Matt Levine / Bloomberg: Exxon is in trouble over climate change
Everything is securities fraud.
Yesterday New York State Attorney General Barbara Underwood filed a securities-fraud lawsuit against Exxon Mobil Corp. “alleging that the company misled investors regarding the risk that climate change regulations posed to its business.” We have been talking about this case since 2015 , when it was first reported that Underwood's predecessor was looking into it. In the intervening years I have often had occasion to remark that everything is securities fraud: Whenever a public company does a bad thing without immediately disclosing it to shareholders, it is arguably deceiving the shareholders about its business and prospects, and an enterprising securities regulator can go after it for fraud. It is often easier to go after a company for securities fraud than for the underlying bad thing, and so in practice regulators have a tendency to punish pollution or sexual harassment or carelessness with customer data or orca abuse or slowing down iPhones or really the whole gamut of objectionable behavior as securities fraud.
I keep saying it, but it keeps being weird. One thing that is weird about it is that securities regulation isn't designed to protect the planet or harassment victims or customer data or orcas; it is designed to protect shareholders . As I wrote in 2015 :
For one thing, if you actually think that Exxon Mobil is engaged in a diabolical conspiracy to suppress climate science to wring extra profits out of an earth-destroying business, the last people you should be worried about are Exxon's shareholders . They're the ones profiting from all that destruction! For another thing, if you are concerned about those shareholders, the last thing you should do is fine Exxon a lot of money. They're the ones who will ultimately have to pay that money!
But the other weird thing about regulating everything indirectly as securities fraud is that it gives up on regulating things directly. You can accomplish a lot of the expressive-emotional-political aims of punishment by punishing polluters for securities fraud. “Pollution is bad,” you say, and then “we have punished the polluters,” and everyone is vaguely satisfied. But you haven't actually regulated pollution! You haven't done the hard work of figuring out the problem and building consensus on addressing it and going through the democratic process and building a regulatory scheme and doing the cost-benefit analysis and writing the regulations.
So I come to a securities fraud lawsuit about climate change with a fair amount of skepticism. But the New York complaint is quite well done. It just reads like a securities fraud complaint, you know? There is no stray rhetoric about pollution or climate change or any of the substantive issues lurking behind this securities-fraud complaint. It's just: Exxon allegedly kept one set of numbers internally but showed another one publicly, and it knew that the public set was false. (Exxon disagrees, saying that the complaint's “baseless allegations are a product of closed-door lobbying by special interests, political opportunism and the attorney general's inability to admit that a three-year investigation has uncovered no wrongdoing.”)
Now, it is an alternate-universe kind of securities fraud. Exxon is accused of lying not in its Securities and Exchange Commission filings—its 10Ks and 10Qs—but in a completely different set of public reports with names like “Outlook for Energy” and “Energy and Climate” and “Managing the Risks.” It is accused of lying not about its financial results—its actual revenues and costs—but about a hypothetical set of numbers called “proxy costs.” The proxy costs were meant to represent Exxon's estimate of the cost per ton of carbon that would be imposed by potential future regulation of greenhouse gas (“GHG”). Exxon just made them up: There's not really a way to know the regulatory cost of producing a ton of carbon emissions in 2040, so you guess.
The problem is that Exxon is accused of making up one set of numbers in its public disclosures and another for its internal planning purposes. In public, Exxon said that it used high proxy costs in modeling the future: It would only pursue projects that would be profitable in the long term even in the face of much stricter future regulation of carbon emissions. From the complaint:
Exxon represented in Managing the Risks that it “rigorously consider[s] the risk of climate change in [its] planning bases and investments” by “requir[ing] that all significant proposed projects include a cost of carbon – which reflects [its] best assessment of costs associated with potential GHG regulations over the Outlook period – when being evaluated for investment.” … Based on this analysis, Exxon assured investors that it was “confident that none of [its] hydrocarbon reserves are now or will become ‘stranded,'” and that “the company does not believe current investments in new reserves are exposed to the risk of stranded assets.”
