms, representing 80 p.c of world industrial emissions. It stays a work in progress, nonetheless like many net zero initiatives, its raw number of consumers and path of journey are spectacular. 

An actual inexperienced engine?

If Native climate Movement 100+ is the model new native climate gentle inexperienced, Engine No. 1 might be a model new darker inexperienced.

GreenBiz’s private Grant Harrison, in his article “Can Engine No. 1 help Wall Highway overcome finance inactivism?“, supplies that Engine No. 1 seeks “to flip the institutionalized inertia of siding with administration on ESG factors by setting a protection that helps a overwhelming majority of native climate and ESG proposals on the proxy ballot.” 

Not just like the Massive Three asset managers, Engine No. 1 discloses its proxy votes in real-time and factors properly timed case analysis on its voting priorities and rationales. Extra, it engages explicit firms on director votes, agency native climate transition plans, greenhouse gasoline target-setting, human capital administration and additional.

Lastly, it has carried out what no huge asset managers have tried — to energy a change in path by instantly tough a company’s administration. 

The rise of proprietor alliances

And whereas jaunty little Engine No. 1 has not too way back hogged the native climate activism limelight, the true engines of change shouldn’t hedge funds or Private Equity. Influential, self-proclaimed gold-standard organizations such as a result of the U.N.-Convened Internet Zero Asset Householders Alliance (NZ-AOA) have emerged over the earlier decade, taking a further world and commerce methodology to stakeholder engagement.

Albeit with fewer daring headlines than Engine No. 1, these alphabet alliances are predominant the associated fee on systematic/systemic hazard, beta activism and native climate stewardship, demanding that each one consumers, significantly frequent homeowners, work collectively, intentionally, collaboratively and urgently, to repurpose capitalism to deal with the three good issues with our time: native climate change; inequality; and threats to democracy, as outlined in “Reimagining Capitalism in a World on Fireplace.”

No one does this larger proper now than the Internet-Zero Asset Proprietor Alliance. With its $10-plus trillion in belongings, the Proprietor Alliance and supporting chorus climatus of world investor NGOs flash neon inexperienced, turning down aim portfolio temperatures and rising the accountability heat on its asset managers as world warming intensifies.

Albeit with fewer daring headlines than Engine No. 1, these alphabet alliances are predominant the associated fee on systematic/systemic hazard, beta activism and native climate stewardship.

Since 2019 they’ve known as, with rising specificity, for internet zero GHG emissions by 2050 and funding portfolios aligned with a most temperature rise of 1.5 ranges Celsius above pre-industrial ranges. Many agree with this directionality, even once they think about that 1.5 C is already out of attain.

The latest blast from the Alliance, “The Manner ahead for Investor Engagement: A reputation for systematic stewardship to deal with systemic native climate hazard,” launched closing month, is a clarion identify for asset homeowners and their managers to “change the rules of the game” which have guided institutional investing for 70 years. 

Now what?

How all this interprets into investor movement stays to be seen. Nevertheless the 2022 proxy season is already shaping up into what must be a season of escalating investor and agency drama.

Oddly, Engine No. 1 is taking a decidedly low-key methodology on this yr’s proxy fights. 

In its place, taking on ExxonMobil is the Dutch NGO activist Observe This. It has filed a proxy resolution that requests Paris-consistent emissions reductions targets. It seeks to stoke a shareholder insurgent 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, “significantly rejects accountability for the emissions of its merchandise by calling Scope 3 accounting methods ‘duplicative and flawed.’”

So why isn’t Engine No. 1 following by on all its fireplace and brimstone of ultimate yr? Cynics would possibly argue that they’re merely good earlier Wall Highway opportunists carrying inexperienced sheep’s garments. The value of their stake in Exxon has surged as a result of the stubborn oil Goliath not too way back predicted doc first-quarter revenue.

Doable, nonetheless unsure. Urged on by long-term contemplating institutional consumers, it’s further seemingly that Engine No. 1 is just the first of a model new interval of beta-focused funding managers determining, partaking and attacking a large harmful bundle of systematic risks to hurry up movement, shield the hard-earned monetary financial savings of tons of of 1000’s of pensioners and proceed to stipulate what’s previous funding as customary.

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