Let’s Speak Privately

Chapter Thirteen

Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.

ARCHIMEDES

We have spent the bulk of our investigative efforts so far determining whether and how the behaviors of companies could be altered and optimized through initiatives like ESG investing and those of Just Capital. At the end of the day, sustainable investment strategies are largely about penalizing scofflaws and rewarding paragons, reaping financial and social rewards in the process. We’ve learned that firms in the S&P 500, MSCI World, Russell 3000, or any other index are prime candidates for direct investment influence. By overweighting or underweighting the stocks and bonds of the companies that investors want to reward or punish, undesirable corporate behaviors may be discouraged and beneficial social and environmental outcomes possibly amplified. Concomitantly, better returns may also be earned. Thus, if Shell or Lockheed Martin are engaging in some untoward activities, the threat of removing them from certain investment portfolios may lead them to course correct preemptively. After all, reputational and financial costs are taxing and should ultimately persuade targeted companies to amend their ways. If the incentives are compelling enough and markets as determinative as many think, ESG investing should be a compelling methodology for making the world a better place, rather like Archimedes suggests. The process of rewarding paragons should also be rewarding for investors.

But as we have looked more deeply at ESG investing and other methods, we have also seen some of the inherent limitations of these arguments. Composite ESG scores and shifting American moral priorities do not appear to

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convey complete or particularly prescient investment information. Basing indexed equity strategies on composite ESG scores alone seems unlikely to generate recurrent, long-term alpha. Moreover, investment strategies based upon composite ESG scores also appear to have minimal direct impact on corporate behavior. Unlike credit ratings, which have promoted greater corporate conformability in accounting practices, ESG scoring systems have not yet created much harmony in corporate “E,” “S,” and “G” practices. In particular, tilting an index through composite ESG scores does not seem to have much influence on individual corporate strategies. Corporations may want to be in an ESG index, but how much they are willing to change for inclusion remains murky. In this respect, ESG incentives and the cost-ofcapital transmission mechanism upon which those incentives depend have been presumed by too many to be more potent than they actually are.

The profusion of composite ESG scores and their limited effects on corporate behavior lie in contrast to their possible direct and outsized influence on investment results, meanwhile. Incurring tracking error while failing to improve specific social and environmental outcomes is an unattractive risk–reward proposition. Furthermore, we’ve learned that extensive divestment efforts failed to dissuade “sin” corporations from conducting their traditional core businesses. Meanwhile, ample financial capital continued to flow to alcohol, tobacco, firearm, and gambling stocks for two compelling reasons. First, their operations remained profitable and legal; second, ubiquitous fiduciary rules encouraged it. This is also why, somewhat counterintuitively, sin shares have historically outperformed the broader market. Their relatively high dividends broadly benefited those who chose not to divest. Finally, we’ve learned how challenging and time-consuming the process of systematically hardwiring corporate goodness will be. TCFD and SASB are compiling valuable road maps for sustainable accounting standards. The sooner they can complete their work, the better. In the interim, though, few corporations have chosen to comply with their evolving reporting standards. This means that investors today are still some ways away from systematically identifying and discounting all material ESG risks. Admittedly, they are further along than where they were when the United Nations launched their Principles for Responsible Investment in 2005, which is laudable. But they are not where they need or want to be. Progress is being made—corporations are certainly now more “ESG aware”—but transmuting greater transparency into better investment returns and a more just, sustainable world remains a long, important work in progress.

THE PERILS . . .

As if these challenges were not enough, there is a further constraint on ESG’s broad efficacy that we’ve not yet considered: the potential relevance of powerful competing economic agents, namely private markets and stateowned enterprises.

Divestment and overweighting as we’ve explored them so far relate meaningfully only to publicly traded companies—that is, those with shares that trade on an exchange and those whose stocks and bonds are included in widely tracked indices. But the ultimate utility of corporate engagement strategies like those of ESG, Just Capital, or B Lab for systemic environmental and social change depends upon their ability to influence the entire corporate ecosystem, not just a fraction of it. Thus, if promoting more inclusive, sustainable growth through corporate engagement strategies is to work, the industrial practices of all of the institutions that are its targets must be sufficiently pervasive for the global economy to be meaningfully recalibrated.

