September 28, 2018
Earlier this week, SEC Commissioner Hester Peirce delivered a speech at the 17th Annual Securities and Exchange Commission Conference where she outlined some key issues with Environmental, Social, and Governance investing, more simply known as “ESG”. Commissioner Hester’s speech aligns with findings from a recent report issued by the American Council on Capital Formation, a member of the Main Street Investors Coalition, entitled, “Ratings that Don’t Rate: The Subjective World of ESG Rating Agencies”, namely that ESG ratings are arbitrary.
Institutional investors that manage a significant of amount of capital on behalf of retail investors, who save through 401(k)s and pension plans, are increasingly engaging with companies on ESG issues such as climate change, gender diversity on boards of directors, and gun safety.
In order to uphold their fiduciary duty, these institutional investors must also make the case that their support of shareholders on ESG issues is also in the best financial interest of their customers. To make this case, institutional investors have claimed that addressing ESG risks will improve the long-term financial position of the company. This is a key argument that other proponents of ESG make to promote their claim that ESG is now mainstream.
In her speech, Commissioner Hester took on these arguments:
“There are two problems with this conclusion. First, given the breadth of topics that the term ‘ESG’ purports to address, it is difficult to say that, for any company, it is ESG factors in particular that have resulted in high returns. Second, because ESG can mean so many things, a company may implement a number of policies that wind up counted as ‘ESG’ measures that are simply the same good practices that companies have embraced for centuries. The problem is that, because discrete, time-tested measures have good results, once they are dubbed ‘ESG,’ their success becomes an argument for implementing all kinds of unrelated, untested measures that conveniently share the ESG label.”
Additionally, Commissioner Hester delved into specific issues that investors face when evaluating ESG factors:
“In many instances, ESG reporting has been presented as though it were comparable to financial reporting, but it is not. While financial reporting benefits from uniform standards developed over centuries, many ESG factors rely on research that is far from settled. Counting the number of female directors may tell you something about how well a company is run. Or it may simply tell you that the company has more female directors. There are studies going both ways. In most cases, the companies themselves are ill-equipped to make these determinations. Does a company that brews beer really have the expertise to assess what energy source would be the best for the environment?”
To be clear, both Commissioner Hester and the Main Street Investors Coalition do not object to the pursuit of ESG objectives. Voluntarily electing to invest in a fund that pursues an ESG strategy is a completely legitimate practice. At issue, is that the significant rise in passive investing has led to an immense concentration in shareholder power in the hands of institutional investors. These firms that are supposedly “passive” have begun to support ESG strategies on behalf of their customers without their permission to do so. When surveyed, 78 percent of retail investors indicated that they invest in passive funds because they want low-fees and consistent returns and only 22 percent wanted their fund managers to use their influence to promote social and political causes.
In other words, retail investors are losing control over how their own money is invested and do not necessarily want their fund manager to pursue ESG. As Hester explains:
“The problems arise when those making the investment decisions are doing so on behalf of others who do not share their ESG objectives. This problem is most acute when the individual cannot easily exit the relationship. For example, pension beneficiaries often must remain invested with the pension to receive their benefits. When a pension fund manager is making the decision to pursue her moral goals at the risk of financial return, the manager is putting other people’s retirements at risk.”
Commissioner Hester further explained how the types of issues that ESG investing addresses inherently lead to disagreement among parties:
“One of the core tenets of ESG investing is that it is ethical and good, but ethics and goodness are subject to interpretation. In fact, while some ESG factors—such as some of those associated with the ‘G’ part—track with conventional notions of good business, many seem to be included in the ESG rubric because they hew to a what a select group of stakeholders believe to be good or moral behavior.”
The issues that exist when institutional investors engage in ESG issues in non-ESG funds are why the Main Street Investors Coalition is calling for fund managers to return their focus to maximizing the performance of companies in their portfolios and ensuring that retail investors who own passive funds through 401(k)s have a say in how their shares are voted. As the SEC grapples with the implications of the rise in passive institutional investors, Commissioner Peirce can play a key role in the regulation of this space by voicing her concerns with ESG.