Saturday, December 21, 2019

What is ESG Anyway?

I have previously commented that many investments describe themselves as “sustainable” or “ESG” (environmental, social, governance) focused, without much standardization as to what those terms mean – and I’ve criticized the SEC for failing to step in to create a set of uniform definitions.

Turns out, the SEC might finally be taking some action, though it’s not necessarily what I’d hoped for:

Many investment firms have been touting new products as socially responsible. Now, regulators are scrutinizing some funds in an attempt to determine whether those claims are at odds with reality.

The Securities and Exchange Commission has sent examination letters to firms as record amounts of money flow into ESG funds. These funds broadly market themselves as trying to invest in companies that pursue strategies to address environmental, social or governance challenges, such as climate change and corporate diversity.

But there have been critics of the growth in these funds. Some argue investment funds should focus solely on returns, and some firms have faced questions about how strictly they adhere to ESG principles….

One letter the SEC sent earlier this year to an investment manager with ESG offerings asked for a list of the stocks it had recommended to clients, its models for judging which companies are environmentally or socially responsible, and its best- and worst-performing ESG investments, ….

The SEC also homed in on proxy voting in the letter, which some investors say is a powerful tool that can be used to influence a company’s governance and might show how an investment fund is carrying out its ESG goals. The letter asked for proxy voting records and documents that related to how the adviser decided to vote on an ESG issue….

Senior SEC officials have sometimes expressed concern that focusing too narrowly on corporate morality could undermine a money manager’s duty to act in the best interest of clients. That could become a problem for pension funds pursuing ESG strategies if their retirees and beneficiaries aren’t as interested in sustainability but are nevertheless locked into funds’ investment choices, Republican SEC Commissioner Hester Peirce said last year.

Ms. Peirce has criticized ESG for having no enforceable or common meaning.

“While financial reporting benefits from uniform standards developed over centuries, many ESG factors rely on research that is far from settled,” she said in a speech last year to California State University Fullerton’s Center for Corporate Reporting and Governance….

Notice there are two separate ideas here, and the article blurs them together.  One idea is that retail investors can’t tell what they’re buying when a fund is labeled “ESG.”  Another idea is that funds should not be permitted to elevate “sustainability” metrics over wealth maximization, even if investors would prefer they did.  And that confusion goes to the heart of my problem with the ESG label as applied to funds.  It can mean at least three things:

(1) I morally/ethically do not want to profit off of some kind of activities, and therefore, even if they would maximize my returns, I don’t want to invest in them;

(2) I am hoping to use my investment dollars to encourage certain kinds of socially responsible activities that might not otherwise get sufficient funding, and I am willing to accept sub-par returns to do that (“impact investing”); or

(3) I believe ESG metrics are one mechanism for maximizing returns because social responsibility is ultimately profitable.

Now, within these categories, there are lots of questions.  Like, if you’re willing to accept below-market returns in order to make socially responsible investments – either for ethical reasons, or because you’re hoping to make an impact – what counts as an ethical investment, or an unethical one?  What kinds of “impact” do you want to have – i.e., how will you define the kinds of beneficial projects that otherwise would not be funded but for your social responsibility considerations?  And how far below market are you willing to go?  Is there a point where you’ll give up and say hey, I’ll go all in on Exxon if it’ll put food on the table? 

Additionally, before investors can make any kind of ESG-investment, they need metrics that describe the characteristics of a particular instrument, so that they understand what it means to say a particular project or instrument is “green” or environmentally-friendly or “sustainable.”  That’s why Europe is working toward a taxonomy that would categorize different projects according to their environmental impact.  Notably, Europe is explicit that these categorizations are based on the greenness of the project for the purpose of advancing environmental goals; they are not categorizations based on an idea that green projects are somehow long-run more profitable.  That determination, and its relevance to a particular investor or asset manager, is left to the investor, who will now simply be informed as to whether a project that says it has certain environmental effects really in fact has those effects.

In the US, of course, we don’t have any kind of labeling system – you can call any project green or sustainable and no one will stop you, which is why market actors will pay actual cash money for a clear assessment of the environmental impact of specific projects.  And because the SEC has apparently given up on developing standardized metrics in favor of, I dunno, preventing shareholders from communicating their priorities to portfolio companies, Europe’s going to be the market leader here.

(For the record, I’m not at all persuaded by Commissioner Peirce’s claim that the SEC’s hands are tied because financial reporting is more reliable than ESG reporting; as I previously argued, modern financial reporting standards are the product of a nearly century-old public-private partnership spurred by the federal securities laws.  Regulation creates the standardization; it’s not necessarily the other way around.)

