ZEUS: Engine No. 1 framework a first step to ESG financial statements

Attaching dollar value to external business creates investor understanding

(David Callaway is founder and Editor-in-Chief of Callaway Climate Insights. He is the former president of the World Editors Forum, Editor-in-Chief of USA Today and MarketWatch, and CEO of TheStreet Inc.)

SAN FRANCISCO (Callaway Climate Insights) — The small hedge fund shaking up the world of ESG activism this year made news again this week with a new way to analyze companies by how their business practices impact climate change and other environmental and social threats.

The Total Value Framework launched by Engine No. 1, which led a proxy contest this past spring to win four seats on ExxonMobil’s (XOM) board of directors, is another in a long line of proprietary ESG scoring mechanisms investment companies promote to attract investors and search for winning stocks.

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This one stood out to me, though, because it is the first I’ve seen that actively assigns a dollar value to a company’s ESG business practices, whether they be oil production, water consumption, diversity hiring practices or even human rights violations. That’s as opposed to the more common ESG scores and rankings, which Engine No. 1 says in its white paper might as well be emojis.

While the data that support the framework are good and getting better, massive holes in corporate sustainability reporting still means they can only go so far. But in a financial world that is hotly debating whether environmental, social and governance (ESG) factors need to be included in corporate financial statements, it is a significant step in that direction.

I wasn’t able to reach Engine No. 1’s Chris James or Jennifer Grancio before publication, but I read the white paper, which was authored with the Wharton School’s Witold Henisz. It’s a fabulous read that starts with the history of how ESG grew into a $35 trillion industry in the past five years, but how confusion over sustainable data and lack of coordinated metrics have muddied the waters for investors looking for an easy-to-use ratings system for stocks.

Essentially, what Engine No. 1’s framework seeks to do is to assign a price to a company’s stakeholder value, which includes the external costs of its business practices, and then match it against the shareholder value. By pricing the practices, which few companies offer to do individually, it arrives at a better barometer for investors who want to find companies fighting climate change and also performing well as businesses and stocks.

“We put a dollar value on the uncompensated consequences of production or consumption that impact third parties and are not reflected in market prices,” the company said in its white paper. “Such as the costs of respiratory disease from burning diesel, or the costs of lost biodiversity when forests are cleared for palm oil production.”

Engine No. 1 said its analysis found that the differences between a company’s total value and its shareholder value was “strongly indicative of future changes in financial outcomes.” It said a review of the 10 largest S&P 500 firms with the largest external impacts “substantially underperformed” the market in the past decade while the ones with the least impacts outperformed.

So how will it perform? After its Exxon victory, the hedge fund is mum on who its next target might be, though the Wall Street Journal reported this past summer their team has met with executives from Chevron (CVX).

Engine No. 1 also launched an exchange-traded fund this summer, called the Engine No. 1 Transform 500 (VOTE), which has more technology companies in it than anything else, including oil and gas. It’s up about 5% since launch, with about $185 million in assets.

Time will tell. But in the crowded and fast-moving world of ESG funds, with pressure on regulators like never before to standardize disclosure metrics to avoid systemic risk, anything that moves the needle toward including climate risks in financial statements is a step in the right direction.