How Engine No.1 is Driving Change as an Activist Shareholder

A never ending battle against greenwashing continues, and the latest salvos have been fired by the European Securities and Markets Authority (ESMA). The ESMA issued a report last week saying that it has observed a "mismatch" between what fund managers are telling ESG clients and their actual allocation strategies. This is happening just as Morningstar removed the ESG label from over $1 trillion in investment funds, saying they don't meet adequate environmental, social, and governance standards. The lines are on what is and what isn't ESG are getting more defined as regulators pay more attention to greenwashing.

A new report published by the new Climate Institute and Carbon Market Watch found that 25 of the world's most valuable companies, including Alphabet, Amazon, and Nestle, are making climate-related promises that they aren't even close to keeping. These global companies, which together accrued $3.2 trillion in revenue in 2020 and accounted for 5% of the global greenhouse emissions in 2019, have climate plans that are weaker than how they've been marketed so far. According to the report, A.P. Moller-Maersk, Vodafone, and Deutsche Telekom are the only ones on track to near-complete decarbonization.

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Meet Michael O'Leary

Michael O'Leary is the former managing director of Engine No.1, an investment firm designed to generate long-term value by driving positive impact through active ownership. (As of October 2022, he is a partner at L Catterton, focused on impact investing.) Prior to joining Engine No.1, Michael was a founding member of Bain Capital's social-impact fund and an investor focused on consumer, technology, and industrials for the firm’s private equity funds. He is also the author of Accountable: The Rise of Citizen Capitalism, and his writing has been featured by the Aspen Institute, Bloomberg, Financial Times, Fortune, the London School of Economics, Vox, and the World Economic Forum, among others.

What's in This Episode?

There are passive investors who take positions in companies and hope for change as it relates to their climate and environmental initiatives, and then there are active investors who take big positions in public companies and try to drive change by taking board seats and demanding action. That's how Engine No.1  rolls. It has emerged as one of the most effective activist investors to come on the scene in decades, and it's putting pressures on companies across industries. It has also launched two ETFs that help retail investors like us participate in its efforts. Michael O'Leary is the managing director of Engine No.1, and our guest on the Green Investor this week. Welcome.

Michael:

"Thanks, Caleb. Excited to be here."

Caleb:

"Michael, I gave the basics from 50 thousand feet, but for the rest of us, explain what Engine No.1 is as you see it and how it operates."

Michael:

"Engine No.1 is an investment firm focused on the connection between a company's social and environmental impact and its ability to create long-term value for shareholders. And so, it starts with better measurement by trying to assess exactly what is the value of the company's create or destroy for their employees and their customers, for communities, for the environment. They're trying to connect that value to core drivers of business success. And then finally trying to focus on what we can do as active owners to help companies improve, to help companies create more value for their stakeholders, ultimately for their shareholders as well."

Caleb:

"Yeah. You're trying to drive value, but you're trying to drive value along with your alignment around the environment, around social issues, around governance. So, you're in it to actually get returns, but you want to make change as well, which is a different model that a lot of people approach. So, how do you do it?"

Michael:

"I think oftentimes ESG gets boxed off as a separate set of issues, as somehow disconnected for financial drivers or disconnected from business value. Part of the problem is that, right now, most investors think in dollars and cents. They're building financial models in Excel. They're trying to model out the future growth of markets, of market share, of profitability. And then you come along with an ESG rating or an ESG ranking, and it can be difficult to see how those two things are connected. The company's value to stakeholders, it's going to create value for shareholders as well."

"And so, our first approach is something we call our Total Value Framework, which is, 'Let's try and measure in dollar terms these other sources of value that companies have for their stakeholders.' Easy example is with carbon emissions. Let's try and measure the amount of carbon and company admits the atmosphere, put a social cost of carbon on that, and then put that in the context of the P&L. And that helps to show whether or not something like carbon emissions is de minimis, it doesn't make a difference to the company, or is actually a huge fact. This is this idea of materiality that often gets talked about in the realm of ESG, and that's what we're trying to focus on is these material issues."

