As we anticipate new proposals from the SEC on human capital and climate disclosure, this recent paper from the Rock Center for Corporate Governance at Stanford, Seven Myths of ESG, seems to be especially timely. The trend to take ESG into account in decision-making by companies and investors, not to mention the focus on ESG issues by regulators and even associations like the Business Roundtable, is “pervasive,” say the authors. Still, ESG is subject to “considerable uncertainty.” In the paper, the authors set about debunking some of the most common and persistent myths about what ESG is, how it should be implemented and its impact on corporate outcomes, “many of which,” they contend, “are not supported by empirical evidence.” Their objective is to provide a better understanding of ESG so that companies, institutions and regulators can “take a more thoughtful approach to incorporating stakeholder objectives into the corporate planning process.” The authors’ seven myths are summarized below.
Myth #1: We Agree on the Purpose of ESG
While the desire to consider ESG as part of the decision-making process seems to be almost inescapable, the authors contend that there is no consensus on the precise nature of the problem that ESG is supposed to address. In this context, the authors cite a survey of over 436 mostly small and mid-sized companies, which found that “only 8 percent say that ESG encompasses a generally understood set of issues and can be easily defined by regulators; 61 percent say it is a subjective term that means different things to different companies and is difficult to define by regulators.” The authors identify three perspectives on the purpose of ESG. To one group, investing in ESG is offered as a way to defeat short-termism—the pervasiveness of which the authors question in a related note—and to increase long-term value by reducing “long-term risk, thereby leading to future profits that are larger and more sustainable.” The idea is that attending to environmental issues helps to lower future remediation costs; investing in employees leads to higher job satisfaction, lower turnover and higher productivity in the long run. The authors call this the “time-horizon argument.” The second view is that “corporate profitability and stakeholder betterment work in opposition to one another”; that is, it’s generally a zero-sum game and maximizing shareholder value results in “reduced welfare for others (evidenced through income inequality, environmental damage, etc.).” In other words, this view suggests that there is a profound issue of companies “profiting at the expense of other stakeholders.” The answer for the proponents of this approach is to “find an equitable balance” between investor interests and social or stakeholder interests through a more inclusive kind of capitalism. The third perspective that the authors identify is consistent with a “corporate social responsibility” approach—that is, companies should promote favorable ESG practices “because it is the right thing to do,” without regard to the economic consequences. Why are these distinctions important? Because, the authors believe that, “without agreement on the fundamental problem that ESG is addressing, corporations, investors, and stakeholders will not be able to agree on what ESG activities to pursue, how much to invest in them, and what outcomes to expect.” How will anyone be able to determine, they ask, “how successful these initiatives are without first understanding what ESG is expected to accomplish”?
Myth #2: ESG Is Value-Increasing
The second myth that the authors highlight is that “ESG improves outcomes for shareholders and stakeholders (so-called ‘doing well by doing good’).” This myth is consistent with the time-horizon perspective of the first myth. But does ESG really increase corporate value or is it “an incremental cost incurred for the betterment of society?” The authors don’t seem to buy the “widespread claims” that ESG increases long-term corporate value, arguing instead that the “evidence is extremely mixed and very dependent on the setting.” In support they cite several analyses and meta-analyses purporting to show that corporate social responsibility is not associated with improved performance. For example, they refer to a 2021 “literature review of over 1,100 primary peer-reviewed papers and 27 meta-analyses,” which found “that ‘the financial performance of ESG investing has on average been indistinguishable from conventional investing.’” (They note that financial performance can also vary significantly depending on the particular element of ESG involved—investing in human capital might lead to higher returns, while, for example, some green investments may not.) Similarly, they cite a 2019 survey of over 200 CEOs and CFOs of companies in the S&P 1500, in which the executives were almost equally divided on the question of whether ESG investment produces net long-term benefits or net long-term costs for the company. The authors’ conclusion: “we do not know the financial impact of ESG.”
Myth #3: We Can Tell Whether a Claimed ESG Activity Is Actually ESG
The authors contend that many corporate initiatives that appear to be undertaken to promote ESG are often indistinguishable from “standard business decisions to maximize shareholder value” under the company’s normal business model, making it difficult to assess the impact of initiatives characterized as ESG initiatives. To what extent, they ask, are ESG investments new investments or are companies just “repackaging and rebranding” regular business investments as ESG? The fuzziness may be compounded by companies’ desires to “demonstrate a commitment to social and environmental causes.” For example, a company may decide to use recycled packaging. Is that an ESG initiative or a financially-motivated decision it might have made anyway. The authors also point to “greenwashing”—such as when a company incorrectly promotes a new product as more environmentally friendly—as a “more extreme form of misrepresenting ESG efforts.” Among other things, the SEC’s recent formation of an Enforcement Task Force focused on climate and other ESG issues suggests that securities regulators, and perhaps others, “will become more aggressive in challenging ESG claims.” (See this PubCo post.)
