The Agency Costs of Sustainable Capitalism

Abstract

The passive index investing revolution and the demand for bespoke environmental, social, and governance (“ESG”) investment products are the most monumental changes to shape the investor landscape for many years. These developments have been accompanied by an unprecedented concentration of power among BlackRock, Vanguard, and State Street (the “Big Three” asset managers), who are now the biggest shareholders and common owners of the vast majority of globally significant companies. Inevitably, the Big Three are among the most powerful shareholders of the companies that have been identified as major contributors to the climate crisis. Due to the failure of governments to take effective action in the global effort to combat climate change, there has been intense pressure directed at the Big Three to provide investor driven solutions. The Big Three therefore increasingly purport to assume what I call the role of “sustainable capitalists”. In this Article, I build upon Gilson and Gordon’s “agency capitalism” framework to put forward a new agency-costs theory of sustainable capitalism. In this “sustainable capitalism” framework, I show that the Big Three still exhibit some form of “rational reticence”, especially with regard to firm-specific sustainability activism. I theorize that they may also be inflicted with a second agency problem that I call “rational hypocrisy”. This concept is similar to corporate greenwashing as the Big Three are incentivized to claim that they have a stronger commitment to sustainability than is actually reflected in their voting and engagement records in reality. The combination of “rational reticence” and “rational hypocrisy” results in a dual monitoring shortfall–the “agency costs of sustainable capitalism”. In the agency capitalism framework, the proposed solution was for specialist activist hedge funds to fill the monitoring shortfall by initiating firm-specific activism as “governance arbitrageurs”. Analogously, in my sustainable capitalism framework, both ESG hedge funds (initiating firm-specific ESG activism) and other “responsible activists” (focusing on portfolio-wide ESG issues) can be thought of as potential candidates for the role of “ESG arbitrageurs”. Successfully mitigating the problem of rational reticence depends on the complementarity of interests between the ESG arbitrageurs (as initiators) and the Big Three (as arbiters). When discussing appropriate strategies for responsible activists, I demonstrate that important lessons can be learned from a close examination of the way activist hedge funds have adapted to fit the role of governance arbitrageurs. Mitigating the problem of rational hypocrisy, however, requires a different approach. Here, I argue that responsible activists may need to focus on, and target their activism at, the Big Three themselves.