ESG: The “Scarlet Letter” of Corporate America

June 20, 2019

This week, the American Enterprise Institute held a panel discussing environmental, social, and governance (ESG) investing as a means to drive social policy goals.  Securities and Exchange Commissioner Hester Pierce gave the opening remarks, beginning with a metaphor to the famous story of “The Scarlet Letter.”

“Here too, we see labeling based on incomplete information, public shaming and shunning wrapped in moral rhetoric, preached with cold-hearted, self-righteous oblivion to the consequences which ultimately fall on real people.”

Comparing the use of ESG assessments as a means to “shame” American companies, Pierce touches on the fact that ESG often comes as a packaged deal, making it difficult to define and hard to measure, and therefore less reliable. Likewise, these vaguely defined categories can cover just about anything, giving those producing the ESG ratings the power to evaluate on nothing more than their own personal judgments.

“In our purportedly enlightened era, we pin scarlet letters on allegedly offending corporations without bothering much about the facts and circumstances, and seemingly without caring about the unwarranted harm such labeling can engender.”

Pierce also mentioned on the effects of ESG ratings on investments with investment advisors buying ESG information from ESG “experts” which then determines where investments are made. While investment advisors have a fiduciary duty to their clients to maximize returns, an increasing number and vocal subset of these investors are demanding their money be invested in accordance to ESG principles.  This has led to many investment advisors admitting companies will be evaluated with ESG in mind.

“Not only is ESG determining where investment dollars go, but at what cost terms.”

Finally, Pierce discussed the use of ESG factors in proxy advisors’ recommendation and proxy votes.  Proxy advisors hold an disproportionate amount of influence in today’s markets, as most investment advisors follow all or most of the recommendations they make. Pierce noted that proxy advisors have no longer focus on the governance part of ESG like they used to and are now prioritizing environmental and social resolutions in their voting recommendations.

As justification to address environmental and social issues, in addition to corporate governance topics, proxy advisors often point to shareholders’ interests. These proxy advisory firms also operate with “skeleton staffs” making so many recommendations, giving sufficient attention to each company wouldn’t be possible.

“Proxy advisor Glass Lewis, for example, has 360 employees, only about half of whom perform research, and they cover more than 20,000 meetings per year in more than 100 countries.”

As with the Scarlet Letter’s infamous red “A”, the potential for a poor “red-lettered” ESG rating often leads companies to complete box-checking exercise that neither serve the environmental or social issue nor maximize the wealth of their shareholders. Pierce acknowledged the fleeting-nature of these ESG-related proposals, and the long-term damage they can cause.

 “If ESG disclosures mean disclosing what is financially material, there’s little controversy. The problem is that the ESG tent seems to house a shifting set of trendy issues of the day, many of which are not material to investors and the long-term financial value of the company, even if they are the subject of popular discourse.”

As Commissioner Pierce emphasized, ESG-influenced investments and voting recommendations are often insufficient and with little evidence to back them up.  It’s clear the SEC acknowledges these flaws and is looking for ways to fix problems within the proxy advisory industry the Main Street Investors Coalition commends the Commission for illuminating the ESG issues that often compound problems within the proxy advisory industry.

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