In a recent speech to the American Enterprise Institute, SEC Commissioner Hester Peirce continued her rebuke of the practice of “public shaming” of companies that do not adequately satisfy environmental, social and governance (ESG) standards—hence the title of her speech, “Scarlet Letters.” According to Peirce, in today’s “modern, but no less flawed world,” there is “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. In our purportedly enlightened era, we pin scarlet letters on allegedly offending corporations without bothering much about facts and circumstances and seemingly without caring about the unwarranted harm such labeling can engender. After all, naming and shaming corporate villains is fun, trendy, and profitable.” Message delivered.
Peirce’s views should not come as a surprise. You might recall that, at the December meeting of the SEC’s Investor Advisory Committee, Peirce opined that the acronym “ESG” stands for “enabling shareholder graft.” (See this PubCo post.) She has also criticized institutional investors (and specifically CII) for advocating ESG disclosure regulation. She remarked that, notably, the SEC did not sign up to the recent statement on ESG investing issued in January by The International Organization of Securities Commissions, which “directed issuers to consider whether ESG factors—which are not defined—should be included in their disclosures, endorsed the use of private disclosure frameworks purportedly designed to get at these factors, and suggested that some disclosures now being made voluntarily under these frameworks should be incorporated into these disclosures.” Peirce objected to the statement because she viewed it as “an objectionable attempt to focus issuers’ on a favored subset of matters, as defined by private creators of ESG metrics, rather than more generally on material matters.” U.S. securities laws focus on “materiality,” and ESG disclosure requirements could well be outside the scope of that concept. In Peirce’s view, requiring “disclosures aimed at items identified by organizations that are not accountable to investors unproductively distracts issuers.” She believed that the SEC should focus its efforts on its core mission of “protecting investors, facilitating capital formation, and fostering fair, orderly, and efficient markets”; to do otherwise would be a distraction. (See this PubCo post.)
So while her views may sound distinctly, um, inhospitable to ESG, to put it mildly, at their core, they do reflect the view of a significant segment, which is that ESG should not be wielded as a tool to impose one’s “values” on companies where the impact may be detrimental to shareholders; rather it should be a driving force only to the extent that it is expected to have a positive effect on shareholder value.
In Peirce’s view, the governance category of ESG has some recognizable “concrete markers, such as whether there are different share classes with different voting rights [or] the ease of proxy access,” but the environmental and social categories are “more nebulous. The environmental category can include, for example, 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. Not only is it difficult to define what should be included in ESG, but, once you do, it is difficult to figure out how to measure success or failure.” To the extent that some ESG issues may have a material financial impact, there is little controversy that those issues should be disclosed, not because of ESG, she contends, but because they are financially material. However, she maintains, the “ESG tent seems to house a shifting set of trendy issues of the day, many of which are not material to investors, even if they are the subject of popular discourse.”
While there are a number malefactors at work here—Peirce names developers of ESG scorecards, proxy advisors, investment advisers, shareholder proponents, non-investor activists and governmental organizations—the primary instigators, she argues, are “non-shareholder activists—the so-called stakeholders—who identify the controversial issues du jour. Other people quickly heed their call to action.” Also substantially at fault are the “self-identified ESG experts that produce ESG ratings. ESG scorers come in many varieties, but it is a lucrative business for the successful ones. The business is a good one because the nature of ESG is so amorphous and the demand for metrics is so strong. ESG is broad enough to mean just about anything to anyone. The ambiguity and breadth of ESG allows ESG experts great latitude to impose their own judgments, which may be rooted in nothing at all other than their own preferences. Not surprisingly then, there are many different scorecards and standards out there, each of which embodies the maker’s judgments about any issues it chooses to classify as ESG.”
Peirce points out that many ratings providers use the data from reports that companies post themselves, but the scoring can be arbitrary, even as the consequences can be serious. An example she gives of arbitrary scoring is that companies may not be credited for conduct that they characterize as a “practice” when the scorer credits only conduct characterized as a “policy.” And a bad rating, she says, “can mean investors shun your stock. When a company has engaged in actual misconduct, this may be the correct result; I am not arguing that any company should get a free pass. When ratings, however, are based on misinformation, the accountability mechanism does not work properly.”
ESG, she reports, is often used, not just in “determining where investment dollars go, but at what cost and on what terms.” Many times, she contends, investment advisers rely on these ESG scorecards to “make decisions about how to vote or what to buy or sell.” While “most investment advisers, in light of their fiduciary duty, want to focus primarily on maximizing the value of their investors’ portfolios, many are also “courting investors, a vocal subset of whom are demanding that their money be invested in accordance with ESG principles.”
Many of the large investment advisers and asset managers have developed their own internal ESG teams and are “elevating ESG in their decision-making.” In fact, she observes, asset managers, such as BlackRock, have advocated that companies recognize their responsibilities to stakeholders beyond just shareholders—to employees, customers and communities. (See this PubCo post.)
The government also fueled the problem, she contends, when it previously determined that investment advisers that followed a proxy advisor’s recommendations had fulfilled their fiduciary duties, thereby effectively entrenching the use of proxy advisors. (That position was subsequently withdrawn. See this PubCo post.) And proxy advisors, such as ISS and Glass Lewis, have expanded their focus beyond governance issues and “have recently made concerted efforts to expand into environmental and social issues.” To win their approval, companies pay attention to their policies and recommendations.
In addition, a number of shareholder proposals, many of which have been submitted by a small group of shareholders, “have pushed companies to focus on ESG issues. Even perennial favorites, such as executive pay, have received an overhaul and now shareholder proposals seek to tie compensation not to performance metrics such as share price, but to ESG metrics.” (See this PubCo post.) International, state and local regulators have also embraced ESG factors.
As the interest in ESG grows, Peirce contends, there have been increasing questions about the impact of ESG on financial results. So far, she maintains, the results are mixed. At the end of the day, investors are “free to invest their money as they wish, but they can only do so if the peddlers of ESG products and philosophies are honest about the limitations of those products. The collection of issues that gets dropped into the ESG bucket is diverse, but many of them simply cannot be reduced to a single, standardizable score. As beautifully simple as it is, a stark letter A does not always serve to convey the truth. The moral authorities of today, like their puritanical forebears, are motivated by a dream of a better society, but methods matter and so do facts. We ought to be wary of shrill cries from a crowd of self-appointed, self-righteous authorities, even when all they are crying for is a label.”