Long-term investors, alleges Underwood, found this material and reassuring:
On May 26, 2016, Wells Fargo equity research analysts hosted a group of investors at Exxon's corporate headquarters to discuss “climate risks including stranded assets.” According to the equity research report in which Wells Fargo summarized the meeting, Exxon stated that it “places a proxy cost of carbon on all of its future developments. Depending on the project and its location, the proxy cost of carbon ranges from $20 to $80 per ton by 2040.” Wells Fargo concluded that “[t]his approach reduces the risks associated with future CO2 emissions and incentivizes [Exxon] to reduce overall emissions of all future projects. Thus we believe ExxonMobil is ahead of the curve on pricing in climate risks.”
But in its internal modeling, Exxon allegedly used much lower proxy costs, or just left them out entirely:
For major projects, rather than applying a proxy cost, Exxon assumed, contrary to its representations, that existing climate regulation would remain in place, unchanged, indefinitely into the future. In these cases, Exxon applied a much lower cost per ton to a small percentage of GHG emissions based on existing regulation, held flat indefinitely. This conduct was directly contrary to Exxon's public representations that it applied escalating proxy costs as a stand-in for the effects of expected future GHG regulation.
The alleged result is that, despite its public statements, Exxon did regularly develop projects that would be less economical in a world with stricter emission regulations. Sometimes those projects wouldn't make sense at all; here is Underwood on a Canadian oil sands project called Kearl:
By applying existing legislated costs instead of the publicly represented proxy cost to Kearl, Exxon reduced the projected undiscounted costs of GHG emissions for that asset by approximately 94%, or $14 billion CAD ($11 billion USD). Depending on Exxon's assumption about the future price of oil, this additional cost had the potential to change the cash flow projections for Kearl as a whole from positive to negative, with concomitant reductions in associated reserves.
It is all recognizable securities fraud stuff: A company told investors it was investing their money in profitable projects, but secretly in its internal modeling it knew that they were unprofitable. Except that the words “profitable” and “unprofitable” there are used not in the normal financial accounting senses, but as “profitable or unprofitable after taking into account hypothetical carbon costs.”
This very normal securities fraud approach is what makes the complaint compelling. As I often write, it is a bit silly to think of Exxon shareholders as the primary victims of Exxon's alleged deception on climate change. But the right way to read Underwood's complaint is not as a defense of shareholders (who cares? 1 ), or a defense of the environment (not what securities regulation is about), but as a defense of efficient capital allocation . The real problem with securities fraud is that it is better when investors invest their money in projects that are good than in projects that are bad, and if people can attract investment to bad projects by just lying about them then that makes it harder to find the good ones. If you say your business makes $100 million a year, and you get people to invest in it, and really it loses $100 million a year, then the harm to society is not so much that your investors lost their money as it is that they invested it in your nonsense instead of something useful.
Exxon makes money. But the point of Underwood's complaint is that it doesn't make as much money as it says it does, if you account for the future costs of climate change, and that it told shareholders that it was accounting for those costs when it really wasn't. Shareholders thought: “We are investing in an oil company that takes into account the costs of climate change, that only pursues projects that are economical despite those costs, and that tries to mitigate those costs by reducing emissions.” Because of this, they bought Exxon stock. This didn't fund Exxon's projects directly—Exxon has been a huge net repurchaser of stock for many years—but it kept up the stock price and rewarded management and generally sent the signal that Exxon was doing the right thing and should continue investing in its business.
But, argues Underwood, shareholders were deceived. Had they known the truth about how Exxon was accounting for carbon, they wouldn't have bought the stock; had Exxon accounted for carbon the way it said it did, it wouldn't have invested in the projects it did. The fraud, she argues, caused Exxon to emit more greenhouse gases:
Exxon's failure to abide by its representations has also had the effect of moving the company's investments toward more GHG-intensive assets, and away from emissions-reducing investments. As a result, Exxon has brought and will bring more GHG-intensive oil and gas to market, such as its GHG-intensive oil sands assets, than it would have if it had abided by its representations. This trend is borne out by the increasing GHG intensity of Exxon's upstream assets over the past decade. In addition to having negative environmental consequences, the increased GHG intensity of Exxon's assets exposes the company to greater risk from climate change regulation than Exxon represented to investors.