"Now, how do we then, through insights that we derive, actually drive change at companies? This is the broader world of what we call it active ownership, which is... three buckets would be the votes we cast at annual meetings, would be the engagements we could do with companies, and all the way up to and including the sorts of activist campaigns that you saw from us with Exxon last year. And that in many ways has always been a part of the traditional investor toolkit and increasingly being part of the ESG investor impact investor tool kit as well."

Caleb:

"Right. So, you're taking positions in companies, you're taking board seats sometimes as well, to really drive that change. So, this is not, 'Guys, we're gonna to stop investing if you don't do what we want.' You want the change, and you want these companies to succeed in making that change. So, what kind of pressure... Let's talk about ExxonMobil. What kind of pressure have you been able to exert on companies, and what has that change brought about?"

Michael:

"So, it's such a good point on... oftentimes, people talk about this escalation path of, 'First you have a friendly meeting with management and then maybe you'll send a public letter.' And the problem is, for most investors, the highest escalation you can get to is you sell the stock, and that is not much of a threat to management to say, 'Your noisiest, loudest investors, putting the most pressure on you has now traded places with some other investor by selling your shares to someone else on the secondary market.'"

"I think the divestment movement that's particularly been focused on oil and gas and climate issues, that divestment movement has been unbelievably effective as a movement at creating huge amounts of focus on climate for investors. You look at just the sheer dollars of assets that have committed to divestment. Something like $25 billion in the mid-2010s, now $13, $14 trillion of assets. But what it's now allowed us to do is focus on climate, and the divestment movement has allowed us to take a step farther on the engagement path to say, 'For investors who are still in these companies for whom now, because the divestment movement, climate is a front and center issue, can we make the case that given companies destroying shareholder value by not focusing enough on the climate?' So, that is, I think, in its clearest case, what escalation can look like. As you say, public companies are run like little corporate republics, where shareholders, elect boards, boards appoint CEOs, CEOs execute strategy ultimately on behalf of shareholders. And so, our idea is that, 'If that company is now not operating in a way that actually benefits those long-term investors, it's up to the investor to to vote, to engage, and sometimes even replace boards so that it will.'"

Caleb:

"Right. And you've been able to do that, not necessarily replace boards, but get into those boardrooms where you're affecting decisions. So, can you give us the ExxonMobil as a case study for what you wanted going in, and what you're trying to achieve by taking position there?"

Michael:

"In the case behind the Exxon campaign in some ways is very simple. It was, 'If you are the fifth-largest greenhouse gas emitter in world history, as Exxon was, and two-thirds of your revenue is coming from countries that have themselves set or are setting net zero targets, you don't have a sustainability problem. You don't have an ESG problem. You have a core strategic problem. And that one thing you can see with Exxon versus its peers, historically, was that as other companies are starting to reckon with the energy transition and try to understand how they are going to be able to create value even as the world works to decarbonize, that Exxon was behind. And that Exxon's leadership, even at the board level, was an extremely impressive group of individuals, with backgrounds leading some of the largest companies in the world, but lacked an energy background relevant to actually helping to navigate this transition."

"And so, December of 2020, we put forth a slate of four new directors, all of them at deep energy experience, but understood how you'd have to approach an opportunity like Exxon to help them transform their business in many ways so they can succeed not just for the next five or 10 or 20 years, but long into the future as they've succeeded in the past. That campaign went all the way through to the annual meeting in the spring of last year and ultimately we were successful in putting three new directors on the board. The reality is Exxon, like any company that has long-lived capital assets, like any company in the oil and gas space, looks the way it looks today, has the emissions profile it has today, because of decisions that were made five, 10, 15 years ago. And so, the goal was never some sort of radical break with history. The goal is to reposition its strategy, its future, so that five, 10, 15 years from now, it can be succeeding in a world that is decarbonizing."

