The growth in active ownership has not only prompted many asset owners to review their investment policies and practices but it is certainly set to change the way asset owners engage with their members.
Active ownership is providing a completely new challenge for the world’s largest asset owners. Anyone who owns an asset automatically has only two inherent rights: they can sell it and they can influence how it works.
What we are witnessing in the financial system is a transformation in the second of those rights – the exercising of ownership rights by the world’s largest asset owners through both voting at annual general meetings and through engaging in discussions with investee companies on particular issues. This reclaiming of power hasn’t come easily and has taken many forms but this undeniable trend has major implications for the world economy and, in particular, the management of climate change. The exercising of those rights has been most prevalent in the environmental, social and governance (ESG) areas.
Until recently, most asset owners would have typically had a default policy position on active ownership – these policies were normally to either vote with the board of the company or to allow their fund managers (or proxy advisors) to decide how to influence their investee companies on the asset owner’s behalf. However this is rapidly changing. Asset owners are now taking back that power and deciding for themselves how to engage or vote on company issues. Furthermore, asset owners are collaborating on issues in order to improve the quality of companies across the board.
While many of the engagement or voting decisions for companies remain around governance and remuneration issues, the financial crisis has provided some asset owners with a new zest and bravery when assessing how companies are managing risks, especially ESG ones and particularly the mother of all ESG risks – climate change.
The active ownership trend has seen a rapid rise in the number of engagement overlay providers offering advice and services about how to deal with companies. But the underlying basis for the advisors has been from the desire of asset owners to extract value in new ways and to drive companies towards some longer-term considerations that better align with their members' long-term financial interests.
This encouraging trend is due mainly to the most successful aspect of the United Nations’ Principles for Responsible Investment (PRI) - its second principle that states asset owners will be active owners. Of the six principles, it is this second one that has been most embraced and has created a sub-industry of active funds that are collaborating in new and unique ways. The PRI is backed by over 900 institutional investors with combined assets under management of US$ 30 trillion. Companies under their ownership are under pressure to respond.
One of the biggest issues at a portfolio level, from a climate change perspective, for asset owners is addressing the manner in which investee companies are anticipating pricing of externalities, such as carbon pollution, and hedge against these risks. This was evidenced in the 2010 BP and Shell shareholder resolutions and the 2011 Woodside shareholder resolution, that sought to ensure highly exposed companies are not using unjustifiably optimistic assumptions in their forward earnings models in order to make certain long-term capital investment models look more attractive. That is, they wanted these companies to be incorporating reasonable carbon price expectations in their long-term business strategy.
The growth in active ownership has not only prompted many asset owners to review their investment policies and practices but it is certainly set to change the way asset owners engage with their members as an increasing number of members realise that their pension or superannuation fund sits atop the financial tree with the power to influence major economic transitions such as that towards the low-carbon economy.
It is worth remembering that mass active ownership began with the collaboration of the Carbon Disclosure Project (CDP) in 2001. The CDP is an independent organization working to drive emissions reduction and sustainable water use by business and communities. It is currently backed by 551 institutional investors with over US$70 trillion in assets under management.
However, the rise of active ownership is also sowing seeds of change for fund managers who will increasingly be asked by asset owners to consider longer term issues like the direction of future carbon prices. This is unlikely to be a smooth transition for fund managers who are still generally incentivised over a much shorter period than the underlying investors - pension fund members who are typically investing for more than 40 years.
Driving the change, as in any market, is the leadership group. Already large pension funds such as CalSTRS and the BT Pension Fund publish their entire voting record. CalSTRS announces in advance of the voting. Whilst the leaders in this area might still be small in number, several are large and with wide influence in PRI and beyond.
To some, the rise in active ownership is showing that a fundamental power shift is in place from the short termers to the long termers and all stakeholders, particularly pension fund members, are keen to see how asset owners are managing these issues given some of the conflicts inherent in the investment chain.
For pension fund members, visibility of which funds are most effective in influencing investee companies is important. For example, members will want to discover which funds think long-term carbon price assumptions are an essential part of a fossil fuel company’s reasonable expectation. They will want to be able to see which funds think that emissions reduction strategies for a company are a good idea. They will want to learn which funds have engaged in collaborative initiatives such as the CDP and PRI and urgently pressure those who are not. And they will want to find out which funds are lobbying governments for change to help protect their retirement nest egg.