This article was originally published on Climate & Capital Media. Read it here.
A year ago, an unknown San Francisco hedge fund with an odd-sounding name hit paydirt. To the delight of the shareholder activist crowd, Engine No. 1 dramatically succeeded where others had fallen short: Humble the mighty ExxonMobil, the 20th-century oil and gas baron. In the 2021 proxy season, a majority of its shareholders supported dissident proxy resolutions to elect three directors nominated by Engine No. 1.
In the heaven of green, birds sang and a claxon rang
It was a stunningly well-orchestrated proxy campaign and public relations coup by the finest from Wall Street and Madison Avenue, backed by a cadre of sophisticated asset owners and managers, particularly CALSTRS, the second-largest U.S. retirement fund and the Church Commissioners for England. A year later, Time magazine beatified Engine No. 1 as one of the 100 most admired companies of 2021. GreenBiz knighted its CEO, Jennifer Grancio, the former COO of BlackRock’s vast iShares ETF business, as one of eight badass women shaping the future of finance and ESG.
The conquering heroes from San Francisco are seen as the de facto face of edgy stakeholder climate activism and impact investing. Engine No. 1 seeks to take climate stewardship to the next level of transparency while offering the usual mix of active and passive index investment management.
However, as a new proxy season begins, Engine No. 1’s campaign against ExxonMobil and its business model remain a riddle. Was its burst of activism a cynical attempt to greenmail ExxonMobil? And did it exploit booming media interest in environmental, social and governance issues to launch itself as a company with invaluable PR?
Or was it a watershed moment for stakeholder capitalism — a bold example of "beyond investment as usual" that challenges the foundational cornerstones of asset management: portfolio construction, security selection and modern long-term investing?
Engine No. 1 finds itself in the middle of a fast-moving debate on the roles and responsibilities of modern money managers in a world in crisis.
The answer is neither. As an emerging asset management startup, Engine No. 1 remains a high-profile work in progress. It enters a $100 trillion global money managing industry where emerging social, geopolitical, environmental and health trends are causing a profound rethink by the world’s largest holders of capital on how to best grow and manage that capital in a sustainable way in the decades to come.
And like it or not, Engine No. 1, perhaps because it has received such a disproportionate amount of publicity, finds itself in the middle of a fast-moving debate on the roles and responsibilities of modern money managers in a world in crisis. This is despite the small amount of money Engine No. 1 manages.
Modern Portfolio Theory under fire
At the center of the debate is how to understand and manage the risk of the rapidly escalating impact of climate change and ESG factors on investor portfolios.
While it may be hard to believe today, these exogenous factors were not considered — climate change did not even exist as an issue — in Nobel Prize-winning Harry Moskowitz’s Modern Portfolio Theory when it was first published 70 years ago in the Journal of Finance.
This matters because Modern Portfolio Theory is the near-universal investing orthodoxy for the world’s largest institutional investors. Little known beyond the world of academics and professional investors, Modern Portfolio Theory (MPT) has guided generations of investment decisions by the world’s largest stewards of capital — the giant institutional pension, insurance and sovereign wealth funds.
Moskowitz’s great contribution to wealth management was his insight on the nature and importance of portfolio diversification to maximize investment return and minimize investment risk.
However, a growing chorus of beta activists argue that there are dangerous flaws in Moskowitz’s theory. In MPT, the benefits of diversification apply only to specific, idiosyncratic risk factors in single companies or particular assets in an investment portfolio.
However, missing from the equation is risk arising from broader systematic risks. Systematic risk is market risk in investments in general. It’s non-diversifiable and contributes to systemic risk, the risk to or arising from environmental, social or financial systems. It’s high-order stuff like climate risk or financial contagion. It affects everyone in the economy. You cannot run. You cannot hide.
As beta activists, Engine No. 1 went beyond a traditional proxy fight and joined the growing movement among institutional investors who believe there is far more risk than assumed in MPT.