Caleb:

"Super challenging when companies are managing for the bottom line though. The executives at ExxonMobil are thinking about quarterly earnings. They're also long-term invested in their business. Because these are long cycle businesses, you can't just go explore a well and dig it up in a couple of weeks and be pumping oil. This is long-cycle businesses, capital-intensive businesses, heavy investments, and heavy risk. Our listeners will remember episode one with Spencer Glendon, and we're talking about trillions of dollars of risk, not just in the companies and their assets themselves, but in the investment in these companies themselves. So, these are evolutionary changes you are trying to bring about, not revolutionary, change your business model on the spot. They'll die if they do, but they'll die if they don't, right, Michael?"

Michael:

"Kind of a finance 101 view here would be to say their job is to make certain assumptions about the future, the future of oil demand, the future of oil prices, and then based off of those assumptions, try and maximize risk-adjusted return on a project-by-project basis. And part of the argument we were trying to make in our campaign was the assumptions they were using, or what the world is going to look like a year from now, five years from now, 50 years from now, were not just out of step with what we might think or what other folks focused on climate or sustainability might think, they were out of step with their competitors, out of step with industry organizations or government estimates, with academics."

"And so, part of the goal was to say, 'The decisions made today about projects that will continue to live for years, if not decades, need to be based off of reasonable expectations about how the world is or is not going to achieve its climate ambitions.' I think that is one thing that's worth keeping in mind that as an investor, we still have to be grounded in reality, grounded in the energy transition, exactly how long that will take, how hard that will be. And understand what it will take to actually create value to that transition for companies who are entirely in traditional energy, entirely in renewable energy, those trying to transition or mix between the two. And all of which is not to say we've got all the answers, but we think we understand the sort of leaders you would want in the boardroom to be making those decisions."

Caleb:

"Yeah. Well, let's talk about investors in general, because this is a reasonable way of approaching these companies to make change that they have to make ultimately. But investors have kind of changed the way they think, and I'm painting with a broad brush, over the last five to 10 years as it relates to ESG, as it relates to climate change, as it relates to their sensibilities. They're investing with their moral and ethical sensibilities, but they're also thinking long-term as well. I want to be invested in companies that are going to be here in 10 years. How have you noticed that change in terms of the clients that have come in to Engine No.1 and the people you're dealing with now?"

Michael:

"It's amazing the degree to which climate has sort of become this Big Ten issue, where you'd be hard pressed today to find a corporate leader or an investor who do not at least pay lip service to the idea that companies need to understand how to navigate the energy transition. And that's not just within the oil and gas sector, that is across auto transportation, across agriculture, across building, across industry, across consumer-packaged goods. Industry after industry are going to be transformed over the coming decades as the world reckons with climate change, and you've got big traditional researchers putting out figures that say, "It's would require $2, $3, $4 trillion dollars per year in incremental spending to able to reach net zero by 2050.' That's the investment opportunity of a generation, of my generation surely as a millennial."

"And so, I think you don't have to make the strong case anymore that focusing on climate is important for investing. I think a lot of people have come to recognize that, and one of the data points I point to is, if you look at shareholder voting every year at annual meetings, this past year, there were 11 proposals at public companies on climate issues that passed, that got over majority support. That compares to three in 2020 and zero in 2019. It's remarkable to think that as recently as 2019, not a single proposal on climate issues was successful, and I think that dramatic change is indicative of a broader shifting mindset among investors, that climate is a core and material issue for many companies."

Caleb:

"And you know first hand, this is not necessarily generational. Yes, younger investors may have this sensibility, but older investors like me and even older than me, who have been investing for a very long time, they're waking up to this as well, right? This is not just a young people thing." 

Michael:

"So, you see it in... there's a great Morgan Stanley report that comes out every year, a survey asking, 'How important is sustainable investing to you? Are doing sustainable investing?' And there's always been... since they started doing it seven or eight years ago, there's always been some differences across generations. But the trend that swamps all of that is that all generations, millennial, Gen X boomer, everyone... everyone is increasingly interested in sustainable investing to the point now where it's 80% of the population at large, it's nearly 99% of millennials. And so, this is a wave that, in many ways, is already crashing across the capital markets, this address and ESG and sustainable investing."

Caleb:

"Absolutely. It is here, and Engine No.1's brought a couple of ETFs, exchange traded funds, to the market to help retail investors like me, like our listeners, access this. Let's talk about VOTE, and let's talk about the NETZ ETFs. Start with VOTE. How is it constructed? How is it performing? Give us a little sense of how that's made."