But even after an instrument is accurately described in terms of its environmental and social effects, investors can’t decide whether those effects add up to “buy” “hold” or “sell” without a clear sense of why they’re asking about those effects in the first place, namely, their higher order strategy: Are they asking so they can follow their morals, so they can make an impact, or because they think ESG is wealth-maximizing? Because until you know that, you don’t know what to do with a specific green, green-ish, or brown investment opportunity.

And in the US, we don’t even have that higher order labeling system.  Europe, again, is ahead of us: UK’s Investment Association recently put out a framework that tries to distinguish between these categories, and urged asset managers to label funds accordingly.  But there’s no common language in the US.

And the reason there isn’t, I’d argue, is because there are a lot of different groups who have an interest in obscuring the distinctions.  Just as individual companies like to claim they have a broader social purpose in order to free themselves from responsibility to one constituency (i.e., shareholders and regulators), asset managers, as well, want to earn the higher fees that come with the ESG label while avoiding any of the commitments associated with it.  See, e.g., Dana Brakman Reiser & Anne M. Tucker, Buyer Beware: Variation and Opacity in ESG and ESG Index Funds (forthcoming Cardozo L. Rev.).  Meanwhile, various advocacy and interest groups have their own (obvious) reasons to try to convince investors that it is entirely costless to insist on socially-responsible behavior from their portfolio companies. 

All of which is to say, to the extent the SEC wants to make sure that ESG funds are clear on their strategy – THIS FUND IS FOR PEOPLE WHO WILL SACRIFICE WEALTH FOR MORALS, AT LEAST UP TO A POINT, AND HERE IS OUR PLAN versus THIS FUND IS FOR PEOPLE WHO BELIEVE THEY CAN DO WELL BY DOING GOOD, AND HERE IS OUR PLAN – I am all for it and believe it would be a great improvement in the marketplace.

But there’s a second issue that I’ve discussed in this space, namely, are funds even permitted to sacrifice wealth to achieve other goals?  Normally, you’d think, if a retail investor understands what they’re doing, why shouldn’t they be able to choose a fund that prioritizes morals over money?  But the latest suggestions from the Trump administration are that, at least to the extent the fund is regulated by ERISA, namely, it’s a private retirement fund, those choices are flat-out prohibited.  

And if that’s what the SEC is after, well, I have to ask – what does the SEC have against markets?

Ann Lipton | Permalink


This raises a fundamental question that has been bothering me as I work on securities law questions surrounding ESG engagement, in particular on climate change. As you rightly note, for ERISA fiduciaries the prevailing understanding of the statute is that in both investing and proxy voting, fiduciaries must pursue solely risk-adjusted, portfolio-wide financial returns. So ESG considerations are allowed only to the extent that they have financial effects--which can leave either a lot of or relatively little discretion, depending on whether the current administration is Republican or Democratic.

But as this post hints at but doesn't quite engage, under the Investment Company Act, fund managers also have a fiduciary duty to their investors. Is that duty like ERISA, so that the focus is exclusively on financial returns? Or are funds allowed to define their goals, including ESG criteria, so that the duty is defined relative to those goals? I haven't dived as deeply into this question as I should, but I have looked a bit, and I'm not finding any clear guidance on the point. Ann (and other readers), any thoughts on what the answer is? I think it should be that funds are allowed to define themselves in part through ESG goals, and actual practice suggests that is the case, but I can't really point to any legal source that makes clear that the rule is actually that.

Posted by: Brett McDonnell | Dec 23, 2019 8:32:04 AM

Hi Brett! I think you're right that it's not entirely clear. This is something I engage briefly in my essay What We Talk About When We Talk About Shareholder Primacy, but, in sum, the documents I've read usually say that the fund has to act in the best interests of the beneficiaries, but that of course can mean different things. Clayton gave a speech where he suggested the duty for funds is wealth max ( and the SEC has a release on disclosure of funds' votes where it suggests the duty is to maximize wealth, but I wouldn't take either of those as definitive.

Posted by: Ann Lipton | Dec 23, 2019 9:24:54 AM

I doubt there is such a fiduciary duty under the Investment Company Act. If so, that would be devastating to those funds who properly disclose in their registration statements that they have non-financial objectives . However, if you want to know the definitive answer, I would contact Arthur Laby at Rutgers Law.

Posted by: Bernard Sharfman | Dec 26, 2019 2:37:20 AM

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