Faculty of law blogs / UNIVERSITY OF OXFORD

Many of the world’s largest firms have recently announced their intention to reduce carbon emissions over the coming decades. The financial sector claims to have mobilized over $130 trillion in support of the net zero transition and 33% of the G20’s largest companies by revenue have set a net zero target in alignment with the goals of the Paris Agreement. Even Shell, an oil supermajor and for a long time a bête noir of climate campaigners, has set itself the target to ‘become a net-zero emissions energy business by 2050.’

Against a backdrop of lackadaisical climate policy, that sounds like a rare piece of good news for climate campaigners. But Shell’s ‘target’ turns out to be anything but a credible commitment. A quick look into the fine print suggests that Shell’s net-zero emissions target qualifies at best as an aspiration that may not even be consistent with Shell’s current plans, strategies, budgets and pricing assumptions. It should be no surprise, then, that anything stated in the page outlining Shell’s net zero target, other than statements of historical fact, and including, therefore, Shell’s statements on emission targets themselves, is explicitly qualified as a forward-looking statement. Actual outcomes, as Shell hastens to clarify, are subject to known and unknown risks and uncertainties that could cause them to ‘differ materially from those expressed or implied in these statements.’

This practice is far from unique to Shell. Allegations of widespread corporate and investor greenwashing cast doubt on the credibility of laudatory net zero pledges, suggesting that they are rife with fudge. A recent study scrutinized the climate pledges of twenty-five major multinational companies representing a cross-section of industries and found that only three of them are planning for ‘decarbonization of over 90% of their full value chain emissions by their respective target years.’ Thirteen of the twenty-five provide detailed plans, but their implementation would on average only curb emissions by 40% over the next few decades.

The lack of credibility in net zero target announcements raise the two central questions motivating our paper: can we expect shareholders and managers to coalesce around sufficiently timely and ambitious climate transition pledges? And, if so, can firms credibly commit to them?

A starting point is to ask whether traditional firm-value maximizing arguments could compel managers and shareholders to credibly commit to reducing emissions. Classical corporate governance mechanisms exhort managers to maximize shareholder value, as represented by the stock price. An important question, therefore, is how climate change might affect a firm’s valuation. 

From this perspective, climate change plays out as an increasingly significant risk factor for businesses, which are confronted by rising costs of physical risks (the costs of climate change on firms’ assets and operations, through flood, draught, fire, extreme temperatures, disease and the like) and transition risks (e.g. regulatory initiatives such as carbon taxes or emission caps, but also changes in market demand, technological change, reputation concerns and potential litigation). At the same time, the transition to a net zero economy also offers commercial opportunity, as the advent of Tesla vividly illustrates. Given the growing costs of climate change and the opportunities associated with a transition to a net zero economy, it is likely that at some point firms will reach a tipping point and conclude their future profits will be maximized by aligning their business model with net zero. Such firms will be able to justify their transition using a conventional business case, fully aligned with traditional shareholder value maximization norms. As transition pathways firm up, more firms can be expected to identify such a business case over time. However, there is much uncertainty about when this point will be reached.

Despite this uncertainty, a growing number of investors appear to be keen on taking firms’ transition plans into account in their valuations, beyond the extent implied by conventional assessments of expected profitability. These ‘climate-conscious’ investors may prefer firms to transition toward net zero before a conventional business case for doing so can be made.

Within the framework described above, our paper makes four contributions to the debate on corporate governance and climate change. First, we show that rational climate-conscious investors will discount climate-related undertakings that are not credible.  Without a binding commitment, firms face a time inconsistency problem. Changes in the costs of transition or in the mix of shareholders in the firm’s register (green vs non-green) may lead the firm to renege on transition ‘pledges’ when the time comes to incur significant costs. Rational climate-conscious investors, cognizant of this risk, would discount the premium they are willing to pay for a firm’s shares accordingly. Assuming a sufficiently large proportion of investors is climate-conscious, making a more credible commitment to transition may thus increase a firm’s valuation.

Second, we show that the corporate governance mechanisms so far proposed to generate corporate commitments to transition have limited credibility. Liability-based mechanisms such as disclosures to shareholders are constrained by the assessment of shareholder losses in purely financial terms, leaving out the value climate-conscious investors place on emission reduction. Governance-based mechanisms such as executive compensation, board structure, say-on-climate votes, and tweaks in the company’s purpose rest ultimately on the board’s discretion for their effectiveness, but share­holders elect the board. Hence, such mechanisms are not robust to the problems caused by changes in the mix of shareholders and their preferences.

Third, we show how a firm can credibly commit by introducing the idea of ‘green pills:’ mechanisms that firms could deploy using private law to deliver credible commitments to transition, a real-world example of which are sustainability-linked bonds. What green pills have in common is that they involve a penalty (in the case of sustainability-linked bonds, in the form of an interest rate step-up) for the corporation that fails to deliver on the climate commitment. We characterize the extent of, and limits to, commitment by these means. Contract-based mechanisms deliver a degree of commitment that can be tailored to the firm’s circumstances. Once a green pill is in place, standard corporate governance mechanisms work to support transition, instead of creating potential obstacles. In particular, green pills serve to align the interests of shareholders focused solely on profits with those of climate-conscious investors, therefore endogenizing the commitment to transition.

Finally, we show that adopting a green pill is in line with directors’ fiduciary duties. Its adoption is subject to scrutiny by Delaware courts under the business judgement standard of review.

As we conclude, green pills offer to clarify where business stands on the issue of climate change. If firms adopt credible commitments to reduce emissions, we know they are serious. If they do not, that raises serious questions about the willingness or ability of business to help drive the climate transition and would suggest that efforts should be redoubled on imple­menting government climate policy.

John Armour is Professor of Law and Finance, Luca Enriques is Professor of Corporate Law, and Thom Wetzer is Associate Professor of Law and Finance and Director of the Oxford Sustainable Law Programme—all at the University of Oxford.


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