Myth #4: A Company’s ESG Agenda Is Well-Defined and Board-Driven
The fourth myth that the authors identify is the belief that companies have developed “rigorous, well-defined ESG frameworks” after conducting broad evaluations of their business activities, identifying stakeholder interests and related risks and opportunities and evaluating their potential impact on strategy and operations. Surveys show otherwise, the authors contend. The authors point to a number of surveys showing that boards acknowledge that they don’t really understand ESG risk very well and don’t have much confidence in their ESG programs and that many companies don’t have formal ESG frameworks or even track performance on metrics. Rather, the authors suggest, “most companies appear to develop ESG priorities and investment in reaction to internal and external pressure.” For example, a recent study by the Rock Center found that 80% of companies in the study faced pressure in the last year to increase their commitment to diversity, equity and inclusion, and 96% made either significant (46%) or some changes (50%) in response. Likewise, 67% faced pressure over environmental or sustainability issues and 98% took significant (40%) or some (58%) action in response. What’s wrong with that you ask? Responsiveness to employees, institutional investors, customers, local communities and other stakeholders to enhance diversity and sustainability and address product social impact seems like it might be a good thing—even just from a business relations perspective. According to the authors, the problem is the potential for “ESG drift.” Without a “rigorous ESG framework, organizations risk being pulled into unexpected directions that weaken both ESG and corporate performance.” From a governance perspective, the authors advocate, to best guide decision-making, the “boundaries of the company’s ESG agenda [should] be well-defined.”
Myth #5: G (Governance) Belongs in ESG
The authors are puzzled by the inclusion of governance as part of ESG. As defined by the authors, governance is a “system of checks and balances to ensure that corporate managers make decisions in the interest of the corporation”; in the absence of appropriate incentives and controls, such as independent boards, proper compensatory incentives and internal controls, self-interested management would “have a tendency to make decisions to further their own interests, even when this conflicts with the interests of the organization.” Although “ESG advocates describe the ‘G’ in ESG as involving board quality, appropriate compensation, accountability to ownership, and ethical business practices,” good governance is important irrespective of ESG, the authors maintain.
Myth #6: ESG Ratings Accurately Measure ESG Quality
Apparently, some view ESG ratings as valuable indicators. However, while investors may rely on third-party rating agencies when making investments and companies may use ratings to establish their ESG credentials, the authors contend that these ratings “have only a weak (if any) association with corporate outcomes such as performance, risk or, failure thought to be indicative of ESG quality.” Citing piles of research, the authors conclude that, not only is there an “unproven correlation with performance,” but the ratings are also “not correlated with one another.” For example, a 2020 study of the ratings from three providers demonstrated an “extremely low” correlation of “aggregate scores (overall ESG ratings) and component scores (environment, social, and governance separately)” and that “these firms’ methodologies differ in most every relevant aspect: input metrics, how metrics are evaluated relative to peers and the industry, how missing data is treated, and the treatment of specific companies.” Moreover, the authors contend, the complexity of the methodologies of these ratings firms “illustrates the challenge of developing reliable ESG metrics”: “The number of input variables is daunting. Rigorous measurement of each dimension constitutes a significant research challenge. Measuring all of them accurately and combining them into an overall composite ESG score that is predictive of outcomes is likely not possible.”
Myth #7: Mandatory Disclosure Will Solve the Problem
The authors’ view on the final myth—that “more disclosure will solve the problem market participants face in assessing ESG quality”—is especially striking given that we are on the precipice of new ESG disclosure proposals from the SEC. Not that they believe disclosure is unimportant for the capital markets, but rather that “informative ESG disclosure will be difficult to produce in a cost-effective manner.” In the authors’ view:
“ESG disclosure would require a massive expansion of [the current reporting standards] to include environmental and social metrics across dozens of dimensions. These would have to be standardized and audited by independent parties across companies and industries. Regulators would have to weigh the tradeoff between informative disclosure of sensitive areas (such as human capital management, supply chain practices, and product safety) and the protection of proprietary information. Implementation would require a large investment in staff, advisors, and internal and external auditors to track and verify this information. And companies in diverse industries no doubt would have trouble standardizing their reporting to specific metrics whose applicability to their circumstances varies. While the output of this effort might increase information quality at the margin, the cost of doing so will not be trivial.”
The authors note here that, while providing ESG disclosure is likely to be costly for companies, especially smaller companies, outside providers, such as auditors, consultants and rating firms, stand to benefit handsomely. (However, it has not yet been determined whether, under the SEC’s anticipated proposals, any ESG disclosure will require independent audit or attestation.) Of course, the SEC is not taking on all of ESG disclosure in its initial proposal, but rather starting with human capital and climate—two major elements of ESG reporting nonetheless.
The SEC’s proposals on human capital and climate disclosure are expected to be released early this year.