One way to look at sustainable finance is through the lenses of corporate governance. 100 large companies worldwide are responsible for 71% of Greenhouse Gas emissions (GHGs). About one third of these are publicly held companies. Therefore, the ability to influence the decision-making of publicly held companies may have a significant impact on climate change. Holding 41% of public equity worldwide, institutional investors can be decisive in establishing a sustainable corporate governance.
In a recent essay, I look at how the law – particularly EU securities law – can support sustainable corporate governance. Focusing on climate change mitigation, which is easier to measure than other dimensions of sustainability, I ask the following question: can legal rules support the effective choice of environmentally sustainable investments by the beneficiaries of institutional investors? As argued by Hart and Zingales (2017), if ultimate investors care about the environment and other prosocial goals, they will choose institutional shareholders that incorporate this preference and, in turn, persuade the management of publicly held companies to cut GHGs. In the spirit of Coase (1960), this decentralized approach to the control of negative externalities may work better than traditional public policies (taxes and regulation) if transaction costs are lower. However, this is counterintuitive: if citizens cannot get their government to control externalities effectively, why should investors fare any better? In my essay, I argue that securities law can significantly lower transaction costs in the relationship between institutional investors and their beneficiaries and is already doing so in the EU.
Institutional investors are an opportunity and a challenge for sustainable corporate governance. They are an opportunity because they concentrate the ownership of public companies. In the U.S. and the UK, the 20 largest investors own a majority of the capital of a typical listed company. In most of continental Europe, where dominant shareholders are more frequent, the 20 largest investors control, on average, at least 15% of the votes. Institutional investors can thus exercise a considerable influence on their portfolio companies. The challenge is that institutional investor may not exercise this influence in the way their beneficiaries want, if at all.
The problem is threefold. First, there is agency cost: beneficiaries have a hard time figuring out which institutional investors act according to their preferences. This problem is more acute in the pursuit of sustainability than of financial return. There is no standard definition of sustainability, which makes it difficult for beneficiaries to screen institutional investors.
The second problem is that institutional investors have different business models, which affect their incentives to pursue the sustainability of portfolio companies. Some institutions follow an active investment strategy, others passively track an index. Active investors have strong incentive to govern through exit, but a much weaker incentive to engage portfolio companies on sustainability. Passive investors have limited possibilities to exit unsustainable companies, but as they compete on cost saving, they cannot meaningfully engage thousands of companies.
The third problem is that beneficiaries might prefer short-term financial return to sustainability. Whether this undermines the case for sustainable corporate governance is a theoretical and an empirical question. Empirically, beneficiaries seem to care enough about the environment. In this and this study, the introduction of salient, standardized indicators of environmental sustainability significantly affected inflows and outflows of mutual funds. Theoretically, because the preference of beneficiaries for sustainability is likely to vary, the commitment of institutional investors to sustainability should vary too. This brings the question whether such a commitment is credible and recognizable by the beneficiaries, allowing the latter to choose.
Legal rules play a crucial role in supporting knowledgeable choice by retail investors. The EU has recently passed legislation that will enable a more informed choice of institutional investors based on their commitment to sustainability. Firstly, the Revised Shareholder Right Directive 2017/828 established, on a comply-or-explain basis, the transparency of voting policies and voting behaviour of EU-based institutional investors. This periodic disclosure must describe social and environmental impact. Institutional investors are unlikely to opt out of transparency on sustainability engagements, having to explain this to their clients. However, they might just pay lip service to sustainability. This brings me to another important piece of EU legislation: The Sustainable Finance Disclosure Regulation (SFDR) 2019/2088, coming into effect in March 2021. This Regulation mandates disclosure by institutional investors on what sustainable investment means and how the financial products they sell pursue it concretely. Not only does such disclosure support knowledgeable choice by retail investors; it also provides institutional investors with incentive to effectively engage portfolio companies on sustainability. Having to justify the sustainability label of their products, institutional investors won’t be able to limit themselves to negative screening as they hit portfolio diversification or index tracking constraints.
Mandatory disclosure of sustainable investments and engagements would be insufficient to incentivize sustainable corporate governance if institutional investors could define sustainability freely. To fix this problem, the EU Taxonomy Regulation 2020/852 established a framework defining environmentally sustainable activities and investments therein. To qualify, economic activities must pass quantitative thresholds defining two fundamental screening criteria of the Taxonomy: i) substantial contribution to one of six environmental objectives; and ii) lack of significant harm to any of the others. These objectives notably include climate change mitigation, for which technical screening criteria based on GHGs targets are already being developed and will apply from 2022. The Taxonomy has a direct impact on institutional investors subject to the SFDR as on the large companies they invest in. Both will have to disclose the proportion of their investments (and for companies, of their output) that meet the thresholds. The Taxonomy is hard to escape. Revealing an understanding of retail investors’ behavioural biases, the Taxonomy Regulation (art 7) compels institutional investors to warn their clients whenever their products “do not take into account the EU criteria for environmentally sustainable activities”.
The EU has been the first jurisdiction the world to design a system of sustainability disclosures that can support sustainable corporate governance. We’ll learn pretty soon whether it succeeded.
This blog was previously posted on the Oxford Business and Law Blog.