Why Engine No. 1’s Victory Is a Wake-up Call for ExxonMobil and Others

Over the past two weeks, activist hedge fund investor Engine No. 1 scored a victory for the climate change movement by wresting three board seats at ExxonMobil with the support of the “Big Three” institutional investment firms BlackRock, Vanguard, and State Street. But the episode also marks a failure in ExxonMobil’s “corporate diplomacy” because of its inability to convincingly demonstrate that it is committed to mitigating climate risks and protecting its long-term business value, according to Wharton management professor Witold Henisz.

“Corporate diplomacy is just the art and the skill of winning the hearts and minds of stakeholders to support an organizational mission,” said Henisz, who has authored a book on the subject. During a recent interview on Wharton Business Daily on SiriusXM, he noted: “It’s about reaching out to community leaders, to NGOs, to government officials and making sure that they’re on the company’s side, that they see the business case or the social case for helping the company. The company needs to cultivate those relationships to deliver its value.” Henisz is also faculty director of the Wharton Political Risk Lab and founder of Wharton’s ESG Analytics Lab.

“ExxonMobil has been a poster child for failed corporate diplomacy,” said Henisz. “Unlike the other major oil and gas companies, ExxonMobil has made very little adaptation to the reality of climate change, and its stock price has been suffering as a result.” He pointed out that Engine No. 1 didn’t run its challenge to ExxonMobil as a “green campaign,” but as one that equated climate risk with financial risk in terms of how it destroys shareholder value. “They convincingly made that case and replaced a quarter of the board.” ExxonMobil’s planned investments in carbon capture and storage failed to persuade Engine No. 1 to back off. (Editor’s note: Henisz served as a consultant to Engine No. 1, supporting the development of a novel approach to integrating ESG data and analytics into fundamental analysis.)

In its campaign against ExxonMobil, Engine No. 1 contended that the energy major faced “diminished returns, high debt levels, and questions about its ability to maintain its dividend.” It noted that “repositioning ExxonMobil for long-term value creation will require an understanding of the trends shaping the future of energy and the opportunities they create, yet none of the independent board members [has] any other energy industry experience.”

The three Engine No. 1 nominees elected to the ExxonMobil board — Gregory Goff, Kaisa Hietala, and Alexander Karsner — are former energy executives, and the latter two have experience in renewable energy. Anders Runevad, former CEO of wind power company Vestas, who was Engine No. 1’s fourth nominee, did not get elected.

Engine No. 1 has only a 0.02% stake in ExxonMobil, but the climate risk issues it pushed for were sufficient to get the three big investment firms on its side. In explaining its stance, BlackRock stated that the energy major needs “to further assess the company’s strategy and board expertise against the possibility that demand for fossil fuels may decline rapidly in the coming decades.” BlackRock CEO Larry Fink had reiterated his company’s commitment to combating climate change in his 2021 annual letter to CEOs; in his 2020 letter to CEOs, he had said that “climate risk is investment risk.”

Business Value of Climate Risk

The concept of corporate diplomacy has evolved as shareholders and the general public want to see companies actively espouse issues that matter to them, be it climate change or racial inequality. It is now conceivable that corporate diplomacy can be monetized and be turned into business value, said Henisz. “It’s not just an idea; it shows up on the profits and loss statement, and it shows up on the risk register.”

The ExxonMobil episode demonstrated that loss of business value, Henisz continued. “A lack of attention to climate risk destroyed the return on invested capital. It destroyed shareholder value. You could link their strategy to the balance sheet, and Engine No. 1 did that very successfully.” The market capitalization of ExxonMobil has shown that sensitivity to climate risks especially over the past 15 years.

Engine No. 1 reached out to a wide range of investors, making the business case that climate risk is financial risk. The support the activist fund received from BlackRock, Vanguard, and State Street reflected that increased awareness of climate risks, Henisz noted. “We’re starting to see a recognition that some of the things we thought of as non-business or non-traditional risks do impact the balance sheet, and that expands the scope of who might vote with an activist.”

The success of the Engine No. 1 campaign against ExxonMobil wasn’t driven merely by environmental activists, said Henisz. “Far beyond the votes they hold, and far beyond people who are engaged on climate change or environmental issues, it opens up the mainstream investment community to these appeals. The majority of the votes came from the pension funds, asset managers, and big institutional investors because they saw the business risk in the strategy ExxonMobil has taken.”

The ExxonMobil episode also marked an effort to remove the barrier between those who are interested in maximizing their investments and others who are interested in climate issues. It went on to “find the group that is interested in both and show that the two are connected,” said Henisz. Similar dynamics are at play in issues related to human rights, labor practices, or a living wage, he added. “The same sort of issues and the same connection loom large in a lot of the debates we have around stakeholder capitalism.”

Protecting Long-term Value

The big takeaway for publicly held companies from ExxonMobil’s experience is “to pay attention to long-term value,” said Henisz. “If they deliver on long-term value to their stakeholders, to their shareholders, to their employees, and to the communities in which they do business, their company will survive. And if they fail to do that, the company will struggle and can be challenged, and its management can be challenged.”

To begin with, companies must determine who their most important stakeholders are. “It’s hard to say who are the most important shareholders, but you want to try to achieve harmony among them and achieve a balance of gains,” said Henisz. “ExxonMobil was tilting the balance towards the short-term shareholder interests at the expense of long-term [interests], communities, and all of us who are affected by climate risk.”

Other energy companies are also finding themselves compelled to invest more in containing climate risks. Last week, Royal Dutch Shell made a commitment to that effect following a Dutch court ruling that it must reduce its global net carbon emissions by 45% by 2030 from 2019 levels.

In their efforts to reengage with stakeholders and rebuild relationships with them, companies “need to understand where they are creating benefits and harm for stakeholders,” said Henisz. “Companies that are producing a lot of emissions are putting out a lot of carbon that has a social cost. They should figure out what that cost is and what they can do to mitigate it.” In much the same way, other companies might be polluting the water, polluting the air, or not providing their employees a living wage, he added. “They need to calculate those social consequences and try to remedy them in a way that still delivers shareholder value.”

For instance, if ExxonMobil does not adequately address climate risk, at some point its oil reserves could get written down to zero, which would hurt its enterprise valuation, Henisz explained. Similarly, a company that contaminates a water supply could face regulatory action or protests, he added. “There are going to be financial costs, but [companies] don’t always connect the dots.”

Companies could connect those dots and mitigate the risks they may create and yet be profitable, said Henisz. He pointed to the transition from fossil fuels to cleaner alternatives such as solar and wind energy or battery storage. “It’s happening in a way that will catch many investors off guard. It’s not happening now, but five, 10 or 15 years from now, there will be a radical shift in energy supplies. If you’re [a company that is] left holding only fossil fuels or primarily fossil fuels, there’s not much valuation in that. There’s a terminal value to your fossil fuel reserves, which approaches zero at some point.”

Companies that fail to find ways to mitigate the financial risk outcomes of issues like climate risk will see their share price suffer, said Henisz. “Both the ExxonMobil case and the legal case against Shell are highlighting the financial consequences of not doing more and not being more aggressive.”