Dual-class shares for low-carbon innovation

One way to look at the climate change problem is through the lenses of low-carbon innovation: to reduce CO2 emissions, the world needs alternatives to fossil fuels. According to the latest estimates by the International Energy Agency, 35% of the green energy required to reach Net Zero by 2050 depends on technologies not yet on the market. Slow technology undermines governments’ ability to reduce CO2 externalities through traditional instruments, such as taxes and regulation, because starving people of energy is politically difficult and hard to coordinate internationally. A related problem affects sustainable finance: so long as burning fossil fuels is profitable, the impact of sustainable finance on global CO2 is limited. However, sustainable finance can incentivize controlling shareholders to pursue low-carbon breakthroughs and step up the transition. Controlling shareholders are best positioned to pursue radical low-carbon innovation because, as opposed to managers of dispersed-ownership companies, they have vision, tolerance for failure, and indefinite time horizons.

In a recent paper, I have argued that dual-class shares, which enable control with less than half of the equity, allow institutional investors to finance low-carbon innovation solving a double commitment problem. On the one hand, controlling shareholders that commit to pursuing low-carbon innovation without increasing agency costs can tap the funds of climate-conscious investors to scale their vision. On the other hand, climate-conscious institutional investors can commit to supporting the controlling shareholder’s vision by relinquishing control rights conditional on the achievement of an ambitious CO2 target. A target-contingent sunset and a divestment sunset support this double commitment.

While dual-class shares allow controlling shareholders to scale their vision, potentially they also increase agency cost. This concern is often exaggerated. Although controlling shareholders have more incentive to ‘steal’ from minority shareholders the lower their equity, this problem is less severe in good corporate law jurisdictions where effective procedural constraints on self-dealing are or can be implemented. Still, the wedge between voting rights and the controller’s equity created by dual-class shares could undermine the incentive to acknowledge the vision’s failure as the controller’s stake becomes too small (for example, a 10:1 wedge enables control with 9.1% of the equity; 20:1 requires only 4.8%). However, the presence of idiosyncratic Private Benefits of Control (PBC) rules out excessive wedges. Idiosyncratic PBC represent the vision’s subjective value – for instance, the pride of making a negative-emissions vehicle – and motivate controlling shareholders to invest all or most of their wealth in a company to implement their vision. To protect the value of their undiversified investment, controllers stop selling noncontrolling stock when investors require a discount as high as idiosyncratic PBC: selling stock for less would reduce the value of the controller’s equity. As investors anticipating agency cost require a higher discount the higher the wedge, finite idiosyncratic PBC limit this wedge setting a lower bound on the controller’s stake. Because controlling shareholders value their vision and may lose everything from failing to acknowledge its failure, the agency cost of dual-class shares is limited.

A target-contingent sunset commits controlling shareholders to pursuing low-carbon innovation to monetize idiosyncratic PBC. Such a sunset would collapse the dual-class structure into one-share-one-vote if the control block is sold before achieving the decarbonization target. Conversely, the dual-class structure would become permanent when the target is achieved. Although controlling shareholders face no time pressure to deliver innovation, they must wait until they hit the target before they can cash in idiosyncratic PBC as control premium. With a target-contingent sunset, climate-conscious investors may incentivize controlling shareholders to pursue low-carbon innovation, as opposed to any other innovation. Importantly, the target must be technologically out of reach in the particular industry. Think, for instance, of a net-zero vehicle (meaning negative CO2 emissions) or low-carbon aviation. Moreover, CO2 targets should be fool-proof and include measurable upstream and downstream (so-called Scope 3) emissions. In my paper, I show with a numerical example that controlling shareholders prefer to commit to low-carbon innovation if climate-conscious investors buy noncontrolling stock at a lower discount than financial investors who only care about risk-adjusted returns.

But why should investors offer such a good deal to controlling shareholders? Institutional investors, particularly mutual fund managers, cater also to the preferences of climate-conscious beneficiaries who are willing to forgo short-term return, however little, to improve climate change. This is not just theory; there is evidence that this mechanism affects mutual fund flows, including of large, mainly index-tracking investors such as the “Big Three” (Blackrock, Vanguard, and State Street). In turn, ownership by the Big Three and comparable asset managers is negatively correlated with CO2 emissions. However, the size of CO2 abatement that can be attributed to institutional investor engagement is much too small compared to the Paris agreement goals. More disturbingly, a recent study reveals that CO2 emissions are positively correlated with low-carbon innovation, suggesting a Jevons paradox: when burning fossil fuels become more efficient, companies – and their institutional owners – prefer cashing in the value of innovation to pursuing further decarbonization. This frustrates the purpose of climate-conscious investors.

To fulfil the mandate of their climate-conscious beneficiaries, institutional investors should tie their hands to controlling shareholders with dual-class shares conditional on low-carbon innovation. This is necessary because, so long as climate risk is mispriced – and it will remain such until catastrophes or new technologies become easier to value – even “universal” institutional owners cannot simultaneously provide competitive returns and have more impact than foreseeable government policies. This clashes with a mandate from climate-conscious beneficiaries to forgo short-term returns for long-term impact. Short of greenwashing, which arguably the EU Taxonomy will curb, such a mandate implies subsidizing low-carbon innovation until it will become profitable in a futuristic decarbonized world, in the spirit of the delegated philanthropy theory of Bénabou & Tirole.

Large, institutional owners cannot support delegated philanthropy for three reasons: a) they are time-inconsistent as they cannot commit to forgoing short-term returns; b) they are incompetent to judge firm-specific innovation, exposing managers to hedge fund activism; c) they have a conflict of interest with low-carbon breakthroughs because, as horizontal, or common owners, some scholars would argue they prefer less competition. Controlling shareholders are a good commitment device for institutional investors because they face none of these limitations: as large, undiversified shareholders, they are committed to the long term; as controllers, they cannot be ousted unless they underperform severely; as visionaries, they compete aggressively.

While a target-contingent sunset supports climate-conscious investors’ subsidy to low-carbon innovation (in the form of a lower discount/higher wedge of dual-class shares), institutional investors could still worry that controlling shareholders increase agency cost after getting undisputed control. To facilitate contracting and overcome this concern, corporate law should feature a divestment sunset as a default rule. A divestment sunset stipulates that a dual-class structure revert to one-share-one-vote if the controller’s equity falls below a certain proportion as of the IPO (or the subsequent establishment of dual-class shares). Complementing corporate law restrictions on self-dealing and other safeguards, a divestment sunset prevents controlling shareholders from increasing agency cost with time by legitimately taking cash out of the company while retaining control.

There are recent examples of controlling shareholders using dual-class shares to support low-carbon innovation rather than to extract cash from the company. Porsche raised €9.4 billion selling non-voting shares, allegedly to foster Volkswagen Group’s global leadership in Electric Vehicles, whereas leveraging on Berkshire Hathaway’s dual-class structure, Warren Buffett has become the largest shareholder of Occidental Petroleum, market leader in Carbon Capture and Sequestration technology. In both cases, institutional investors have played along. Combining a target-contingent sunset with a divestment sunset aims to mainstream dual-class shares for low-carbon innovation.

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By Alessio Pacces, Professor of Law & Finance at the Amsterdam Law School and the Amsterdam Business School of the University of Amsterdam.

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