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This article was originally posted on the Oxford Business Law Blog on 2 July 2021.

By John Armour, Luca Enriques and Thom Wetzer

Business models that depend on the extraction and sale of fossil fuels involve profiting from the social costs that their activities generate

A small number of firms have an outsize impact on climate change. The majority of global carbon emissions since human-induced climate change was officially recognised can be traced to a relatively small number of corporate and state entities which have been dubbed ‘systemically important carbon emitters’ (SICEs). Moreover, many of these firms have expended considerable resources on lobbying and spreading doubt on climate science.

The activities of the SICEs involve significant externalities. The price of carbon as reflected in the current market price of these firms’ fossil fuel products is far below the social costs that the related emissions generate in terms of impact on climate change. Consequently, business models that depend on the extraction and sale of fossil fuels involve profiting from the social costs that their activities generate.

Amongst other things, the Financial Stability Board has likened the role of the SICEs in climate change to that of systemically important financial institutions in bringing about the near-collapse of the financial system in the 2007-9 crisis. ESG activist investor pressure group Climate Action 100+ has singled out the SICEs for special shareholder activism intended to bring about change in their business models to lower emissions.

Why do shareholders care about corporate carbon emissions?

The case for such change—and shareholder activism to initiate it—could be framed in at least two distinct ways. The first is a business case, expressed purely in terms of profits to the SICE firm. That is, the expected returns from shifting its business model away from fossil fuels and towards renewables and other forms of green energy are higher than those associated with remaining on its original path. This depends crucially on the cost of carbon emissions, as priced—directly or indirectly—by regulation. The higher their cost, the better the return on investment associated with renewables, and the greater the devaluation of fossil fuel assets. Once this tipping point is in vision, such a case for change should be persuasive for all investors and for managers with equity-based compensation.

Secondly, a case for change might be made independently of the firm-level business case, based on the wider preferences of investors. There are plausible reasons why investors might support initiatives designed to reduce carbon emissions even where this is not clearly profit-maximising for the firm. On the one hand, institutions holding widely diversified portfolios have incentives to engage with firms whose activities create widespread negative externalities, as the costs they incur across their portfolios likely exceed the profits received from holdings in those firms. On the other hand, so-called ‘ESG’ funds—whose mandate encompasses the pursuit of Environmental, Social and Governance objectives—can be understood as reflecting an expressed preference by end-investors for trading off some element of financial payoff in return for the pursuit of social objectives, amongst the most salient of which are climate-related goals. The extent to which such a trade-off occurs in practice is controversial, but conceptually it makes sense to think that there may be some actions ESG funds would support that regular investors would not. Together, these constituencies may successfully push for change even where a purely financial business case is lacking.

Promises made: SICEs’ carbon-reduction pledges

Recently, some of the SICEs have signalled a change of their position. In 2020, first BP and then Shell announced a major reorientation of their strategies that includes the goal of achieving ‘net zero’ status by 2050.  This is an ambitious target, framed by reference to the COP26 goal of securing global net zero by the same year. In contrast, Chevron and ExxonMobil, while acknowledging the existence of the need for carbon emission reductions and making a number of incremental steps in that direction, did not announce any over-arching target for carbon reduction. Indeed, ExxonMobil presented analysis suggesting that global demand for carbon will continue to grow at least until 2040. ExxonMobil’s stance attracted ire from institutional investors. A newly formed ESG-activist hedge fund, Engine No 1, launched an extraordinary proxy contest against ExxonMobil in late 2020. This received widespread support from institutional investors, leading in 2021 to the appointment of three new members to ExxonMobil’s board, who are focused on exploring avenues for change.

An obvious question to ask in the light of these public statements is whether they go far enough. Even the more ambitious pledges are only in terms of the emissions from their own business activities and upstream emissions (Scope 1 and 2 emissions), which are only a small fraction of the total emissions associated with these companies, most of which are produced by downstream users of their product (Scope 3 emissions). In May 2021, the International Energy Agency published a report setting out necessary steps to achieve net zero by 2050. These include no further investment in new fossil fuel supply, which goes far beyond the announced goals of even the most ambitious of the SICEs’ net zero targets. It seems likely that these firms will come under renewed pressure from activists, investors, and governments to raise the ambition of their commitments.

Promises kept? The (questionable) credibility of carbon commitments

A separate question from the ambition of the pledges made by firms regarding climate change is the credibility of these undertakings. In essence, this goes to how easily firms might renege upon them. The problem arises because firms are likely to have a time inconsistency problem regarding their pursuit of green objectives.

We can illustrate this time-inconsistency problem by considering each of the two rationales we articulated above for shifts toward lower emissions. If the business case is expressed purely in firm-level profits, the assessment of relative expected returns depends crucially on political movement on carbon pricing. The volatility of political commitments to carbon transition means that there is a wide range of potential pathways, each encompassing different costs of carbon emissions. The best estimate at t = 0 may be of a relatively rapid rise in carbon prices, but the continued validity of this conclusion depends on political outcomes. If, for example, a major world power elects or otherwise appoints a leader at t = 1 who is less committed to controlling climate change than their predecessor at t = 0, this may reduce the relative expected returns of ‘green’ versus ‘brown’ business models. A firm that is focused solely on maximising expected returns, but which at t = 0 had pledged to reduce its carbon intensity by a stipulated amount might now wish to tone down the scope of its pledge in order to increase expected returns given the new political direction.

