Driving change: how investor activism supports the green transition

Jean-Pierre Danthine’s interview with Erwan Morellec

Can investor activism facilitate the green transition? The publication “Investor Activism and the Green Transition” by Sebastian Grylewicz, Simon Mayer, and Erwan Morellec, sheds light on whether and when activist strategies can have a positive influence on corporate strategies, and how such activism interacts with environmental regulation.

This theme is of utmost importance in the fight against climate change, as it can define finance as a force for good and help firms accelerate the widespread adoption of clean solutions. By leveraging shareholder influence, investor activism can drive corporations to align their practices with environmental goals, thereby accelerating the transition toward a sustainable future.

In this article, Jean-Pierre Danthine (JPD), E4S Honorary Director, interviews one of the paper’s authors, Erwan Morellec (EM), Full Professor of Finance at the Swiss Finance Institute at EPFL, to disentangle the complex impact that investor activism can have. Their dialogue helps to understand under which circumstances this strategy can be a valuable ally of the green transition and when, on the contrary, it can be counterproductive for the cause.

 JPD: Professor Morellec, first of all, can you please explain what you mean by investor activism and why it is important for the energy transition?

EM: By investor activism, I mean the adoption of active strategies through which investors exercise their control rights to impact firms’ decisions, such as through board representation, management oversight, strategy development, or voting on proposals. This type of strategy is opposite to more passive investor strategies, which involve investing in “clean” firms and divesting from “dirty” firms to influence their cost of capital so as to incentivize investment in the green transition.

Recent research shows that passive or exclusion strategies may have very little impact on firms’ behavior and this is why it is important to understand whether and when investor activism can facilitate the adoption of clean solutions, and when these strategies don’t work.

JPD: Could you explain the main elements of interactions between management and activists in your model?

EM: Our analysis recognizes that transitioning to greener production processes is costly and risky and requires the combined efforts of the activists and management. That is, activists and managers work together to produce the green transition and share the benefits of it. This sharing reduces the transition gains to the activist and therefore activists’ incentives to exert private effort. So, in our analysis, it is not that activists are not well-intentioned but more that their incentives to exert effort are reduced relative to first best as they only capture part of the gains from effort while incurring the full cost. This is even more the case because activists only own part of the firms they invest in.

JPD: Would this still be the case if the activist’s motivation was purely intrinsic and if the activist’s benefit is a public good (the manager’s and passive shareholder’s benefit do not detract from the activist’s)?

EM: A common assumption in the literature on sustainable investment, that we also make in this paper, is that the activist is a warm-glow agent that derives personal (dis-)utility from its actions. The warm-glow effect experienced by the activist increases with the amount invested in the firm and its contribution to the reduction in social costs. In addition, independently of its preferences, the activist still needs to incentivize management and pay the private cost of effort. Thus, under our assumptions, it does not matter if the motivation is purely intrinsic. I imagine we could get different results if we assumed that activists are consequentialists who internalize the consequences or impact of their actions on others.

JPD: In your publication, you conclude that when we consider the impact of activism, the carbon tax may be below the Pigou tax (a type of tax levied on economic activities that generate negative externalities, such as pollution). Could you develop?

EM: Carbon taxation increases the financial gains from transitioning from brown to green technologies. As a result, they provide additional incentives for activists to exert effort to help the firm’s transition. But a side effect is that the cost of buying a stake in a firm that has not yet transitioned also increases, as the gains from transitioning become larger. If this value creation is fully reflected in the price at which it acquires a stake in the firm, the activist cannot capture the gains from activism and thus has no incentive to invest in the first place, causing a free-rider problem. That is, carbon taxes increase the activist’s post-entry impact and hence the value created through activism and the free-rider problem that disincentivizes entry. Carbon taxes should be set at a level that does not discourage entry, which is lower than the Pigouvian tax.

JPD: One empirical observation is that green activists have a propensity to form coalitions such as Climate100+. The cost of acquiring a position is thus split among large groups of (often historical) investors. Doesn’t this water down the quantitative impact of the mechanism you describe?

EM: If effort towards transitioning is also shared then it does not matter. What matters is how much effort you have to put in compared to the benefits you get from transitioning.

JPD: Conversely, you argue that subsidies may reduce the impact of good activism and presumably have a wrong impact on the green transition. In fact, you conclude the regulator should not rely on investment subsidies to boost the green transition.  Could you explain intuitively?

EM: When there is a moral hazard, activists need to incentivize management to exert effort to facilitate the green transition. Firm-level investment subsidies, by reducing the cost of green investment, make it optimal to incentivize higher managerial effort. However, this requires a larger incentive compensation for management, thereby reducing the activist effort incentives and crowding out activists’ efforts. We show that when there is a moral hazard, subsidies can reduce overall effort by crowding out activist efforts. In addition, subsidies discourage entry and increase exit incentives for good activists, reducing the extent of “good” activism.

This article is part of the new E4S series Frontier Research. This series is designed to guide you into selected applied research, simplifying complexities and making crucial contributions to the green transition accessible to all.