Think of the Great Depression of the 1930s or the Great Financial Crisis of 2007-2009 that almost brought down the world’s banking system. The rules and regulations after those crises — the U.S. SEC was created in 1934 — were made to buffer the world’s economic and financial systems from the kinds of global systemic and systematic risks that you cannot diversify away from.
Missing from MPT action: 75 percent of all portfolio risk
In their seminal and brilliant book "Moving Beyond Modern Portfolio Theory: Investing That Matters," Jon Lukomnik and James Hawley argue that the specific risk in a single company or particular asset has become much less critical than previously thought. They say 75 percent of all risk to an investment portfolio return arises from broader systematic risks that are not incorporated into MPT. "In effect, MPT tells us that you can affect what matters least," says Lukomnik.
Lukomnik and Hawley ambitiously and convincingly synthesize current thinking around what is called "systems investing." Their work and others such as The Shareholder Commons and The Investment Integration Project are arguing the investor should focus on a beta over alpha approach.
The new beta activist
This is why Engine No. 1’s fight with ExxonMobil is so instructive. As beta activists, Engine No. 1 went beyond a traditional proxy fight and joined the growing movement among institutional investors who believe there is far more risk than assumed in MPT.
Beta activists target systematic risks at companies but more critically at clusters of companies and sectors in transition, in a quest for better outcomes for all companies and stakeholders. Beta activism is about influencing the performance of the overall investment market. It lasers in on the externalized costs — think carbon pollution or the effects of smoking tobacco — which companies foist upon us all. Finally, it also intentionally targets the feedback loops and the impact of our investments on companies and the real economy.
Beta activism pulls all this together and, by doing so, challenges the unthinkable: the holy book of MPT.
Wall Street’s new masters of the universe
The world’s largest asset owners are driving this profound shift in investment thinking. They are diversified Universal Owners exposed to the whole economy — its good and bad fortunes. These investors unequivocally support stakeholder capitalism. They ask companies to move beyond business as usual and support a new beyond investment as usual.
What makes these owners so different is the sheer size of their portfolios and that they own the "whole market" — or about $61 trillion in institutional assets worldwide. That is, they are most interested in the overall outcomes. They care about broader beta because they are more interested in systematic risks than in one-off company risk. Not by choice, but by definition, they become "good citizens," urging actions that do no harm and benefit all stakeholders.
The ExxonMobil proxy fight was not the first. Still, it was undoubtedly the highest-profile example of how a new generation of investors is incorporating the following order of external risks — also known as "systems investing" — into consideration when managing investment portfolios.
The rise of Engine No. 1
Engine No. 1 is simply a very shiny example of beta activism at work. The firm is the brainchild of veteran Silicon Valley investors Chris James and Charlie Penner, who, with Gancio, did what no environmental activists had succeeded at doing: Rock the inner sanctum of ExxonMobil’s boardroom. And they did so by playing Wall Street hardball.
Armed with Wall Street’s coin of the trade — an 80-page PowerPoint investor deck, fresh capital and years of experience in activism (Penner), hedge funds (James) and institutional investing (Grancio) — the company strategically decided to take on target-rich ExxonMobil, and by doing so, turbocharged the once almost apostolic world of earnest investment stewardship.
Chugging into uncharted investment and stewardship territory, Engine No. 1 test drove a new model of engaged ownership and investment that spoke the language of Wall Street, not the vicarage, but with a heavy green accent.
ExxonMobil was a target not to end fossil fuels or save the world but because it lacked a "successful and transformative energy experience on the Board." Most damaging for long-term investors was that the ExxonMobil board had failed to "position the company for long-term value creation in a changing industry and world, and to create value in a decarbonizing world."
Engine No. 1 is simply a very shiny example of beta activism at work.
To the surprise and shock of almost everyone, particularly ExxonMobil, the beta activist campaign worked. The upstart won three seats on the board. It won, in part, by using the same brass-knuckled tactics of the marauding corporate raiders of the 1980s, only this time to add a new green agenda.
