Why companies must get to grips with the changing needs of their investors
Shareholders used to push firms to outperform peers, but the rise of passive investing means the focus is now on systemic risks
Damages caused by five of the world’s most polluting companies will knock $4.1bn off the value of the Norwegian wealth fund.
That’s according to recent research from the Institute for Energy Economics and Financial Analysis (IEEFA), whose analysts have developed a way to factor environmental and social externalities into how investors calculate the worth of companies.
IEEFA’s report centres on Norway’s $1.6trn Government Pension Fund Global (GPFG), one of the largest asset owners in the world with stakes in more than 9,000 companies.
It assigns a ‘social cost’ to every ton of carbon emitted by BHP, Exxon, Rio Tinto, Shell and BP, and calculates the impact of those externalised costs on the performance of GPFG’s broader portfolio.
The conclusion: that in 2023 alone, those five firms created a combined drag on the fund’s performance of -0.27%.
“Externalised costs are a problem for all universal owners,” says Alasdair Docherty, who authored the IEEFA report.
Mainly used to refer to major pension funds and insurers, ‘universal owners’ are investors with exposure to more-or-less the entire global economy. This means that if the business activities of an investee company incur costs for other parts of the economy – by sapping natural resources or creating climate instability, for example – their other investments may end up footing the bill.
“Eventually, they are going to have to calculate whether the financial upside left in a stock outweighs the damage the company is doing to the returns of their wider portfolio,” continues Docherty.
It is a calculation that is starting to happen among some more progressive European pension funds, but it’s not easy: simply cutting off finance to harmful companies doesn’t stop the harm or the impact it has on the remaining portfolio.
Instead, what is changing is the demands that investors feel they are entitled to make of companies and their boards and management.
A new type of investor base
And it’s not just universal owners whose demands are changing. The rise of indexing over recent decades has seen many investors move away from picking their favourite companies within a sector or region, towards holding a slice of the entire market.
“The rise in passive investing has been a game-changer,” explains Tom Powdrill, director of UK-based consultancy Social Governance Solutions.
“You’ve now got all these highly-diversified investors who basically hold every big company, and that changes their perspective on how each one should behave.”
Powdrill gives the example of an investor that owns a single company in a sector.
“In that instance, as an active manager, I’m incentivised to want that company to pay whatever it takes to get the best talent in the industry to run it, because I want it to outperform its peers,” he says, adding that this would be likely to translate into votes in favour of hefty executive remuneration packages.
“But if I hold every company in that sector, then my interests are completely different: there’s suddenly no point in that same company forking out loads of money to poach talent from another company I hold.
“And you can’t simply pay everyone more, because that increases costs across the portfolio. There’s no competitive advantage to that in reality – it just hurts me as a shareholder.”
So the same executive pay dilemma at the same company can result in a completely different voting decision in a passive world.
Diverging duties
Writing earlier this year in the publication Directors & Boards, Piers Hugh Smith described the growing prevalence of these highly-diffuse passive investors as an “important shift that will dramatically affect the conduct of the corporation’s shareholders”.
The head of global stewardship at US investment giant Franklin Templeton said the trend had created a “new tension between the role of the director and the role of the investor” as the latter relies increasingly on broad market stability as a source of financial returns.
This is one reason for the slew of sustainability-related shareholder proposals at listed companies’ annual meetings in recent years; some of which have frustrated boards, who see them as financially nonsensical.
Much of the tension has centred on decarbonisation, but Hugh Smith and his co-author cite pay as another example: research suggests inequality can be destabilising for an economy, making it a risk for diffuse shareholders. To help manage that risk, they may ask a company to pay its lowest earners the living wage, despite the fact that could impact its profitability.
This tug of war between investors – dutybound to safeguard their clients’ assets – and company management and boards – legally obliged to prioritise the success of the individual corporation – is changing the nature of interactions between the two parties.
While their interests have historically been entirely in-step, they are now diverging.
But safeguarding clients’ assets is still sometimes aligned with maximising company value, points out IEEFA’s Docherty.
Although shrinking in number and size, there remain those with more concentrated portfolios, adding another layer of complexity to the dynamic.
“You might be an investor with all your money in an energy ETF,” he suggests. “And your manager is pushing energy companies to change their business model to protect its wider investments from climate risk. That’s potentially a problem for you, if it means they could forgo opportunities to make you money.”
But, with passive funds overtaking active for the first time ever last year, companies must get to grips with the fact that, for most of their investor base, safeguarding assets now means balancing the growth of firm-level profits with the reduction of system-level risks.
And, however financially nonsensical they may seem on the surface, shareholders expect boards and management to respond to those needs when making decisions about how they run their companies.