Alternatively, coalitions of investors with climate-focused preferences may trigger pledges even in the absence of a firm-level business case. To the extent that such pledges are inconsistent with a profit maximization goal, they will only be honoured so long as the coalitions supporting them have control over the general meeting. Yet, share ownership changes over time, which render their control unstable. In particular, if a gap opens between the profit-maximising strategy at the firm level and the firm’s stated environmental commitments, it may be vulnerable to attention from shareholder activists who seek to reverse the commitments in order to increase firm-level profits.  In other words, to the extent that making a climate pledge is driven by a desire to meet the preferences of ESG investors, the firm’s commitment will be conditional on the shifting sands of its shareholder register: again, a time inconsistency problem.

For a carbon reduction pledge to be robust to this problem, it has to be backed by a credible commitment. With such a commitment in place, the firm will stick to its green pledges even if, during the period for which they are made, indicators such as the stock price suggest they are not shareholder wealth-maximising. Many existing corporate governance mechanisms designed to back up corporate carbon commitments—like making executive compensation sensitive to reaching decarbonisation milestones—are not credible in this sense, and remain vulnerable to the time-inconsistency problem.

‘Green pills’ can lock in corporate carbon commitments, making them credible  

We propose a novel mechanism for making carbon reduction commitments credible, which we term a ‘green pill’. The basic idea is that the firm should give a binding undertaking to make a payment conditional on non-fulfilment of its green commitment. This delivers a level of commitment that varies continuously with the amount of the promised payment. The degree of commitment can consequently be both readily understood by investors and calibrated to the context by management. Once made, a commitment of this sort would unite the interests of purely financially motivated and of ESG investors.

In their first-year classes, law students are typically taught that contract law provides a means of making a credible commitment. Each party promises their performance to the other. These promises are made credible by the mutual knowledge that if the performance is not delivered, the promisee can bring a claim for damages in the courts against the promisor. The standard measure of contract damages seek to put the promisee in the same financial position they would have been in had the contract been performed. As is well-understood in the classical discussion of ‘efficient breach’, the commitment this creates for the promisor is far from absolute. A contractually binding promise commits the promisor only insofar as the cost to them of performance is less than the financial value of performance to the promisee.

It is thus immediately obvious that a standard contractual undertaking by a firm is insufficient to deliver a credible commitment to carbon reduction. First, the ordinary measure of contract damages seeks to put the promisee in the same financial position as if the contract had been performed. The costs of a SICE failing to meet a carbon reduction target are likely to be widely distributed, such that any contractual promisee is only going to bear a tiny fraction of them. This means that ordinary contractual damages—or even a liquidated damages payment based on a reasonable pre-estimate of loss—are unlikely to provide sufficient inducement to commit the firm credibly. Moreover, it will be very difficult for any promisee to demonstrate the financial value to them of the promised performance.

Yet with appropriate transaction design, a commitment mechanism based around a financial payment can be crafted in a way that is legally effective. The key to avoiding the operation of the rule against penalty clauses is to structure the arrangement as an independent promise, rather than a remedy that is stipulated for breach of the promise, eg, to reduce carbon emissions by x percent by a given year. For example, a payment made under escrow at the time of entering into the contract, which is specified to be revocable on completion of the carbon reduction undertaking, would function to deliver commitment up to the value of the payment, but not fall foul of the penalty clause rule. Similarly, the grant of an option, exercisable on breach of the carbon reduction promise, to purchase new commercial paper issued at a deep discount would have the same functional impact on the promisee but equally not fall foul of the penalty clause rule.

Examples are beginning to emerge of provisions that appear to be designed to deliver some level of liquidated commitment to green undertakings. Thus, for example, Enel Group, a large Italian energy utility firm, has successfully issued ‘sustainability-linked bonds’ in 2019 and 2020. Unlike most ‘green bonds’, the issue does not ringfence the funds for a particular project but rather uses them for Enel’s general financing. However, Enel has sought to commit to sustainability-related goals in relation to its general activities. These sustainability-linked bonds seek to underline that commitment by making the rate of interest vary according to whether the firm meets a particular target with respect to the fraction of energy it delivers that is sourced from renewables rather than fossil fuels. The bond agreement is structured such that the firm does not make any contractual undertaking to the bondholders to meet the sustainability target; rather, it simply stipulates an additional interest payment that conditions on this event. Hence it falls outside the scope of the rule on penalty clauses.