This is the best argument I have seen for regulating everything as securities fraud. The deep theory is that a well-informed market is the best regulator of everything: Securities markets allocate capital to its best uses, and if they have complete truthful information they will take into account all manner of badness in deciding what uses are best. Excessive pollution and sexual harassment are bad, and so shareholders will not allocate capital to them if they know the truth. You don't need to address specific problems through the democratic process; you can address them through the capital markets, and just use securities regulation to make sure that those markets are fully informed.
I said it's the best argument, not that you'd find it convincing. You probably think that government is better at regulating pollution and sexual harassment and consumer privacy and animal abuse than the capital markets are! You're probably right! But perhaps you despair a little of government effectiveness, of the possibility of addressing large difficult sensitive problems through the democratic process. The market may not be the ideal regulator, but if it's the only one we've got, we might as well make sure it's informed.
Still this theory is particularly odd when applied to proxy costs. Proxy costs are just made-up estimates of the hypothetical future costs of climate regulation. Exxon allegedly made up higher numbers in its public reports and lower numbers in its internal planning, but Underwood can't prove—and doesn't even allege—that the high numbers were right and the low ones were wrong . Nobody knows, yet.
But also consider the alternative to using proxy costs. Exxon allegedly sometimes neglected them altogether and just projected existing environmental regulation indefinitely into the future: There are rules regulating pollution and carbon taxes and so forth, and Exxon can calculate their cost, and then it can apply that cost to its future projects. This, argues Underwood, is illegitimate, because Exxon ought to know—and indeed often says publicly—that climate-change regulation will get stricter over time and those costs will go up.
But for that to be true, regulators need to get stricter about climate change . Budgeting with zero proxy costs accurately reflects the current state of regulation. Governments need to change how they regulate carbon emissions for the proxy costs to be accurate or economically meaningful.
In a sense, by suing Exxon for ignoring proxy costs, Underwood is demanding that Exxon do the government's work for it. If governments took stronger actions to address climate change, that would impose more costs on Exxon, and those costs would flow through Exxon's financial statements. If they don't, though, those costs will only be hypothetical, and will only flow through Exxon's alternative reports as proxy costs. Underwood wants Exxon to take those government actions seriously and treat them as real costs—but she can't be sure that the government actions will ever happen. If you can't get governments to do something, you can't really expect the markets to act like they will.
One share one vote.
When a company goes public, it raises money by selling stock to a bunch of different investors. You could imagine a world in which this proceeded by individual negotiation: The company goes to Fidelity and negotiates to sell it 100 shares with 2 votes each for $18, and then it goes to BlackRock and negotiates to sell it 70 shares with 3 votes each for $19, and so on down the line. But this is not how our world works, for a variety of very good reasons: Corporate structure is easier with only one or a few classes of shares, stock trading works best if the shares are all the same, nobody wants to buy if they think they're getting a worse deal than someone else, etc. And so when a company goes public, for the most part, it sells one type of shares with one set of rights at one price to a bunch of different investors.
But investors want things. They have price preferences, certainly; they also have views on voting rights and corporate governance and other features of public companies. If a company wants to go public with two share classes—giving public shareholders low-vote shares so that its founders can keep control with high-vote shares—and some investors dislike that, they can complain, and maybe call up the company and say “we would prefer a single share class.”
But there is no mechanism for them to actually get that. Either the company issues dual-class stock or it doesn't; it can't negotiate one structure with some investors and another with others. If the company is dead-set on issuing dual-class stock, then investors who do not want dual-class stock have only two choices:
- Buy it anyway; or
- Don't buy it.
If you think that dual-class stock is a bad form of governance but also that the company's stock will go up , you should probably buy it anyway, because otherwise you will underperform your competitors. And so Snap Inc. went public with shares that have no votes at all , and investors complained bitterly and then bought the stock anyway. On the other hand, if you think that your competitors also won't buy the stock, then you should refuse to buy the stock, because then no one will buy the stock, and then the company will be forced to scrap its dual-class plans and issue the single-class stock that you really want.