But that is not the case.

By almost every metric, listed firms compose less than half of all economic activity. Moreover, state-owned enterprises and private firms still lie well outside the ordinary reach of activist ESG influence. To date, private firms and state-owned enterprises have remained relatively immune to ESG pressures. Because listed firms represent such a small segment of global commercial activities, ESG’s current lever is not long enough, nor is its fulcrum sufficiently secure to protect the earth’s climate or alter social outcomes consistently and systemically on its own.

All of this is why we must speak privately.

While the primary targets of corporate engagement—the fifty thousand or so corporate names that are included in the most widely followed indices—are the most visible components of the global economy, they are far less influential than is commonly understood. Consider the U.S. economy. Of the thirty million businesses incorporated in the United States, only 0.0125 percent are listed on an exchange or access the public bond market. For universal impact, activists and ESG enthusiasts need to develop additional strategies for engaging the remaining 99.9875 percent. Part of this challenge is a function of firm size, of course, but only part. Globally, corporations with fewer than one hundred employees outnumber those with more by a margin of seventy to one. While thirty-five million Americans work for Russell 3000 companies, this still amounts to less than one-quarter of the 155 million Americans who go to work every day. If promoting fair wages, greater diversity, and employee satisfaction are top goals—to list just a few desirable

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objectives—proponents for improving labor market outcomes must also find a way to reach employers of the other 77 percent.

Authoritative, comprehensive data on private firms is hard to find because corporations that do not register to sell securities need not file detailed activity documents with organizations like the Securities and Exchange Commission. This means that more than 99 percent of all U.S. corporations never report their cash flow, inventory turnover, investment, or employment data, let alone granularity on their scope 1, 2, and 3 emissions. In one of the more recent studies comparing public firms with their private counterparts, researchers at Harvard and NYU estimated that privately held firms were responsible for 70 percent of all nongovernment employment, 60 percent of all sales, and 55 percent of all nonresidential fixed investment. They also estimated that private firms account for more than 50 percent of all pretax corporate profits.1

Upon further reflection, though, this data should not surprise anyone. Many of the largest privately held companies in the world are household names. These include accounting and advisory giants like Deloitte and Ernst & Young, with 330,000 and 290,000 employees, respectively; luxury brands like Rolex and Lacoste; the financial giants Bloomberg and Fidelity Investments, with 60,000 employees between them; Dell, with nearly $60 billion in revenues and 110,000 employees; and the confectionery giant Mars, the supplier of my beloved Twix and Snickers bars and the employer of more than 130,000. Some industries are dominated by private giants. Of Forbes’s two hundred largest private companies in America, sixty are in the food business, including fourteen of the top twenty-three.2 Two other well-known names—Cargill and Koch Industries—are among the world’s largest commodity and energy engineering companies. Were we to assign Cargill and Koch conservative price–earnings multiples, given their annual revenues exceed $100 billion each, both would rank among the top twenty-five most valuable companies in the S&P 500. The Dutch energy and commodity trader Vitol is even larger than Cargill and Koch, meanwhile, with reported annual revenues exceeding $250 billion. Vitol’s global sales are higher than Google’s and Samsung’s. Hundreds of private companies have thousands of employees; dozens have hundreds of thousands. When you add all of this together, you realize a largely underappreciated fact of commercial life: the activities of private firms matter much more in the global corporate ecosystem than do those of their public counterparts.

Most private companies are not household names. Often, this is intentional. Many significant private companies eschew public attention. Thus,

THE PERILS . . .