Back then, a "green" — as in money — premium was paid by a company to the raider for its shares, coupled with an agreement to go away. This was derisively known as "greenmail," a strategy used by infamous 1980s hedge fund investors such as T. Boone Pickens and Carl Icahn. Others would follow, storming America’s corporate citadels to squeeze return and capitalist efficiency out of sleepy American icons.
Engine No. 1, however, is not greenmailing. They and other Exxon activists are not going away. They are expressing a new form of green investing — call it climate green — that believes future investor returns depend less on jawboning a company to restructure itself internally and more on pressuring companies to understand and capitalize on external green ESG factors, factors that, like climate change, the Ukraine war or energy shocks, grow more serious by the day.
New-age hero with green knuckles or traditional activist?
That stinging "money talks, B.S. walks" investment critique, along with using activist tactics rarely seen before in sustainability investment stewardship, weaponized stakeholder activism — and got the new company the kind of priceless PR coverage most startups could only dream of achieving.
"It was ESG activism, but it was also traditional activist activity," said Engine No. 1 legal counsel Elle Klein, a 2022 Dealmaker of the Year. "Engine No. 1 engaged with Exxon because it was a company that was underperforming. But it also had a very important overlay of ESG issues."
So what really is Engine No. 1?
Despite its big victory over ExxonMobil, what remains unresolved is just what kind of green stakeholder Engine No. 1 wants to be. They are not a few pink-capped climate activists who stormed BlackRock’s New York headquarters at Park Avenue Plaza a few years ago.
Nor are they just new-age greenmailers with a conscience. They use activist tactics such as board director campaigns, but those are coupled with climate stewardship best practices. They are also hearty capitalists, building a modern investment platform with passive and active ETFs, VOTE and NETZ, and a thematic "Perennial Value" hedge fund.
The founders claim to be forging a new model of active ownership. The firm’s $750 million assets under management are small compared to its impact. It hearkens back to an earlier era of investing when small leveraged buy-out shops such as Henry Kravis and George Roberts’ KKR had a disproportionate impact on business as usual relative to the number of assets they managed.
So it is far too early to know if there is fizzle or sizzle in Engine No. 1’s approach. Take its business model. There is little insight into the finer details of their "new way of seeing value" or smart data, magic green investment model. They claim they will deliver long-term value in the context of significant opportunities in ESG engagement and climate solutions. But so does every ESG shop on Wall Street.
Riding long SRI coattails and investor climate collaborations
Far more interesting is a review of whence they came and what they are leveraging, not individual company-focused beta activism.
The firm is surfing the mainstreaming of the original Socially Responsible Investing (SRI) wave, pioneered by a generation of dogged and diverse activist seers and doers. But it all started way before that, in the 1700s, just as America was emerging as a nation and John Wesley first preached "no harm."
In that vein, starting in the 1960s, early SRI leaders targeted specific environmental and social issues, or in finance parlance, idiosyncratic risks, such as those from asbestos, smog, aerosols or guns, at single companies or small clusters of them. Specialty SRI investment managers sprung up, investor networks were organized and sustainable investing started to the mainstream after the SEC issued its first climate guidance in 2010.
In 2015, the SRI movement, now rebranded ESG, began to pick up steam on Wall Street. The Big Three asset managers, BlackRock, Vanguard and State Street, started to build "governance and sustainability" stewardship teams and crank out blueprints and whitepapers and, in the case of BlackRock, investor letters from CEO Larry Fink.
Engine No. 1 seeks 'to flip the institutionalized inertia of siding with management on ESG issues by setting a policy that supports a vast majority of climate and ESG proposals on the proxy ballot.'
In 2017 the American pension fund CalPERS played a first spark role in convening an even more ambitious global engagement effort for the global cause of industrial greenhouse gas emissions reduction. The following year, a new investor initiative, Climate Action 100+, was formed and sought to move beyond idiosyncratic events to take on significant industrial sources of public company emissions. It was a coordinated campaign to address the higher-level systematic investment risks posed by unabated fossil fuel combustion business models.
