Many of us find it hard to imagine that firms seeking to maximize profits would credibly commit to reducing their greenhouse gas (GHG) emissions. But in Green Pills: Making Corporate Climate Commitments Credible, Oxford professors John Armour, Luca Enriques, and Thom Wetzer argue there is reason to believe that such firms, even in the absence of regulation, might credibly commit to “net-zero” targets. The article lays out a case for such optimism and proposes a mechanism through which corporate managers can enhance the credibility of commitments.
Green Pills initially describes a world in which profit-maximizing companies might eventually credibly commit to reducing GHGs even without regulatory intervention, because a green transition not only imposes physical and transition risks but also creates profitable commercial opportunities. Even as investors are largely climate-indifferent—meaning that they are unwilling to pay more for companies that make significant headway in mitigating their impact on climate change—Armour, Enriques, and Wetzer believe “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.” (P. 291.) (Net zero refers to the goal of cutting a firm’s net GHG emissions to as close to zero as possible within a stated time frame). But change of this sort may be a long time in coming. Any gains from transition are likely to be long-term and unexpected, while costs will be certain and immediate. In the minds of corporate managers—whose expected job tenures and therefore time horizons are short—the costs of reducing GHG emissions will weigh more heavily than the benefits, making managers “likely to be highly conservative in their transition policy.” (P. 300.)
But how might managers behave if shareholders in their corporations include influential climate-conscious investors? Here Armour, Enriques, and Wetzer make a key contribution, arguing that climate-conscious investors can trigger stock-price effects, giving corporate managers incentives to make credible climate commitments. Climate-conscious investors “place a higher valuation on firms that are making headway toward reducing emissions” (P. 300) than do climate-indifferent investors. Some such investors have green preferences; others have strictly financial motives but attribute a higher value than does the median investor to firms that credibly commit to reducing their emissions. Either way, these investors’ willingness to pay more for clean companies can shift those companies’ stock prices.
The claim that investors’ willingness to pay can affect stock price is a vital one, as well as a challenge to orthodox finance theory. The conventional view holds that the price of a company’s stock is determined by sophisticated investors paying attention to the company’s fundamental financial data—namely, measures of the company’s risk and return.1 In response, Green Pills marshals theoretical and empirical evidence in support of climate-conscious investors’ ability to move stock prices. On the theoretical side, the authors note that as climate-conscious investors’ demand for clean stocks increases, they can bid up prices of these stocks, creating a premium, or “greenium.” Arbitrage by climate-indifferent investors may fail to reverse the greenium due to the potentially “large volume of capital coming from climate-conscious investors” (P. 303) and the greater expense of short positions relative to long positions. On the empirical side, there is already evidence of climate-conscious investors triggering stock-price increases. The authors detail studies showing that firms that appeal to climate-conscious investors trade at a premium, although the economic significance of this price effect is currently “quite modest.”
While there is reason to believe that climate-conscious investors can drive up stock prices for clean firms, Armour, Enriques, and Wetzer do not claim that corporate managers are, at this point, seeking to attract these specific investors. Instead, “the extent to which managers respond to the preferences of climate-conscious investors depends on the significance of these investors’ presence in the marketplace and the intensity of their valuation differential from that of climate-indifferent investors.” (P. 306.) The calculus for managers is to minimize the sum of the cost of carbon emissions and of emissions avoidance, minus the premium generated by climate-conscious investors. Accordingly, if this premium is large enough, managers will have real incentives to attract these investors.
That threshold has apparently not yet been reached—but when it is, how are managers to appeal to climate-conscious investors? An important means might be net-zero and other climate commitments. However, rational climate-conscious investors will suspect that firms are greenwashing or that these commitments aren’t commitments at all—that they are reversible. What is needed are credible climate commitments.
Here, the authors clear brush, dismissing the potential of existing corporate-governance mechanisms to ensure credibility. Securities litigation offers little hope because climate claims are often forward-looking. Firms might shape compensation packages, structure their boards, and hold say-on-climate votes with eye toward appealing to climate-conscious investors, but each of these mechanisms depends on shareholders siding with those climate-conscious investors. Even corporate purpose statements may be unwound by a majority of shareholders.
The authors propose an eminently sensible and elegantly designed alternative to these existing governance mechanisms that fall short. They argue that what they call “green pills” can establish commitments that climate-conscious investors will find credible. According to this proposal, a company would enter into a standard contract with investors or a third party, promising to pay a given sum, either to investors or a third-party, if the company fails to deliver on its transition milestones. Firms may calibrate their levels of commitment. As the authors note, “the firm should only be willing to commit to payment that has an ex ante valuation equivalent to the climate-conscious investors’ additional valuation of the commitment.” (P. 323.) The authors contend with multiple potential complications, among them that the scheme would be subject to heightened judicial review. Importantly, the use of green pills is likely to be reviewed under the business judgment standard of review.
Green Pills warrants a close reading. The article’s challenge to orthodox pricing theory is itself detailed and persuasive, and the claims on behalf of the green-pills proposal are careful yet hopeful. Those who regard profit maximization—as reflected in share prices—as a barrier to credible net-zero pledges might find real possibilities here. Indeed, share prices could well be the mechanism through which climate-conscious investors express their preferences, hastening the green transition.
- As Judge Frank Easterbrook once put it, a stock’s demand curve “may shift up or down with new information but it is not sloped like the demand curve for physical products.” West v. Prudential Sec., Inc., 282 F.3d 935, 939 (7th Cir. 2002).