Michael:

"Yeah, so, VOTE in some ways is a radically simple idea. Most ESG investing today, nearly all ESG investing today is about what you have in your portfolio. What sectors do you exclude? How do you re-weight companies based off an ESG index. How do you decide what companies are morally virtuous or not? And how do you create a portfolio that reflects that? Our idea with VOTE, with the Engine No.1 Transform 500 ETF it's called, is, 'What if we define ESG investing not by what's in your portfolio but by what you do as an owner of those companies.'"

"And so, VOTE in many ways is an extremely simple traditional index fund. It holds the 500 largest public companies in the U.S. by market cap, so it looks nearly identical to what a lot of investors already have in their 401(k)s, already have their portfolios. What's different is, if you go back since 2015 and look at the average S&P 500 fund, the average S&P 500 fund voted against something like 85% of social and environmental proposals. This is on climate, on gender pay disparity, on human rights, the supply chain, and deforestation, to a whole host of racial equity, workforce issues. A whole host of ESG concerns. The average S&P 500 fund, where probably a lot of people who are listening have their money voted against those proposals, mainly because the big trillion dollar asset managers just tend to take a more traditional, deferential approach."

"VOTE is the exact opposite. VOTE has the same underlying holdings to what a lot of investors already have but then takes a more social and environmental-focused approach to how we vote those shares. We have supported over 90% of social and environmental proposals since launch, and then how we engage with those companies, including through work, like what we've done at Exxon or that we're doing around electric vehicle transition in GM and other ones. So, that's the idea. It's passive investing with a twist on ESG, not by changing what it holds, but by changing what it does."

Caleb:

"Right. And you can look at the report card, so to speak, and the record of voting and what shareholders have done and what the company has done, and that's probably... one of the things that's attractive is that I actually want to see what's inside and I want to see how these companies have behaved according to the resolutions that have been proposed."

Michael:

"In my experience talking with investors, many investors, especially on the retail side, they don't even know that there are annual meetings happening with their votes being cast on their behalf on issues they care about. And then once they realize that, they don't know that oftentimes their votes are being cast in a way that directly conflicts with their long-term interests and their values. And so, our approach is not just to vote a better way, but then to publish those votes real time on our website and try to put pressure on other investors, other managers, to follow and ultimately create a product that is simple, that anyone can access, but that is trying to drive real impact directly in the companies we hold."

"NETZ is a super-exciting, just-launched product from Engine No.1. Most ESG funds that are more actively managed or more concentrated, you'll tend to see a lot of companies in those funds that are big solution providers, that are that are disrupting an industry, that are high growth, really exciting companies. Our idea, though, with NETZ, was that a lot of the value to be created through the transition across sectors is going to come from big incumbent players who are transforming, who have figured out a strategy that puts them on a path to net zero and a path to create value while they're doing it. This is... companies like General Motors, that still today is one of the biggest emitters in the auto sector, no doubt, but has now made the ambition to go all electric by 2035, which, if they are successful, could take 200 million tons of carbon out of the atmosphere every year versus what would have happened otherwise. Companies like this, for us, are a critical, critical part to actually achieving net zero."

"And this product, which is a concentrated, actively managed fund to try to generate returns... in this product, we think by creating a portfolio of those sorts of companies, puts us in a better position to try and deliver attractive returns to investors. That's the goal. And so, if you look at the investing continuum from pure active to pure passive, a lot of ESG investing gets stuck straddling the middle, or it's not quite a passive fund because it has real deviation. It would exclude certain sectors and re-weights from market cap. And so, you can see it outperforms the 2020, underperforms the 2021, never by huge numbers, but nothing you notice. But it's not quite active either, because a lot of ESG funds are following an index or a simple approach. It's unclear why that should generate enduring alpha for years. Our idea was, 'What if we could stay on those two ends of the spectrum, a pure passive product (that's VOTE) or a pure active product (that's NETZ)?' In both cases, trying to engage, to create impact. But then investors can choose, is it a core equity holding in an index portfolio? Do they want a kind of satellite exposure, trying to earn outsized returns. In either case, it's an ESG approach or an impact-oriented approach. But it doesn't look much like most ESG investing today."