A further challenge to using a contractually binding undertaking lies in the possibility for strategic interaction with the promisee. Consider a green finance security that promises investors a significant payout if the firm fails to meet a particular carbon reduction target. If the firm fails to meet its target, then holders of this type of security will obtain a significant payout. If the securities are purchased—whether initially or in the secondary market—by investors whose preferences are limited to financial returns, then the value of the securities will rise as default becomes more likely.  What is more, if the amount at stake is sufficiently large, investors will then have incentives to combine holding the green finance securities along with the firm’s common stock, and using the voting rights associated with the latter to cause the firm to fail to meet its carbon reduction commitment in order to secure a payday. The investors’ incentives to engage in such ‘brown voting’ would actually make it less likely that the firm would meet its carbon reduction target: a wholly counterproductive result.

A solution to this problem is to structure the arrangement such that the additional payment is made not to the holders of the securities, but to a third party with no ability to influence the firm’s behaviour. In the context of carbon reduction targets, a potentially suitable party that would satisfy this criterion might be an independently run foundation that safeguards the company’s green credentials, an environmental charity, or NGO. By entering into a binding undertaking to pay such a third party, the firm could credibly commit itself to climate targets up to the cost of the undertaking. 

‘Green pills’ need not contravene directors’ fiduciary duties

Having established the contours of what an effective green pill might look like, we now ask whether signing up to a commitment like this would be possible as a matter of corporate law. At the core of the arrangement would be the board tying the company’s hands with regard to the (non-)pursuit of particular types of business opportunity. However, in the context of M&A poison pills, mechanisms that strongly tie boards’ hands not to redeem—so-called ‘dead hand’ and ‘no hand’ poison pills—have been struck down by the Delaware courts. Most significantly for current purposes, in Quickturn Design Systems, Inc. v. Shapiro, the Delaware Supreme Court struck down a poison pill expressed to be non-redeemable for a period of six months as an invalid attempt to restrict a board from exercising their fiduciary duties on an ongoing basis. This was, at least on its face, expressed not to be so much a concern about entrenchment, but rather about the board’s need to be free to exercise its fiduciary duties on behalf of the company on a continuing basis. Similarly, English company law also has a doctrine restricting the ability of directors to enter agreements that fetter their ability to discharge their fiduciary duties. In each case, for the hand-tying to be consistent with directors’ fiduciary duties, the significance of being able to make the commitment must be traded off against the potential foreclosure of future opportunities that it will entail.

The business case for this form of commitment would have to be based on an analysis of the likely long-run trajectory of carbon pricing and the need to adopt a long-term strategy towards carbon reduction in response. Against this, the volatility of short run political sentiment means that carbon may be priced far below its ultimate level for a considerable period of time, leaving opportunities for profits to be made in the meanwhile. The longer these profits are pursued, the harder the transition. On this rationale, a hard commitment locks the firm to a strategy that is likely to deliver superior returns in the long run. This is a purely financial analysis, which focuses just on returns to the company. The limitation with this approach is the uncertainty over long-term models. Yet, there is likely sufficient evidence to support a good faith assessment that such a commitment is justified. Firms regularly commit to a particular course because the board believes this will be value-maximising—for example, a long-term exclusive supply agreement. However, the more extensive the commitment, the more the analysis would be subject to scrutiny to ensure the credibility of the board’s claim of good faith.

Credible carbon commitments can ease the pathway to carbon reduction policies

Complementing this analysis is the impact of such credible commitments on the political economy of carbon pricing. Responding to climate change requires an unprecedented level of coordinated political commitment. Despite the high and still-growing salience of the climate crisis, the challenge of political coordination is enormous. This plays out in multiple overlapping ways: between politicians with short time horizons and the rest of humanity, between present and future generations, between citizens and countries who benefit more from carbon-related activities and those who will suffer more from climate change.

Until recently, the fossil fuel sector has lobbied uniformly and consistently—and, seemingly, successfully—against initiatives calculated to increase carbon pricing. However, if such firms break ranks in a significant and credible way, then it will no longer be in their interests to lobby against change: quite the reverse. Given the considerable lobbying resources available to the sector, this will plausibly increase the scale and speed of carbon pricing regulation. In other words, a credible commitment to change by systemic emitters can help endogenise the regulatory environment, as well as shareholder preferences. There is thus a powerful virtuous synergy to credibly committing to green business models.

John Armour is Professor of Law and Finance at the University of Oxford and ECGI Fellow.

Luca Enriques is Professor of Corporate Law at the University of Oxford and ECGI Fellow.

Thom Wetzer is Associate Professor of Law and Finance at the University of Oxford and Founding Director of the Oxford Sustainable Law Programme.

This post is based on contributions to and the discussion at the 5th Annual Oxford Business Law Blog conference on ‘Business Law and the Transition to a Net Zero Carbon Economy’ which took place online on 25 to 27 May 2021. The post is forthcoming in Andreas Engert, Luca Enriques, Georg Ringe, Umakanth Varottil and Thom Wetzer (eds), Business Law and the Transition to a Net Zero Carbon Economy (CH Beck - Hart Publishing 2021) (forthcoming).


Event: Business Law and the Transition to a Net Zero Carbon Economy (25 - 27 May 2021)

Videos of the presentations are available on the ECGI website and YouTube channel.

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