Shadow Boards Engagements

In early April, the UN backed Net Zero Asset Owners Alliance published an insightful paper on the future of investor engagement[1]. I would like to commend the authors for publishing such a critical piece of research, at a time where active ownership has become the lever of choice for asset owners to drive sustainability change, and bring about the transition to a sustainable economy. Before I go further, I would like to stress that I stand wholeheartedly behind many of the paper’s recommendations, notably those touching on sector engagement and policy advocacy. Nonetheless, I do wish to point out that the paper missed an opportunity to address a key structural weakness in the conception and delivery of the engagement function as it stands today.

Before diving into the alluded to structural weakness, it is important to note that the success of ESG-related engagements by institutional investors according to a seminal research paper by the European Corporate Governance Institute stand at a mere 25%[2]. This finding aligns with previous research in the field which puts the probability of ESG engagements success at well under 50%. The recent disappointing progress report from Climate Action 100+ is an empirical confirmation of the inadequacy of current engagement methods[3]. The issue of limited engagement success, in the absence of large-scale divestments, remains a perennial ESG hurdle that the responsible investing industry is yet to resolve. Building on this, I would like to focus on engagement in the context of net zero transformation, and why the current engagement model is not fit for purpose.

The transition to a sustainable net zero economy requires a fundamental transformation of sectors, industries, and business models. Transformations of this nature require a deep understanding of the micro and macro factors underpinning the value creation and capture process of a multitude of companies and industries. The knowledge base for this understanding tends to exist within companies, at the board level and not at the shareholder level. This dynamic, which is often overlooked in the net zero engagement debate, ?introduces a sustainable transformation asymmetry between companies and their shareholders. By overlooking the idiosyncratic nature of net zero business transformations, institutional shareholders, directly and through collective engagement venues such as Climate Action 100+, have engaged with portfolio companies on the basis of an indicator-based engagement model, with limited sectoral sensitivity. Pre-determined indicators are highly valuable in assessing progress on a given set of ESG metrics, but indicators alone cannot deliver a coherent net zero business model, nor can they truly assess the business viability of a sustainable corporate repositioning. A failure to understand the net zero business case, in a business context no less, is the Achilles heel of today’s engagement function.????

Addressing the aforementioned deficiency requires a deep restructuring of the engagement process. Expanding engagements from a company to a sector (as the cited paper proposes as one of the solutions) doesn’t necessarily solve this structural challenge, namely asset owners and managers are not developing the internal sectoral or business expertise to engage with companies or sectors at the strategic level required to solve for net zero business transformations. In most institutional settings, engaged companies are assessed by overworked analysts, tasked with assessing the climate transformation strategies of hundreds of companies. The disconnect between the complexity of the task, and available resources, naturally leads to heuristic, framework based, engagement approaches. To overcome this limitation,?asset owners and managers need to contemplate the creation of what I would describe as 'shadow board' engagement capabilities. A 'shadow board' composed of senior engagement/industry executives would have the singular task of engaging with a select group of companies and sectors around their net zero transformation at a fundamental, idiosyncratic, and strategic level.

Such an engagement approach is not novel, activist hedge funds have pursued such in-depth strategic engagement with target companies for decades, although the premise of such engagements tend to be financial for the most part, the processes, capabilities, and expertise associated with such activist approaches are readily transferable to the ESG domain. Borrowing from activist hedge funds playbook is something mainstream institutional investors need to seriously contemplate. Without the introduction of such in-depth research and engagement execution capabilities, the engagement function will increasingly become a low-level compliance function, designed to meet regulatory and stakeholders demands, rather than growing into a real lever to manage ESG/business risks and drive real sustainability change.

Nawar Alsaadi,

Senior Portfolio Manager, ESG Investing

Canada Post Pension Plan

?The opinion in this piece is personal to the author, and is not necessary representative of the opinion of his employer, or any other organization with whom he might be affiliated.

[1] https://www.unepfi.org/wordpress/wp-content/uploads/2022/03/NZAOA_The-future-of-investor-engagement.pdf

[2] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3235190

[3] https://www.responsible-investor.com/climate-action-100-reveals-disappointing-results-in-update-to-company-commitment-tracker/