Seen by many as the most successful investor collaboration organization globally, Climate Action 100+ boasts 700 investors, with $68 trillion in assets, targeting 166 companies, representing 80 percent of global industrial emissions. It remains a work in progress, but like many net zero initiatives, its raw number of investors and direction of travel are impressive.
A true green engine?
If Climate Action 100+ is the new climate light green, Engine No. 1 is possibly a new darker green.
GreenBiz’s own Grant Harrison, in his article "Can Engine No. 1 help Wall Street overcome finance inactivism?", offers that Engine No. 1 seeks "to flip the institutionalized inertia of siding with management on ESG issues by setting a policy that supports a vast majority of climate and ESG proposals on the proxy ballot."
Unlike the Big Three asset managers, Engine No. 1 discloses its proxy votes in real-time and issues timely case studies on its voting priorities and rationales. Further, it engages specific companies on director votes, company climate transition plans, greenhouse gas target-setting, human capital management and more.
Finally, it has done what no large asset managers have tried — to force a change in direction by directly challenging a company’s leadership.
The rise of owner alliances
And while jaunty little Engine No. 1 has recently hogged the climate activism limelight, the real engines of change are not hedge funds or Private Equity. Influential, self-proclaimed gold-standard organizations such as the U.N.-Convened Net Zero Asset Owners Alliance (NZ-AOA) have emerged over the past decade, taking a more global and industry approach to stakeholder engagement.
Albeit with fewer bold headlines than Engine No. 1, these alphabet alliances are leading the charge on systematic/systemic risk, beta activism and climate stewardship, demanding that all investors, in particular universal owners, work together, intentionally, collaboratively and urgently, to repurpose capitalism to address the three great issues of our time: climate change; inequality; and threats to democracy, as outlined in "Reimagining Capitalism in a World on Fire."
No one does this better today than the Net-Zero Asset Owner Alliance. With its $10-plus trillion in assets, the Owner Alliance and supporting chorus climatus of global investor NGOs flash neon green, turning down target portfolio temperatures and increasing the accountability heat on its asset managers as global warming intensifies.
Albeit with fewer bold headlines than Engine No. 1, these alphabet alliances are leading the charge on systematic/systemic risk, beta activism and climate stewardship.
Since 2019 they have called, with increasing specificity, for net zero GHG emissions by 2050 and investment portfolios aligned with a maximum temperature rise of 1.5 degrees Celsius above pre-industrial levels. Many agree with this directionality, even if they believe that 1.5 C is already out of reach.
The latest blast from the Alliance, "The Future of Investor Engagement: A call for systematic stewardship to address systemic climate risk," released last month, is a clarion call for asset owners and their managers to "change the rules of the game" that have guided institutional investing for 70 years.
How all this translates into investor action remains to be seen. But the 2022 proxy season is already shaping up into what should be a season of escalating investor and company drama.
Oddly, Engine No. 1 is taking a decidedly low-key approach in this year’s proxy fights.
Instead, taking on ExxonMobil is the Dutch NGO activist Follow This. It has filed a proxy resolution that requests Paris-consistent emissions reductions targets. It seeks to stoke a shareholder rebellion against ExxonMobil for its "refusal to set Scope 3 targets," which majorities supported at Chevron, ConocoPhillips and Phillips66 in 2021. Exxon, it says, "specifically rejects accountability for the emissions of its products by calling Scope 3 accounting methods ‘duplicative and flawed.’"
So why isn’t Engine No. 1 following through on all its fire and brimstone of last year? Cynics may argue that they are just good old Wall Street opportunists dressed in green sheep’s clothing. The value of their stake in Exxon has surged as the stubborn oil Goliath recently predicted record first-quarter profits.
Possible, but doubtful. Urged on by long-term thinking institutional investors, it is more likely that Engine No. 1 is just the first of a new era of beta-focused investment managers identifying, engaging and attacking a big bad bundle of systematic risks to accelerate action, preserve the hard-earned savings of millions of pensioners and continue to define what is beyond investment as usual.