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Beta activism

Third-stage corporate governance is taking centre stage over climate change, says Jon Lukomnik, a recent Pembroke Visiting Professor at Cambridge Judge Business School.

Satellite picture of a hurricane.

Jon Lukomnik, the Managing Director of Sinclair Capital LLC and former Executive Director of the Investor Responsibility Research Center Institute, recently served as Pembroke Visiting Professor at Cambridge Judge Business School.

Pembroke Visiting Scholars have been welcomed at Cambridge Judge since 2012 to allow senior faculty active in finance to visit the business school for periods up to six months. Holders of the post are admitted to Pembroke College, one of the Colleges of the University of Cambridge.

We invited Jon to write an article for the Cambridge Judge website on a topical issue, and here are his thoughts on third-stage corporate governance, beta activism and climate change:

Twenty-five years ago, I had an epiphany. It led, a quarter-century later, to my term as the Pembroke Visiting Professor of International Finance at Cambridge Judge Business School.

At the time, I was the New York City official in charge of investing the City’s five defined benefit pension funds. It was the fourth-largest pool of institutional assets in the United States, totalling more than $80 billion.

I had a staff of almost 60. I hired, fired and oversaw scores of outside money managers, managed billions of dollars on an internal trading desk, dealt with custodian banks, actuaries, lawyers, accountants, NGOs, etc. It was incredibly rewarding, but also frenetic.

One afternoon I suddenly realised that trying to beat relative return benchmarks like the S&P 500 was wasted energy. Instead, I actually faced a much more straightforward task: I needed to find somewhere to invest $80 billion to earn a rate of return above inflation forever.

The simplicity of that formulation (however difficult the implementation) stunned me. The overall return of the markets affected our returns – any large investor’s returns – much more than does the ability to correctly pick stocks, bonds or other securities. Systematic risk issues account for 75 per cent to 95 per cent of the variability in return.

The problem is that modern portfolio theory (MPT) tells you how to diversify your investments to deal with idiosyncratic risks, but when it comes to the systematic risks that shape overall market risk and return profile, MPT basically says you have to accept them.

Well, perhaps not. I was invited to Cambridge to further my research into what my co-author, Jim Hawley, and I call the third stage of corporate governance. Stage one corporate governance, dating to about the mid-1980s, was focused on governance at specific companies, around issues such as executive compensation and voting rights. It focused on the agency problem of corporate managers being able to extract economic “rents”. Stage two, dating to the foundation of the Principles for Responsible Investing in 2005, expanded the focus to environmental and social issues – and so expanded the definition of performance from short-term financial to a more holistic view – but still focused on individual companies. In that way, both states one and two continued MPT’s focus on idiosyncratic situations.

By contrast, third-phase corporate governance directly targets material systematic risks that shape the risk/return of the market. We call this beta activism, activities designed to mitigate systematic risk across the market, rather than at any particular company.

In the midst of my term at Cambridge Judge earlier this year, Larry Fink, the CEO of BlackRock, told the world that “Climate risk is investment risk”. It was a timely, and apropos exemplar of third-stage corporate governance beta activism.

Others had previously said that climate risk is investment risk, but the fact that BlackRock was saying it made the familiar newsworthy. BlackRock is the world’s largest asset management company, with some $7 trillion of assets under management. BlackRock had previously been criticised by some for talking the talk, but not walking the walk, when it came to environmental issues. It had not, for example, joined Climate Action 100, though 350 of its peers had. Some of its votes on shareholder resolutions relating to climate were inconsistent and, in the view of many climate activists, not helpful. BlackRock explained by saying that the votes were influenced by its private talks with companies. But those talks, and what was or was not accomplished in them, were not transparent.

BlackRock joined Climate Action 100 in early January. Then, two days later, Larry Fink released his 2020 letters to CEOs. He wrote: “Climate change has become a defining factor in companies’ long-term prospects… I believe we are on the edge of a fundamental reshaping of finance… In the near future – and sooner than most anticipate – there will be a significant reallocation of capital.” He went on to announce “a number of initiatives to place sustainability at the centre of our investment approach, including: making sustainability integral to portfolio construction and risk management; exiting investments that present a high sustainability-related risk, such as thermal coal producers, launching new investment products that screen fossil fuels and strengthening our commitment to sustainability and transparency in our investment stewardship activities.”

And then he asked the CEOs to whom the letter was addressed to start reporting data according to SASB and TCFD standards. SASB – the Sustainability Accounting Standards Board – is a foundation that has established a framework for “industry-specific disclosure standards across environmental, social, and governance topics”. TCFD is the Task Force on Climate-related Financial Disclosures, which has suggested a set of “voluntary, consistent climate-related financial risk disclosures”.

I find the suggestion that companies report using SASB and TCFD frameworks particularly noteworthy. There has been a confusing array of disclosure frameworks, so BlackRock was, in effect, acting as a beta activist by setting a game-changing market standard designed to report on risks, so as to be better able to mitigate them. BlackRock’s announcement confirms that we are now in the third stage of modern corporate governance, and that climate change is front and centre as the key systematic risk investors care about. It suggests that investors will be climate allies. And the evolution of beta activism as the hallmark of third-stage corporate governance gives them a new set of tools to do so.