The climate crisis presents a challenge of unprecedented scale for policymakers around the globe. Unsurprisingly, corporate governance has drawn considerable attention in this context from scholars and regulators alike. This has resulted in an abundance of policy proposals—some already implemented and others still being debated—to ensure that corporations play their part as the world transitions to a green economy. These policies aim primarily at public companies rather than private ones. At first glance, this may seem perfectly reasonable as far as regulatory efficiency is concerned. Public firms are typically larger than private companies, which means their economic impact overall—as well as their contributions to greenhouse gas (GHG) emissions—is likely to be higher. In fact, the largest corporations are usually public ones (e.g., Amazon, Apple, Tesla, etc.). The same is true for most energy giants such as Exxon, Chevron, and Shell. Yet, a single-minded regulatory focus on public companies within the context of environmental sustainability will drive—and is already driving—carbon-intensive activities to private firms, hampering efforts to combat climate change.
In a recent working paper, we study this problem—which we term sustainability arbitrage—and offer a possible regulatory response. We start by emphasizing the prominent role of private companies in the climate crisis and the economic activity overall, especially in emerging economies with less developed capital markets. We also note that relatively small firms in certain sectors may have an oversized contribution to GHG emissions due to the nature of their operations. This means prioritizing public firms will leave out a significant portion of economic activity in any case.
What is more troublesome, in our view, is the problem of sustainability arbitrage. This means private firms have an advantage vis-à-vis their public rivals in terms of engaging in environmentally unsustainable activities, thanks to the more relaxed regulatory standards they are subject to. As a result, we predict a shift of so-called dirty assets from public to private entities and some private companies shying away from going public in the first place. The most obvious manifestation of this problem is a public company selling its fossil-fuel assets to a private corporation, which would then continue to operate in the same unsustainable albeit much less transparent manner. A clear example was the oil giant BP’s sale of its Alaska oil field to a privately-owned company in 2020. In cases like this, the listed enterprise does succeed in slashing its emissions, but the same activity is resumed by a privately held company out of sight, out of mind. Recent evidence confirms our fears by demonstrating that the shift of fossil fuel assets from public companies to private actors is indeed rampant.
A Survey of Current Regulatory Tools
We then examine the question of whether the currently employed or proposed sustainability regulations would serve their purpose within the context of private companies. One regulatory approach mainly focuses on integrating sustainability considerations into company directors’ decision-making processes by providing them with broader discretionary power and necessary incentives. This, in turn, requires rethinking and re-designing the corporate purpose and restructuring fiduciary duties accordingly. A recent report by EY prepared for the European Commission, which explicitly supports the stakeholder approach against the shareholder primacy and recommends integrating ESG metrics into executive compensation structures, is a prime example of this regulatory approach. However, no matter how much managerial discretion is granted to board members, one cannot expect a change in corporate behavior as directors of private companies are de facto representatives of the controlling shareholders. Even supposing the stakeholder approach would induce directors to consider ESG-related issues in corporate decision-making, enforcement of such pro-stakeholder fiduciary duties would still be quite challenging in private companies due to a narrower audience with a more limited access to information.
Besides expanding the managerial discretion of directors, there are also increasing calls for and a growing practice of integrating sustainability metrics into the executive payment models. Making executive compensation sensitive to reaching ESG related objectives has already gained significant traction in the UK and US in particular. However, “paying well by paying for good” may not be a practical tool to incentivize directors in private companies whose interests are already aligned with the controlling shareholders. Either the controller would not adopt such a compensation model in the first place, or the board members would not push aside the controller’s interests and thus run the risk of being removed.
While the debate about corporate purpose and the practice of ESG-oriented compensation is centered around the board, there has also been a push to stimulate investor pressure on public companies as far as sustainability is concerned. Investor stewardship (i.e., the idea that shareholders should use their voice to bring about better governance practices) has a key role in this context. Shareholders—the large and institutional ones in particular—can ensure long-term value creation by using their influence on public firms for these to become more sustainable. Moreover, recent regulatory action and proposals in Europe and the US requiring large and public companies to disclose details about the non-financial aspects of their businesses may arm institutional investors with the necessary information to assume the role of environmental stewards. Considering the ever-growing appetite for sustainable investing, climate policies built on the promise of investor stewardship are likely to gain even more prominence in the future. Unfortunately, such policies do not hold much promise when it comes the private firms for rather obvious reasons. Private companies are isolated from public investors, meaning that these enterprises will be mostly free from the pressure by institutional investors seen as sustainability stewards.
A Proposal to Overcome Sustainability Arbitrage
To prevent sustainability arbitrage and ensure that private companies are part of the transition to a green economy, we recommend a mandatory climate disclosure framework for private companies. However, such a framework should not lead to a one-size-fits-all approach, and hence become a procrustean bed for all types and sizes of business organizations. Accordingly, we argue for adopting a mandatory disclosure regime and offering opt-in strategies, such as implementing new legal forms and legal certifications. These regulatory tools are not mutually exclusive but complementary insomuch that opt-in regimes, combined with incentives such as tax benefits or public procurement priorities, are expected to provide flexibility within the sustainable governance framework and lead to a race to the top in terms of sustainability.
Under the framework we propose, firms would be required to disclose (i) their GHG emissions, and (ii) how the firm’s activities fit in with local, regional or global decarbonization targets. To ensure that the proposed policy would not impose extensive costs especially on SMEs, we suggest that only firms exceeding certain emissions thresholds be required to disclose such information. We recognize this might potentially result in fragmentation of carbon-intensive activity among numerous small firms to evade disclosure obligations. To prevent such an outcome of intra- private- market arbitrage, which we call the division of emissions, we recommend that firms operating in carbon-intensive sectors (e.g., energy, transport, and chemicals) be subjected to reduced thresholds when compared to other companies.
Implementing this type of disclosure requirement would help eliminate the sustainability arbitrage problem. One can question, however, if disclosure would really work in private markets without climate-sensitive public shareholders. While such concern would not be unfounded, we believe disclosure obligations for private firms would still be beneficial in two ways. First, non-shareholder constituencies—equipped with sufficient information thanks to the proposed disclosure requirements—can exert significant pressure on private companies to align with relevant decarbonization targets (e.g., that of the country where the firm is headquartered). Stakeholders such as the employees, consumers, the media, NGOs engaging in climate litigation and financiers may all play a role in pressuring private firms to become more sustainable, a topic which we discuss in detail in our paper. Second, we argue that the proposed policy would produce benefits in terms of better and more informed policymaking. Currently, sustainability arbitrage pushing emissions from public firms to private ones makes it increasingly challenging to plan for and then measure the success of the climate policies, given the lack of information about private firms and their activities when compared to public companies. Moreover, public companies divesting from fossil fuel assets may create a false sense of regulatory success by making the current policies focusing primarily on public firms appear effective in meeting carbon reduction targets at the macro level. Therefore, requiring disclosure by private companies can also be expected to improve policymaking.
Cem Veziroglu is an Assistant Professor in Commercial Law at the Koç University Law School and an Affiliated Scholar with the UNESCO Chair on Gender Equality and Sustainable Development.
Abdurrahman Kayiklik is a Research Assistant at the Koç University Law School.
This post is adapted from the authors’ paper, “The Sustainability Arbitrage Problem and Regulation of Private Companies”, available on SSRN.
The views expressed in this post are those of the authors and do not represent the views of the Global Financial Markets Center or Duke Law.
