ESG Investing and Ratings
As I mentioned in the last blog in this series on ESG, back in September 2019, when I first wrote about environmental, social and governance (ESG) matters (see HERE), and through summer 2020 when the SEC led by Chair Jay Clayton was issuing warnings about making ESG metric induced investment decisions, I was certain ESG would remain outside the SEC’s regulatory focus.
Enter Chair Allison Herron Lee and in a slew of activity over the past few months, the SEC appointed a senior policy advisor for climate and ESG; the SEC Division of Corporation Finance (“Corp Fin”) announced it will scrutinize climate change disclosures; the SEC has formed an enforcement task force focused on climate and ESG issues; the Division of Examinations’ 2021 examination priorities included an introduction about how this year’s priorities have an “enhanced focus” on climate and ESG-related risks; almost every fund and major institutional investor has published statements on ESG initiatives; a Chief Sustainability Officer is a common c-suite position; independent auditors are being retained to attest on ESG disclosures; and enhanced ESG disclosure regulations are most assuredly in the works.
Investors are focused now more than ever on ESG matters. The world is experiencing an enormous intergenerational wealth transfer concurrently with the rise of Robinhood type trading platforms and digital asset acceptability that value ESG in making investment decisions. Heavyweight investors are also on board. In his annual letter to CEOs, Larry Fink, head of giant BlackRock, was very clear that he wants to see climate disclosure including a net zero plan and board responsibility for overseeing such a plan.
One thing has not changed and that is that the system of “rating” or “scoring” a company based on all things ESG is extremely over-inclusive and imprecise. The Aggregate Confusion Project from Massachusetts Institute of Technology (MIT) found that “It is very likely…. that the firm that is in the top 5% for one rating agency belongs in the bottom 20% for the other. This extraordinary discrepancy is making the evaluation of social and environmental impact impossible.”
In a series of blogs I am tackling the wide and popular current ESG conversation. In the first blog, I focused on climate change initiatives (see HERE). In this second blog I am discussing ESG investing, ratings and the role of a Chief Sustainability Officer, and the third blog will be on ESG disclosures in general.
Backing up – What is “Environmental, Social and Governance” or “ESG”
It is clear that ESG matters are an important factor for analysts and investors and thus for reporting companies to consider. It is also clear that companies have increasing pressure to report ESG matters and will be judged on those reports by different groups with different criteria in a current no-win environment (pun intended).
In the broadest sense, “Environmental, Social and Governance” or “ESG” refers to categories of factors and topics that may impact a company and that investors consider when making an investment and analysts and proxy advisors consider when making recommendations about investments or voting matters for corporate America. However, from a micro perspective, ESG means different things to different constituencies and has become a sort of catch-all phrase for a spectrum of topics ranging from very real and serious societal issues to the topic de jour touted by paid special interest groups and influence peddlers.
The G (governance) in ESG is a little more concrete, including, for example, whether there are different share classes with different voting rights, the ease of proxy access, or whether the CEO and Chairman of the Board roles are held by two people. The environmental category can include, for instance, water usage, carbon footprint, emissions, what industry the company is in, and the quantity of packing materials the company uses. The social category can include how well a company treats its workers, what a company’s diversity policy looks like, its customer privacy practices, whether there is community opposition to any of its operations, and whether the company sells guns or tobacco.
However, once a topic is fitted into a category, the measurement of that category and the meaning behind the information are much more nebulous. Furthermore, ESG topics are being heralded by non-shareholder stakeholders influencing investors. A number of self-identified ESG experts have developed and many groups produce ESG ratings. The ratings are not standardized, and as such the analysis can be arbitrary as it may treat similarly situated companies differently and may even treat the same company differently over time for no clear reason.
ESG Investing and Ratings
It is clear that ESG matters carry great weight with the investment community, especially powerful investors such as hedge funds, ESOPs, pension funds, family offices, unions, and private equity groups, and as such companies cannot ignore potential ratings and analyst coverage on these matters. Investors are pouring billions into asset managers who proclaim ESG who are in turn pumping out new ESG products (I can’t help but think about the mortgage bundling and complicated hedging products created around it right before the housing bubble in 2007-2008).
