Environmental, social, and governance (ESG) activism has been moving from the fringes of shareholder activism landscape into the mainstream in recent years, as the strategy promises strong returns for first movers.
According to Activist Insight Online, four of the nine dedicated activist hedge funds launched over the past five years in the U.S. have a strong ESG focus. This year alone, Jeffrey Ubben left his multi-billion-dollar ValueAct Capital Partners to launch ESG activist fund Inclusive Capital and Charlie Penner started Engine No. 1 after a stint at Jana Partners. Over in Europe, Gianluca Ferrari left activist firm Shareholder Value Management to start work on setting up Clearway Capital, arguably the first dedicated ESG activist fund in Europe.
“We believe that there is an increasingly large pool of capital that is keen to generate a positive impact on the world on top of a financial return and the scope of that includes pension funds, endowments funds and family offices,” Ferrari said in an interview with Activist Insight Online, referring to the potential investors for his fund.
Pension fund California State Teachers’ Retirement System (CalSTRS) has been one of the leading seeders and supporters of ESG activists, investing in funds that use ESG criteria like Impactive Capital Partners and backing Engine No 1’s campaign at Exxon Mobil.
Investor appetite for companies with good ESG metrics has been growing rapidly in recent years, partly driven by a generational shift, with millennials becoming richer and believed to be more conscientious with their investment money.
“Millennials are being catered to by major investment companies and that spills over into what Jeff Ubben and others are doing,” Tom Ball, a proxy solicitor at Alliance Advisors, told Activist Insight Online.
Sustainable funds’ assets nearly doubled between 2018 and the third quarter of 2020 to $1.25 trillion globally, with 82% of that in Europe, according to data from Morningstar. The trend accelerated this year. The global inflows into sustainable funds rose from a quarterly $20 billion in the first quarter of 2018 to $80 billion in the third quarter of 2020.
That is still a very small part of global assets under management, which according to the Investment Company Institute amount to over $55 trillion as of the end of 2019. The rapid growth, however, is creating once-in-a-lifetime opportunities for activists.
Good is in high demand
Companies with good ESG practices are experiencing growing demand for their shares, in many cases resulting in premium valuations. For activists, the opportunity is in targeting ESG laggards and pushing for improvements that close the sustainability gap between worst- and best-in-class companies, hoping for a bump in the share price in the process.
“When externalities start to affect the stock price, a change in strategy to ‘fix’ the E and S that is rewarded quickly in the stock price is a classic idiosyncratic return the activist investors will chase,” Ubben told Activist Insight Online for this article.
Ferrari says now is a good time to launch an ESG activist fund because the market could reward those companies that improve their ESG metrics much faster compared to five or 10 years ago. “Thanks to flows of capital towards ESG strategies, the value of long-term sustainability is starting to be reflected in short term stock prices,” Ferrari said, adding this “makes it easier for companies to move away from quarterly thinking and start thinking about what really matters in the longer term.”
“Passive ESG is easy to replicate and will lead to a low return” because ESG “darlings” already trade at high valuations, Ubben said. By contrast, investing in companies with low price-to-earnings ratios could result in a higher return by pursuing an ESG improvement strategy.
Indeed, Ubben invested in electric utility AES at the end of 2017 and later joined the board to help the company move away from coal. Between 2015 and 2021, AES reduced its coal capacity by two-thirds to 5.8 GigaWatts and doubled its renewables capacity to 17 GW. “The transformation has been stunning in reduced carbon intensity versus expectations,” Ubben said.
As AES shifted its business model, some conscientious investors started building stakes. Norway’s pension fund Norges Bank Investment, for instance, started buying shares in early 2019 and gradually increased its stake to 2.1%, as AES fit its investment criteria of owning energy companies where coal generation is less than 30%.
AES shares have appreciated more than 100% since Ubben invested, and its valuation has improved, although it is still below that of peer NextEra Energy, which is believed to be one of the leaders of the green movement.
Ubben noted E and S investments that are “core to the business” increase costs, but if “investors are going to capitalize the long-term return of this increased investment, companies will in fact move much faster, reallocating capital from things like share repurchases.”
New is better than old
One of the most glaring examples of underperformance driven by ignorance of ESG is Exxon Mobil. According to Activist Insight Vulnerability, Exxon’s five-year total shareholder return is negative 19% versus 15% for its peers, as the oil major doubled down on crude investments, at a time when many oil companies decreased them.
Exxon is now facing a proxy contest from Engine No. 1 and further criticism by shareholders ranging from D.E. Shaw Investment Group to CalSTRS and The Church of England. “We believe it is time for change at Exxon Mobil and are supporting this campaign as an extension of our stewardship activities. We intend to use our proxy votes to support the proposed slate, if nominated, at the next annual shareholders meeting,” a spokesperson for CalSTRS told Activist Insight Online.
Yet going green has not always translated into a re-rating of the stock. Earlier this year, British oil company BP committed to slash its greenhouse gas emissions to net zero by 2050 and gradually shift investments into green energy projects. However, BP’s stock price remains depressed, partly due to doubts over how it will finance the transition given its high debt levels.
Energy companies are arguably an extreme example of the opportunity set in the ESG sector and one with higher risks. Ferrari sees more openings at companies that do not have to change their entire business model to survive in an ESG economy.
“There is so much low-hanging fruit out there. We can find companies with strong business models and a low financial risk profile that are undervalued by the markets primarily because they are not taking sustainability as seriously as they should be,” Ferrari said, referring to European small- and mid-cap companies.
The activist sees opportunities in telecommunications, industrials, and infrastructure, but said he would avoid going into situations where the company’s core products are at risk of disappearing permanently, like coal.
Ubben himself has largely invested in small- and mid-cap companies in the U.S. consumer sector, including Lindblad Expeditions, Strategic Education, Unifi, and Nikola, although he said he took a small stake in BP when it launched its green initiative.