Hilcorp may be the largest producer of oil and gas you’ve never heard of. Unless you are in the oil and gas business, there is no reason that you would have. Yet Hilcorp ranks near the top of all oil producers in Louisiana, Ohio, Pennsylvania, Texas, and Wyoming. They are also the largest oil or gas producer in Alaska and the San Juan Basin. Hilcorp earned top billing in Alaska after buying all the Alaskan upstream and midstream assets of BP in 2019 for $5.6 billion. In this landmark transaction, BP divested all their interests in the giant Prudhoe Bay field, as well as their 48.4 percent stake in the Trans-Alaska Pipeline System. In the process, BP shed a considerable amount of financial and reputational risk. As you would expect, BP won plaudits from the investment community for their decision; their stock rose more than 8 percent in the first few weeks that followed this announcement. But BP’s sale certainly did not mean that Alaska’s oil would somehow stay in the ground. Meanwhile, Hilcorp plans to make the most of its multi-billiondollar purchase, as you might expect. And while ESG investment enthusiasts cheer BP, they have no meaningful way to express their displeasure with or influence over Hilcorp, the other side of the transaction. Hilcorp has also so far profited from their purchase.

I mentioned Shell and Lockheed Martin at the beginning of this chapter for a reason. Both recently used the same playbook as BP, shedding controversial assets that seemed to weigh on their enterprise values. They sold them to privately held companies or to other firms that could not be branded negatively. Specifically, Shell and Lockheed spun off carbon-intensive energy interests to show critics they were making some progress toward the goals of Paris. Shell sold their significant oil sands holdings in Canada to a subsidiary of Canadian Natural Resources for $7.25 billion in 2017 and a portfolio of onshore, upstream assets in Egypt for $646 million in 2021. Lockheed sold their energy services business to a privately owned firm, TRC, in October 2019. In each of these cases, shareholders cheered the results, while the corporations that took over the controversial assets and businesses incurred no corresponding penalties. The global economy also became no greener or sustainable on a net basis, even though investors responded on balance as if it somehow had. These actions help illustrate why Reclaim Finance wants to punish all businesses that sell gross carbon assets instead of closing them down and writing them off. Moving ownership of Canadian oil sands from one pair of hands to another generates no net benefit for global carbon accounting.

LET’S SPEAK PRIVATELY

Salacious stories impugning the Koch family and their vast influence over large swathes of the U.S. economy and public policy are standard media affairs. Their right-leaning—perhaps more accurately, libertarian—viewpoints have made them an irresistible target for left-leaning publications. Rolling Stone magazine largely set the tone in a 2014 expose: “The Koch family’s lucrative blend of pollution, speculation, law-bending, and self-righteousness stretches back to the early twentieth century. . . . Charles and David Koch control one of the world’s most enormous fortunes, which they are using to buy up our political system; what they don’t want you to know is how they made all their money.”3

But how the Koch brothers make their money is quite simple and straightforward. Koch Industries flourishes by providing a vast array of products and services that consumers need and consistently use. Fuel for trucks, cars, and jets; tempered glass for construction and transport; fertilizer for more abundant crops; surgical and medical devices, including insulin infusion pumps; paper products ranging from napkins and disposable towels to cups and toilet paper; fabrics for combat uniforms and first responders. Like other so-called sin companies, Koch is well positioned to provide products and services people are certain to consume whether others approve of their consumption or not. Note too, Koch is particularly well positioned to provide products that have been historically supplied by now-sanctioned Russian firms, like oil and fertilizer. Is it not better to buy these products from Koch Industries than Putin? Meanwhile, what you will not have read in Rolling Stone is that Koch Industries and their affiliates have simultaneously won 1,200 industry awards since 2009 for environmental excellence, community stewardship, safety, and innovation in sustainability. In fact, in April 2021, Koch Industries won the Environmental Protection Agency’s top Energy Star Partner of the Year Award for protecting the environment through improved energy efficiency. Since 2015, Koch has also invested more than $1.5 billion to promote energy conservation. Today Koch recycles and treats 91 percent of their waste products, more than many companies who claim membership in the circular economy. Koch Industries is also meticulous about following the law. Add this all up, and you can be sure Koch Industries is not going out of business anytime soon. As they are crucial to maintaining pressure on Putin, I suggest we thank them rather than persecute them. You can also bet that, should the shareholders of Exxon, Chevron, or any other public energy producer be forced to exit their oil and gas operations, companies like Hilcorp and Koch will be ready to step in at the right price and bring those carbon assets to

THE PERILS . . .

market. As long as it is legal, financially attractive, and strategically important, Hilcorp, the Koch brothers, and other private firms like them are primed to supply the oil and gas that consumers continue to use. None of this is to heap judgment on Hilcorp or Koch, positive or negative—though it must be mentioned Hilcorp has been named to Fortune magazine’s “100 Best Companies to Work For” for seven straight years. Instead, my primary point is that every molecule of oil held by public corporations could be liquidated—something many activists covet—yet all those carbon assets could be snapped up by private purveyors and still end up being consumed. Legally.

