The momentum in ESG trends has led to growing calls for the finance sector to embrace stakeholder capitalism, where profit motives are matched with broader commitments to society. Yet despite much pious nodding of the head in agreement, there is still a gap between what ESG investors promise to do and how they invest. To help close this gap we will need to think outside the box. Here are three potential archetypes of scalable stakeholder equity for ESG investors:
Common shares with ‘earmarked’ special ESG dividends – special dividend distributions would be based on certain ESG metrics being met. They could be paid at regular intervals based on an ESG path being monetised – say via divestment or new product launch – and pre-agreed via a shareholder vote. Shareholders could also vote on a third-party audit of whether the ESG metrics were met before the special pay out.
This could help issuers on a ‘transition’ towards greater ESG alignment reward their shareholders for supporting their valuation whilst the transition is underway, and create a greater financial incentive to hold securities not classified (yet) as best in class in ESG from third-party rating agencies.
Convertible zero coupon ESG shares – the issuer here would sell a form of preference shares and use the proceeds fund achievement of a particular E, S or G target, probably time stamped at issuance and with commitments to third party assurance that the terms of the ESG target being reached. To align values with value, the preferred would only pay a coupon ‘in kind’ via extra shares as ESG targets are reached. A completed ESG journey would trigger the potential for conversion – but if the ESG targets were not met in the time frame set at issue, the conversion option would expire worthless.
This would be an instrument directed very specifically at providing the capital for resolving or improving an ESG issue. As with any convertible, the incentive to convert would be highest when the common share appreciated past the convertible’s strike price – generating an additional measure of the so-called ‘sustainability premium.’ Holders of the common shares would also share an incentive with the preferred holders to keep track of the ESG targets being met, broadening the scrutiny of management’s ESG strategy execution.
ESG Tracking stock – the issuer would isolate a business unit that is particularly focused on achieving an ESG goal - with its own balance sheet, P&L and full-time resources – and issue tracking stock in that unit. These shares would have no voting rights in the parent company but would benefit from any potential dividend distributions made from the tracking stock business unit. The parent company could retain a holding – and share in the potential upside from dividends - but would commit to remain a minority investor.
This security could be a useful instrument for a company particularly exposed to criticism that its ESG business activities are too small to make a material difference to the ESG rating of the parent company. Pure play ESG investors would benefit by getting exposure only to the ESG focused activities of the parent issuer, and thus reduce the potential for greenwashing accusations.
We realise that the proposals above are outside the mainstream and represent a challenge to both issuers and investors given their current statutes, regulatory permissions, and frames of reference. But if the ESG trend is to fund a meaningful change of model, we will have to change the way investment propositions are framed. Stakeholder capitalism sounds good in theory - but to build it in practice, we will need stakeholder equity.
Olivier Lebleu is Head of ESG, Edelman Smithfield.