Caleb:

"Yeah. Folks, we're going to link to the fact sheets on both of those ETFs, so you can check them out because they are very different than what you'll see across the industry today. But to your point on GM, when GM made that declaration, when they pivoted hard and said, 'We are going to make this change,' we have one of the best performing stocks of 2021. Ford too. So, they either have to get in line, or they can just be one of the great companies of the 20th century that never made it out. They look like they're making that move right now. So, you're definitely having an impact there."

"I've heard you say that ESG investors should be defined by not what they hold, but what they do. And that is kind of what I'm feeling is the philosophy behind everything at Engine No.1. This is an active, in the fact that you are taking positions, but you're also, as an investment committee, looking at those companies where there is opportunity for them to transform themselves into companies that have sustainability for the future and don't degrade the environment. Is that a fair way to look at it? You're looking to make these changes, and you think investors want that too?"

Michael:

"Oh, absolutely. And I think the core point here is that this is how, in today's market, we think we can create value for investors. And increasingly investors are recognizing that too. And so, I think for a long time, ESG was seen as adding in some new interest outside of financial interests. I think what we're getting to across the market today, and for sure where Engine No.1 sits, is trying to show that these are the core factors you should be focused on. Your workers, the value you're creating for your customers, your communities, for the environment. These are the core factors and core investment that companies should be making if they're trying to generate long-term returns for their shareholders."

Caleb:

"So what's needed, Michael, in the industry to drive more change? Is it better education? Is it more rules? Is it more clarity on what ESG and SRI mean? Because, as our listeners know and as you know, you've been in the industry a while, so much ambiguity, it's alphabet soup when it comes to all the acronyms there. But what is needed for more of this push, especially from the retail base, to get into this?"

Michael:

"Ultimately, the public markets are a team sport for investors. During the Exxon campaign, we owned two basis points of the company, which meant unless we can convince 49.91% of our fellow shareholders that we were right, we were not going to be successful in placing any new structures on the board. And the same is true for all the shareholder proposals that we support. Ultimately, it's nice if we supported it in the competition, and we can show this great competitive differentiation, but it doesn't get a whole lot done for companies or a whole lot done for stakeholders or the environment. And so, we're in this kind of odd position of trying to actively erode our competitive advantage, trying to push other shareholders, other asset managers, to vote in a way that better aligns with the long-term interests of kind of pro-social, pro-environmental interests of a lot of the end investor."

"Retail investors, I think this is an important point... right now, something like 93% of every vote that's cast in an S&P 500 company is being cast by an institution. That's BlackRock or Vanguard or State Street or us or a pension fund. Only 7% are being cast by individual retail shareholders. Part of the reason is because fewer than one out of 10 retail investors who own shares directly actually vote. Most people, they get the proxy statement, it goes right in the trash or they archive it in their inbox. The reality is that a lot of these proposals are narrowly passing or narrowly losing. I mean, there's something like a dozen proposals or more every year that's just by a hair, a couple of percentage points difference between success and not."

"And so, one thing I'm starting to see is, especially in the startup community, folks trying to make it easier for retail investors to vote. You saw the acquisition of, say, technologies from Robinhood. I think that's kind of a step in the direction of Robinhood saying, 'This would be an area of greater interest.' And so, I think all investors today should be thinking about two things: One is how they vote if they own shares directly, of course, and then two is, if they've got shares through funds, through an index fund or mutual fund or otherwise, are those funds voting their shares in a way that aligned with the way they'd want it to? And if not, should they be moving capital to someone who would?" 

Caleb:

"The last year and a half has really broke that open as such a key issue, but it's a long time coming. So fascinating. Folks, check out what they're doing at Engine No.1 and Michael O'Leary, the managing director of Engine No.1. Thanks so much for joining the Green Investor. Really fascinating."

Michael:

"Thank you, Caleb. Appreciate it."