There are obvious operational limitations to optimizing the trajectory of the global economy through publicly listed companies alone. Privately held companies play outsized roles in a wide range of industrial, environmental, and employment practices, including the production of carbon-based fuels. Since 2010, the private equity industry has invested $1.1 trillion in the energy sector, double the combined market value of Exxon, Chevron, and Shell. Private energy companies are also ready to do much more. “We have an appetite to acquire,” Brian Gilvary, the head of Ineos Energy, the arm of a private UK chemicals company and a former executive of BP, recently said. Ineos bought Hess Corporation’s oil and gas assets in Denmark for $150 million in the summer of 2021. Gilvary went on, “We’re a private company with private shareholders, but we still have to operate in a way that is in line with what governments, banks and investors want to achieve.”4

Beyond publicly listed and privately run firms, there is yet another segment of the global economy that will limit the impact of pressuring domestic energy companies to change their ways: state-owned enterprises. Shell and BP; Exxon and Chevron; and Hilcorp, Ineos, and Koch Industries are all nongovernmental organizations. Each occupies an important component of the global energy complex. But China’s National Petroleum Corporation, Saudi Arabia’s Aramco, Russia’s Rosneft, Brazil’s Petrobras, Venezuela’s PDVSA, and Iran’s National Iranian Oil Company are all government owned. When it comes to the future of oil and gas production, taken together, these stateowned enterprises are far more determinative.

More than three-quarters of the world’s known oil reserves are not in private hands; they are under government control. This means that state-owned oil companies are three times more important than their privately run counterparts. With annual revenues of $450 billion, Sinopec is the world’s largest oil company and nearly twice the size of Exxon, the largest U.S. producer.

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Sinopec’s sister, CNPC—China’s second-largest state-owned oil company— is about the size of Exxon and Chevron combined. Obviously, it will not be possible to alter the globe’s production and distribution of oil and gas meaningfully—making it cleaner and greener—without convincing the governments of Brazil, China, Iran, Russia, Saudi Arabia, the United Arab Emirates, and Venezuela that they, too, must be part of the solution. Just like European gas imports, U.S. importation of Russian oil reached a record in 2021, surpassing imports from Saudi Arabia. As U.S. producers pulled back, America’s most pernicious adversary and the world’s dirtiest oil producer— Russia—had to step in to sate U.S. consumer needs. Shortsightedness in Europe and the United States meant revenues for Russia’s state-owned energy champions and war funds for Putin’s decimation of Ukrainian cities and citizens.

In 2017, Sinopec expanded into Africa by purchasing 75 percent of Chevron’s South African assets. Just as Hilcorp’s purchase of BP’s Alaskan assets benefited BP’s ESG rating without making the world any greener, Sinopec’s purchase allowed Chevron to score highly with energy activists. At the same time, the state-owned purchaser paid no reputational price. “We spend all this time focusing on BP and Shell,” Angela Wilkinson, the head of the World Energy Council, caustically observed. “What about Saudi Aramco and ADNOC [Abu Dhabi National Oil Company]? We see pressure on a small subset of listed oil companies. But it’s not at all a realistic picture of the overall energy system.”5

