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Investors increasingly engage their portfolio companies in conversations about their ESG expectations, encouraging them to improve their performance and practices, and the disclosure thereof. In fact, the use of engagement and voting has risen by double-digits in the last 10 years in Europe, becoming the second most important responsible investing strategy after stock exclusion. This builds on a growing consensus among scholars and practitioners on the positive effect of engagement between investors and companies. At the same time, regulations, such as the recent amendment to the EU’s Shareholder Rights Directive and the UK Stewardship Code further encourage asset owners and managers alike to exercise their shareholder rights. Engagement is therefore only expected to increase in popularity going forward.
Although the impact of shareholder engagement is well-documented in the literature, the levers for successful engagement and strategies being employed are not. In fact, due to its qualitative nature and lack of transparency about the process and outcomes, engagement remains a bit of a black box. Additionally, what triggers corporate change among engagement targets is particularly unclear. What makes one company more likely to respond to engagement than another? Interestingly, target companies seem to have been left out in shareholder engagement research to date. With their input, however, one can better understand the process in its entirety and identify the levers to successful engagement.
With this in mind, we conducted more than 70 in-depth interviews with asset owners, asset managers and listed companies in developed markets globally. We set out to identify what strategies investors use for ESG engagement. Additionally, we asked both investors and companies about the levers for successful engagement.
Engagement strategies and tools
Our interviews revealed that investors can move between four distinctly different engagement strategies: Conservatism, Opportunism, Constructivism and Activism (Figure 1). It is important to note that these engagement strategies are not mutually exclusive. An investor may use different engagement strategies for different funds or products, use them in a layered approach or move between them, if they feel that they are not getting the desired response from the company.
Two of these strategies – Opportunism and Conservatism – can be described as ‘top-down’, meaning they focus on system-level issues for the whole portfolio, rather than specific firm-level problems. They are frequently employed by very large investors, sometimes called universal owners, who invest in thousands of companies globally, and for whom it is impossible to invest in firm-level engagement or one-on-one relationships with all companies. Looking at the financial materiality of the issues and size of the holdings is one way of dealing with this. Using some sort of screening strategy to identify red flags or identifying important themes is, however, also a way for these types of investors to get their arms around and structure engagement on ESG topics.
Opportunism and Conservatism, then, differ in purpose and language. The former is often a thematic approach, which can follow global trends – such as Net Zero commitments – or be influenced by events in the media, like the 2020 Black Lives Matter protests, which caused many investors to launch diversity-focused engagement programmes. Conservatism, on the other hand, is focused on screenings (based on controversies, for example) best-in-class rankings or ‘red flags’. These help the investor identify which firms may present elevated risk, and those are then selected for engagement.
The engagements in Opportunism usually target an entire portfolio of companies, which makes it an especially useful strategy for issues that require system-level change. Tools used include clear communication of expectations around disclosure, policies and practices, as well as the voting on related issues. Opportunism also lends itself well to collaborative engagements, often organised by non-profit groups such as ShareAction. These types of collaborations are not only efficient, given that work is divided between investors with a mutual agenda, but they also add weight to the engagement because of the collective level of assets under management. Companies appreciate collaborative engagements, too, as it allows them to speak to many important investors about the same issue at the same time. Collaboration, however, is not a silver bullet for creating industry-wide consensus. Moreover, many investors may not actively participate in the engagement and only sign the letters, which could increase risks of greenwashing.
Due to the nature of the topics discussed, Conservatism is likely less consensus-oriented than Opportunism. Since Conservatism is focused on screens that identify ‘bad’ firms, engagement tools and topics are inherently more adversarial. For example, screenings conducted to assess which companies are in breach of UN Global Compact principles (or other minimum standards) according to data providers such as MSCI and Sustainalytics are often done to comply with minimum standards in client policies. An engagement tool that can be used for escalation, in case the position is held actively, is exclusion. This may come to pass when, for example, companies on human rights watchlists do not even bother to respond to an engagement. The downside of this is that divestment (the stick to the carrot) means that you are essentially giving up on the engagement. This also means that you no longer have a foot in the door to keep trying. Therefore, investors may prefer using another escalation tool: teaming up with other investors to increase leverage with the target company, as described in the previous paragraph. One note of caution with the Conservatism strategy is that over reliance on scores, and therefore to some extent screenings, is a point of frustration on the company side. This is especially the case when investors exclude companies on the basis of off-the-shelf ESG scores without giving the company an opportunity to defend itself in a prior engagement.
