Why passive investors now want to talk

All responsible investors are expected to be active owners. This means companies are finding themselves on the receiving end of a new and previously unsuspected source of engagement activity: passive investors. With divestment off the table, responsible passive investors are using all the stewardship tools at their disposal to influence investee companies to change their behaviour. Companies should be proactive in engaging on evolving ESG topics with this cohort, before signs of escalation become apparent.

According to the PRI, responsible investment is “a strategy and practice to incorporate environmental, social and governance (ESG) factors in investment decisions and active ownership.” With more than 4,900 signatories representing an estimated assets under management of more than US$121 trillion, the weight and global reach of the PRI is remarkable. It follows that a surefire way to uncover responsible investors is to check out the PRI’s signatory directory. 

Signatories to the PRI publicly commit to adopt and implement six Principles for Responsible Investment, and in doing so, “contribute to developing a more sustainable global financial system.” Of note, passive investors don’t get a ‘pass’ on implementing Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices. PRI signatories are also required to report on their responsible investment activities each year. This reporting is scored and investors are expected to keep evolving their responsible investment efforts – and outcomes – each year to maintain or improve that scoring. 

A key component of responsible investment is active ownership, or stewardship. The PRI describes stewardship as “the use of influence by institutional investors to maximise overall long-term value. This includes the value of common economic, social and environmental assets, on which returns and clients’ and beneficiaries’ interests depend.” Put simply, stewardship activities aim to change the behaviour of investee companies through improved ESG practices, outcomes, or disclosure.

The terms ‘engagement’ and ‘stewardship’ are often used interchangeably, but stewardship is a broader umbrella term that houses several active ownership practices, of which engagement is one. Engagement – or active dialogue – can include meetings, calls, emails and letters between an investor and an issuer to discuss ESG issues and expectations. Whether done individually, in collaboration with other investors (e.g., Climate Action 100+), or through a service provider, the goal of engagement is to encourage an issuer to improve its ESG and sustainability practices and report on them. 

Companies may have noticed a shift in engagement points with investors (i.e., more formal, more structured, more follow-ups, or just plain ‘more’), which ties back to the PRI and signatories’ obligation to report on engagement activities each year as per Principle 2. Asset owners are also asking for engagement reports from their asset managers, so there is seemingly a push from all sides for investors to engage, and to do it well. 

Engagement is typically the first step in an investor’s active ownership plan; if unsuccessful after a certain period of time, investors will consider different escalation strategies to bring about the desired change in behaviour.

First is proxy voting. While many investors leverage the analysis and recommendations of proxy advisors such as ISS and Glass Lewis to support their voting activities, PRI signatories are expected to dedicate time and resources to make informed decisions in accordance with their voting policy, rather than automatically voting in line with a proxy advisor. As active owners, exercising voting rights is a mechanism for listed equity investors to formally express approval or disapproval on specific ESG issues, and thereby communicate – or reinforce – their views to a company. Engagement and voting practices are closely connected, so companies shouldn’t be caught off guard by voting actions if they’ve been paying attention to investor engagements activities throughout the year.  

If engagement activities, either alone or in collaboration with other investors, and proxy votes remain ineffective, shareholders may also decide to file a shareholder resolution. Indeed, they are entitled to introduce resolutions, or proposals, to put specific issues, including those of an ESG nature, to vote at the next annual general meeting. Depending on the country, votes for shareholder resolutions may be advisory and non-binding, or not. Regardless, a shareholder resolution doesn’t need to win a majority to succeed in influencing management to adopt some or all of the requested changes. In fact, sometimes the act of filing a proposal is sufficient to persuade management to implement changes, resulting in the proposal being withdrawn before it goes to the ballot. Conversely, a company may receive the same proposal over multiple years, with increasing support until it achieves a majority, and still resist the call to change its behaviour. 

When even shareholder proposals fail to move the needle, shareholders and other stakeholders are increasingly taking legal action to force companies – and their directors and senior officers – to fulfil their duties with respect to sustainability-related issues, with some success.

The stewardship activities covered so far have all shared one common goal – to change the behaviour of companies through improved ESG practices, outcomes and/or disclosure, to make for better managed companies. So, how does that compare to the goal of activist investors? Traditional activists target companies to seek any changes in strategy, disclosure, or capital allocation to unlock hidden short-term value. Activist investors are typically specialized hedge funds seeking above-average returns over a shorter time horizon than many institutional investors. When activists see untapped value based on how a company is run, the strategy it pursues, its capital allocation, ineffective management, etc. they often try to get Board representation to help achieve their goals.

Although activists have historically set their sights on mergers and acquisitions or dividends and share buybacks, the two worlds are converging, with some responsible investors adopting a more aggressive approach to have ESG and sustainability issues addressed. A notable example was Engine No. 1, a relative unknown on the hedge fund scene, leading a successful proxy fight in 2021 to replace three of Exxon Mobil’s 12 Board members with the goal of pushing the company to reduce its carbon footprint. With only ~0.02% of Exxon’s proxy votes, Engine No. 1 campaigned to win over Exxon’s three largest shareholders – BlackRock, Vanguard, and State Street – who collectively accounted for nearly 20% of the company’s voting shares. CalSTRS, a universal owner, also joined the campaign, explaining that all of its other avenues for effecting change had failed – they had previously voted against the entire Board, they had supported shareholder proposals that had passed but been ignored by the company, and collaborative engagements such as Climate Action 100+ had failed to yield the same types of commitments as from other companies in terms of reducing emissions.

When engagement, voting and resolutions haven’t worked, shareholders can ultimately decide to exit an investment; however, the PRI cautions that “divestment alone weakens an investor’s influence over the entity and may do little to improve outcomes in the real world.” Rather, the preferred choice by responsible investors is to stay and engage, in order to create long-term value for society and for the company. 

For passive investors, the decision of whether to buy or sell a company’s shares is out of their hands. For passive investors adopting responsible investment practices, engagement becomes virtually the only activity available to influence companies to better manage their ESG or sustainability-related issues. These investors are also collaborating with like-minded peers because they have seen that engagement becomes effective when practiced at scale. 

As a result, companies will increasingly see shareholder engagement on sustainability-related issues from a large investor segment that has historically been quiet. They should therefore consider how the nature and frequency of their shareholder engagement should change to serve those active owners that can’t walk away, and be prepared with clear messaging and disclosures about how they are managing their material ESG issues.