The leading energy consultancy Wood Mackenzie estimates that BP, Chevron, Exxon, Shell, Total of France, and Eni of Italy—all listed companies— have disposed of more than $28 billion in energy assets since 2018. Most of these dispositions went to private or state-owned hands. Wood Mackenzie projects further disposals of more than $30 billion in energy assets in the years to come. The total value of oil and gas assets that may be up for sale from listed companies over the next decade could be more than $140 billion. The quickest way to shrink one’s carbon footprint and claim temperature alignment is to shed physical assets. But such sales do nothing to reduce emissions; they merely move carbon assets from scrutinized balance sheets to less scrutinized ones. A 2021 ruling from a Dutch court insisted Shell cut their absolute carbon dioxide emissions far more quickly than planned. Shell’s subsequent decision to delist in the Netherlands was a predictable response. It’s likely that most of Shell’s disposed energy assets will still end up in state-owned or privately held companies, but they can now

THE PERILS . . .

proceed at a more measured pace. Of course, if they do, Shell may end up greener in the end, but the world almost certainly will not.

A recent OECD report zeroed in on the double challenge state-owned enterprises present for optimal environmental, social, and governance outcomes. When it comes to “G,” state-owned enterprises appear uniquely problematic. It turns out that governments are not very good at governing themselves. Nearly half of all state-owned enterprises report losing an average of 3 percent of annual profits to corruption or other irregular practices, a multiple of private sector infractions.6 Though state-owned enterprises compose about one-fifth of all global economic activity, they account for more than half of all known corporate corruption. The OECD estimates that 1.5 percent of state-owned enterprise expenses are dedicated to detecting or preventing corruption. Improved governance standards are needed globally—but they would make the most significant impact if they were applied by governments to their wholly owned utilities, natural resource, finance, transportation, postal, agricultural, and communications companies.

Publicly listed companies receive the most significant amount of scrutiny from activists because they are the most visible. Privately held firms are no less law-abiding than their listed counterparts. Still, the playing field is unlevel because they operate further away from public glare and are subjected to much less reporting rigor and ESG capital allocation scrutiny. This inconsistency allows private firms to exploit market inefficiencies that divestiture pressures and trends invariably create. State-owned enterprises are in a league all their own from both operational and legal standpoints. They are held to account only when their governmental owners decide it is in their best interest to do so. Moreover, given that state-owned enterprises are unusually inclined toward bribery and other forms of corruption, their peculiarities pose a unique challenge to global sustainability accounting standards. Putin’s 2022 oil revenues will likely exceed those of 2021, moreover. This too is infuriating.

Why have I gone to such lengths discussing private firms and state-owned enterprises? To make this point: If net zero is a global aspiration, we must go much further than encouraging BP, Exxon, Shell, Total, and their other publicly listed counterparts to clean up or abandon their core energy businesses. They are a very, very small part of the much larger energy corporate ecosystem. If we want businesses to accelerate human development, reduce their emissions, and improve working conditions throughout the world, we will need to focus on privately held companies and state-owned enterprises at least as much. Even more importantly, we must address the issue of energy demand.

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The threats of divestment and the promise of higher valuations for publicly listed companies taken by themselves implicate a surprisingly small segment of the global economy, especially in the energy sector. While this means strategies for reducing carbon emissions must become more comprehensive, it is also true for other social priorities as well, including workforce diversity and economic mobility. Now that we more fully appreciate the role private and state-owned oil companies play, it is also increasingly apparent that the globe has little prospect for achieving the goals of Paris without significant changes in policies that apply to all economic agents. One principal lesson of the past year is that reducing oil supplies while demand remains unabated or continues to rise undermines self-sufficiency and impacts the poor the hardest by sending oil and gas prices higher. Had we been more thoughtful about ongoing demand dynamics, painful energy price hikes and our senseless reliance on Russian oil and gas could have been avoided.

Does all this mean we should stop looking to publicly listed corporations to minimize their environmental, social, and governance risks? No, it does not. It merely raises concerns about how effective publicly listed–only activist campaigns are. It also raises questions about how much more we must do to promote inclusive, sustainable growth comprehensively.

But this is not the only challenge of campaigns that favor divestment as a tactic for forging progress. Divestment arguments have always had another weakness. Not only does the threat of share divestment not work as hoped; the act of divestment is also inherently counterproductive. When it comes to changing corporate behaviors, it is more effective to be an inside shareholder fighting for change than an outsider carrying placards and shouting slogans on the picket lines.

Much more effective.