A tiny hedge fund is taking on ExxonMobil, accusing the energy giant of dragging its feet on climate change, which has led to disappointing financial returns. Amazingly, the fund’s campaign has received the support of one of the largest asset-owners in the world, the California State Teachers’ Retirement System (CalSTRS). The fund wants four changes at Exxon: (1) refresh the board; (2) impose greater long-term capital allocation discipline; (3) implement a strategic plan for sustainable value creation in a changing world; and (4) realign management incentives. If it succeeds in pushing through a new slate of directors, the hedge fund will embolden a new generation of activist investors who can push corporations to embrace more progressive ESG policies.
Something interesting is happening among shareholders of the energy giant ExxonMobil, which may usher in a new era in activist investing. A new activist hedge fund, Engine No. 1, is pushing widespread reform at Exxon through its “Reenergize Exxon” campaign. What makes this campaign extraordinary is Engine No. 1’s tiny size — it holds only a $40 million stake in the multibillion dollar company. Yet there are strong signals that Engine No. 1 is in position to reorganize and reform Exxon from the very top of the company.
Exxon’s financial situation certainly lends itself to an activist hedge fund campaign. As of December, 2020, Exxon’s market cap hovered around $175 billion, down from its peak of $528 billion on December 24, 2007, but up from its trough of $139 billion on October 26, 2020. In August 2020, it’s 92-year membership in the Dow Jones Industrial Average ended. And in an open letter of December 7, 2020, addressed to Exxon’s board of directors, Engine No.1 notes that Exxon’s Return on Capital Employed (ROCE) for Upstream projects (which have historically accounted for over 75% of total capital expenditures) has fallen from an average of around 35% from 2001-2010 to around 6% from 2015-2019.
The company’s poor capital allocation decisions are based on decades of denial about climate change on the company’s strategy. Greenpeace has documented over 50 years of climate change denial and Exxon’s actions to thwart efforts to deal with climate change. Exxon counters that it “has supported development of climate science in partnership with governments and academic institutions for nearly 40 years.”
This research certainly hasn’t influenced the company’s strategy. Carbon Tracker notes in an October 2020 report by Paul Spedding, “How the Mighty Are Fallen—How Chasing Growth Destroyed Value in ExxonMobil,” that a major reason behind this poor performance was that Exxon overinvested in high-cost assets in order to chase growth. “The consequential ballooning in its capital base and its operating costs were a major factor behind the collapse in its return on capital. Its shareholder returns followed suit.”
So, what chance does Engine No. 1 have to succeed with its campaign? We think it has a good chance for three reasons. We have already discussed the first — the company’s continued abysmal financial performance with no reason to believe it will improve under its current leadership and strategy. It is important to note that Engine No. 1’s campaign is not based on ExxonMobil’s irresponsible approach to climate change; it is based on the financial consequences of this approach. That’s a message that the broader shareholder community can easily get behind.
The second is that Engine No. 1 is making four sensible and reasonable recommendations: (1) refresh the board; (2) impose greater long-term capital allocation discipline; (3) implement a strategic plan for sustainable value creation in a changing world; and (4) realign management incentives. Spedding would likely agree with (2) and (3): “In an energy transition, a low-cost strategy with capital discipline will be more beneficial for shareholders than chasing growth. Matching its volume ambitions to a Paris-accord demand profile would be a step in the right direction,” he wrote in the Carbon Tracker report. The executive compensation system must then be changed to provide the right incentives for a different and better strategy.
Given the company’s track record, it is unlikely the last three recommendations can be implemented without the first. Towards that end, Engine No. 1 has proposed an alternative slate of four independent directors: Gregory J. Goff, Kaisa Hietala, Alexander Karsner, and Anders Runevad. Goff was the CEO of Andeavor, a leading petroleum and marketing company, and was named in 2018 by the Harvard Business Review as one of the “Best Performing CEOs in the World.” Hietala served as the EVP of Renewable Products at Neste, a petroleum refining and marketing company, named in 2019 by Innosight as one of the “Top 20 Business Transformations of the Past Decade.” Karsner is Senior Strategist at X (formerly Google X) and is a Precourt Energy Scholar at Stanford University’s School of Civil and Environmental Engineering. Runevad was the CEO of Vesta Wind Systems, a wind turbine, manufacturing, installation, and servicing company, and was included in Fortune’s “Businessperson of the Year” list in 2016. All of these directors bring valuable energy experience to the Exxon board.
Getting these four candidates elected to the board will require a majority of the shares voted at the company’s annual shareholder meeting on May 27, 2020. Which gets us to the third reason we think this campaign can succeed — there is a good chance Engine No. 1 can get the necessary votes. Proxy voting is playing hardball, but this is a skill activist hedge funds have honed over many years of practice, and this is what Engine No. 1 brings to the party. They have made the case for change and now they must round up the necessary votes to enact it.
This campaign is already gaining steam. For starters, on December 7, 2020, the California State Teachers’ Retirement System (CalSTRS), the second largest public pension fund in the United States with $280 billion in assets under management and owning $300 million of Exxon’s shares, announced it would support this alternative slate. Further, Exxon’s top three shareholders own nearly 18% of the shares (Vanguard with 7.75, State Street Global Advisors with 5.17, and BlackRock with 4.99). The top 10 own about 25 percent of the company’s shares. The company has a large retail shareholder base which historically has not showed up at the annual meeting in large numbers. This means that if Engine No. 1 can marshal the votes of the largest shareholders, they have a good chance to prevail.
We asked Aeisha Mastagni, a Portfolio Manager in the Sustainable Investment & Stewardship Strategies Unit at CalSTRS, why they were supporting what some might think is a quixotic campaign. Her response: “At CalSTRS we are developing the idea of ‘Activist Stewardship.’ The idea is to combine our role as a constructive, engaged shareholder with deep financial analysis, while utilizing the full suite of activist tools available to address companies that are failing their shareholders and other stakeholders. ExxonMobil is our first example and it’s hard to think of a better one given the company’s financial performance and decades of indifference to its shareholders.”
In other words, Engine No. 1 is part of what might become a major shift in equity markets. Traditionally, activist funds have been regarded as the thorn in the side of management pursuing nothing other than short-term shareholder returns. However, some funds are now recognizing that environmental and social issues are major constraints on the financial performance of their investments. Pure long-term financial considerations are therefore dictating a greater focus on issues that activist investors have previously shunned. If the Little Engine’s “Reenergize Exxon” campaign succeeds, it could be the prelude to many similar ones by other funds to the benefit of shareholders and society at large.