The companies we spoke to emphasised that engagements are only helpful conversations when investors are knowledgeable about their company. Ill-informed investors are seen as an obstacle to successful engagement.
The two remaining strategies – Constructivism and Activism – can be categorised as ‘bottom-up’, meaning the focus of engagement is on individual company characteristics. They are often found in combination with investment strategies that favour a concentrated portfolio, whereby the investor knows the companies well or has high stakes in them. Although they are similar in the sense that they are focused on conversation depth, quality and fundamental research, they differ in language. Constructivism is more focused on collaboration and mutual understanding, which is valued by companies. Language used is consensus-oriented and there is a focus on relationship-building, as both parties are trying to understand and work with the other’s point of view. The companies we spoke to emphasised that engagements are only helpful conversations when investors are knowledgeable about their company. Ill-informed investors are seen as an obstacle to successful engagement. Hence, in the case of an investor where the engagement team and portfolio managers are separated, it may be helpful to conduct engagements together to ensure deeper dialogue.
The engagement tools for Constructivism are ‘soft’, with engagements being private (focus on finding consensus) and relying on frequent outreach from both sides (relationship-building). Constructivism also makes use of voting rights but will likely steer clear of voting in a matter that is too controversial, given their focus on resolving differences behind closed doors. Constructivism is a favoured strategy by companies, as they can use investors to test and discuss ideas and policies. Long-term and constructive engagements can also give companies insights into investment decision-making, which is usually opaque to them. This is in contrast to most engagements where companies do not hear back from investors post-engagement, which means that they are left in the dark in gauging how helpful the conversation was to the investor.
The collaborative nature of Constructivism is in stark contrast to the Activism approach, where shareholder resolutions and public engagement are staple items in the engagement toolbox. The language used in this strategy is more demanding or even adversarial and the focus is on investor objectives rather than on finding consensus. This strategy is often seen as the last resort in persuading ‘Corporate Castles’ that are largely unreceptive to the ESG conversation. Significant changes are often demanded at board level, as the general unresponsiveness to more subtle engagement attempts may be a symptom of serious governance issues. Getting a Corporate Castle to change is more likely to happen when the largest shareholders team up (to the extent they can according to local regulations) and pressure the company into taking a different direction. Although these are typically associated with activist hedge funds, it is not uncommon for other types of shareholders to resort to this, when softer engagement strategies do not produce desired results. An example is the Follow This movement in the Netherlands, which led to the filing of a shareholder resolution at Shell to encourage them to become more ambitious in their climate strategy. This endeavour was backed by several large investors that are not considered to be activist in nature. Another example is the recent ‘Reenergise Exxon’ campaign, where large institutional investors backed a new director slate proposed by the new and small activist hedge fund Engine No. 1, on climate grounds.
The recognition and use of engagement strategies can be critical for its success. Investors must use the right strategies and associated tools to achieve the desired engagement outcome. By recognising not only their own intent but also the interest that companies have in engagements, interactions can be planned and executed more efficiently. Moreover, a key learning is that the language used is important to companies. Company interviewees have indicated that they appreciate investors that focus on relationship-building and know the company well. This suggests that all engagement strategies can benefit from (1) more consensus-oriented language (2) more frequent outreach (relationship-building) and (3) analyst participation (in case of engagement and investment team separation).
While the interests of companies and investors may not always align, these considerations can be helpful to understand corporate engagement behaviour.
Robert Eccles is a Visiting Professor of Management Practice at the Said Business School, Oxford University
Stephanie Mooij is Responsible Investment Manager at Aegon Asset Management
Judith Stroehle is Senior Research Fellow and Programme Lead Oxford Rethinking Performance Initiative