Many big investors dislike dual-class stock, or at least they dislike perpetual dual-class stock that gives founders and their heirs control of a company forever. You could imagine them all getting together and saying “we refuse to buy dual-class stock”; if they could all credibly commit to doing that, then companies would probably stop issuing dual-class stock, because they'd know that no one would buy it.
And so here is a statement from the Council of Institutional Investors —as its name implies, a group of big investors—saying that perpetual dual-class stocks are bad and that companies that go public with multiple share classes should “include in their governing documents provisions that convert the share structure within seven years of the initial public offering (IPO) to ‘one, share-one, vote.'”
But the statement does not go on to say “… and if you don't, we've all agreed not to buy your stock.” There are a number of reasons for this, but let me point out two big ones. First, these big institutional investors have fiduciary duties to their investors, and if they conclude that a company with dual-class stock is nonetheless a good investment, they'd have trouble refusing to buy it on principle if buying it would be better for their investors. Second, when a bunch of gigantic companies to get together in a room and agree to boycott some products in order to advance their commercial interests, that does seem like an awkward antitrust problem.
Instead, the statement asks the New York Stock Exchange and Nasdaq to change their listing rules to implement CII's demands. BlackRock Inc. and T. Rowe Price Group Inc. and the California Public Employees' Retirement System and the other big institutional investors endorsing CII's statement can't credibly commit not to buy perpetual dual-class stock, but Nasdaq and NYSE can easily commit—in their public, binding listing requirements—not to list dual-class stock. And if they don't list it, those big investors really won't buy it. So if both NYSE and Nasdaq change their rules to ban dual-class listings, then companies that want to go public will be stuck with their own simple hard choice:
- Sunset their dual-class stock (or just go public with a single share class); or
- Not go public (or go public in a foreign jurisdiction that is friendlier to dual-class stock).
In 2018, choice 2 is not obviously terrible; capital markets are global and private capital is abundant. Still it seems reasonable to assume that, if both of the big U.S. listing exchanges ban dual-class stocks, many companies that would otherwise have gone public with perpetual founder control will still go public, but without perpetual founder control. The big institutional investors will get to invest in companies they like, but without the voting structures they dislike.
I'm not sure the exchanges will bite :
Nasdaq President Nelson Griggs said his company is a “firm believer in the flexibility of share structure,” but he left the door open for future changes.
“We consider the input of all stakeholders when establishing and modifying listing standards,” Griggs said in a statement. “We will continue to review our listing standards to make sure they protect investors, while also allowing those investors access to innovative companies.”
But the point is that much of the process of companies going public is about solving the coordination problem among investors. The investors can't just get together to demand the rights and protections that they want, and credibly commit not to buy stocks without those rights and protections. Instead they rely on intermediaries to make those demands for them.
The classic intermediary is the underwriter: Investment banks that take companies public will tell them, no, you can't do that, that's not market and investors won't buy it. (Generally speaking investors will accept all sorts of off-market things if companies really insist—the Snap IPO and Spotify Ltd.'s direct listing are good illustrations of that—but the job of the investment bank is to keep the companies from insisting.) A popular modern intermediary is the index provider : Big indexed investors will convince index providers to leave companies with bad provisions out of their indexes, because then bankers can tell companies “you can't have that provision, it will get you left out of the index and reduce demand for your stock.”
But the stock exchanges are also useful intermediaries: Their listing standards have a lot of clout, and are supposed to reflect investor consensus around what sorts of companies can and can't be public. The investors may not be able to express that consensus directly, by just deciding which stocks to buy. But they can always write the stock exchanges a letter.
Also, as I frequently point out, if you want to protect the shareholders, suing the company for money is an odd way to do that. If Underwood wins and fines Exxon a lot of money, that's money that Exxon can't give back to shareholders.
Matt Levine is a Bloomberg Opinion columnist covering finance. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz, and a clerk for the U.S. Court of Appeals for the 3rd Circuit. Petroleumworld does not necessarily share these views.
Editor's Note: This article was originally published by Bloomberg, Oct 25, 2018. All comments posted and published on Petroleumworld, do not reflect either for or against the opinion expressed in the comment as an endorsement of Petroleumworld.
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