However, just like with ratings organizations, ESG fund managers and ESG products are not standardized in their meaning. As Commissioner Roisman said in a recent speech:
“When an asset manager markets a fund as having an ESG strategy, it has an obligation to disclose material information about that fund to investors and potential investors. Additionally, it would make sense to me that asset managers who want to use these terms to name their funds or advertise their products should be required to explain to investors what they mean. How do the terms “ESG,” “green,” and “sustainable” relate to a fund’s objectives, constraints, strategies, and the characteristics of its holdings? Are “E,” “S,” and “G” weighted the same when selecting portfolio companies? Does the fund intend to subordinate the goal of achieving economic returns to non-pecuniary goals, and if so, to what extent?”
Also, it would not make sense for ESG to mean the same thing for different funds. That is, one investor may be much more interested in investing in a fund that is concerned with renewable resources while another wants one focused on social issues such as diversity. I note that the same issue presents itself when talking about a standardized ESG disclosure regime, which I will talk further about in another blog in this series.
Irrespective of the difficulty in defining ESG, it is clear that index funds and long-term investors are interested in long-term value for their portfolios. In order to preserve long-term value, a fund or investor must have a diverse portfolio that mitigates systematic risk including climate change risk, financial stability risk and social stability risk. This long-term portfolio management means that not every investment will be a winner and not every investment will consider ESG, but a diverse portfolio definitely involves ESG considerations.
We also now have an ESG friendly administration, meaning that ESG issues could find more support by the SEC for inclusion in a company’s annual proxy statement. Shareholder proposals such as demands for reporting of greenhouse gas emissions, gender and race issues in the workforce and of course more on climate change, have historically been blocked as involving ordinary management decisions or micromanagement of the corporate structure. Under the new administration, these proposals may survive attack and appear on proxy statements for shareholder approval.
Likewise, the new administration is likely to support regulatory changes that will either directly or indirectly impact public companies. For example, near the end of the Trump administration the Department of Labor (DOL) passed rules that would prohibit ERISA fund managers from considering factors, that were not directly cost benefit based, such as ESG, in making voting and investment decisions for retirement funds. On March 10, 2021, the DOL announced that it will not enforce these new rules. Rather the DOL recognizes the use of ESG considerations in improving investment value and long-term investment returns for retirement investors and as such fiduciaries will not be prohibited from using these factors in any voting or investment decision analysis.
Who is a Chief Sustainability Officer
The time and expense of covering ESG ratings and attracting ESG investors is substantial. Enter a Chief Sustainability Officer (CSO). A CSO is now a common position in Fortune 500 companies and growing in all sectors. In addition to fielding the numerous ratings organizations and assisting management with messaging on ESG matters, a CSO is generally responsible for reviewing and helping to formulate ESG policies. These policies include both engaging in more socially responsible activities (investments in climate change initiatives) and reducing irresponsible activities (reducing pollution from corporate plants or changing materials to make products more sustainable). A CSO will also be integral in assisting with compliance with the existing and new climate and ESG disclosures in general.
Importantly, a CSO has the potential to reduce the impact of third-party ratings organizations. Until there are standardized rating systems in place, third-party ratings remain arbitrary and capricious. A CSO can work on data and analytics that are presented to rating organizations and analysts that reduce the information gaps and analyst irregularities. A CSO can also put programs and messaging in place for direct corporate engagement with the investment community related to ESG matters.
It is now commonplace for a company to issue sustainability reports and those reports, although not generally currently filed with the SEC, are made publicly available on a company’s website. A CSO should likewise be integral in the reports contents and importantly communicating its meaning to the board of directors.
Regardless of the noise surrounding ESG, there is no doubt that ESG is an important factor in Enterprise Risk Management (ERM) and must be understood and considered by a board of directors in its duties for ERM oversight. An effective CSO must be able to help the board unpack these issues as well.