End of Week Notes

About that SEC Commissioner’s over-the-top Scarlet Letter ESG speech

One thing I’ve noticed about critics of sustainable investing is that they often seem to have no idea what they’re talking about. They concoct a caricature of ESG based on common misconceptions and use it to convince their audience how ridiculous the whole enterprise is.

At least that seems to be what is coming out of right-wing circles in Washington these days — the latest from SEC commissioner Hester Peirce, who, in a speech that hardly seemed appropriate given the office she holds, spoke to the choir at the American Enterprise Institute this week, delivering a over-the-top broadside against ESG.

Just so you know where she’s coming from, Peirce has spent her entire career inside Washington right-wing policy circles: George Mason Law School, Republican staffer on the Hill, the Federalist Society. She has written a book published by the Mercatus Center, a think tank financed in part by the Koch Brothers.

Reading through the transcript of the speech, I’d describe it as an ominous, massively exaggerated screed describing “ESG activists” as hellbent on bringing down defenseless corporations and perhaps shareholder capitalism itself.

Peirce argues that ESG activists are affixing a “scarlet letter” (her first name being Hester led her to that clever metaphor) on companies, shaming them based on incomplete information without taking into account their full character:

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.

Nothing in that statement is accurate.

First of all, ESG evaluations are all about trying to gather facts and understanding their context. ESG ratings are based on systematic frameworks and a plethora of indicators. They are focused on financial materiality and peer-group comparisons. The whole enterprise is about bothering a lot about facts and circumstances. The goal is to produce actionable information for investors. No one would take ESG ratings seriously if they didn’t “bother much” about facts and circumstances.

And one thing we know for sure, and this is really at the root of Peirce’s issue with it: ESG is being taken very seriously by more and more investors, including virtually every asset manager of any size and import on the planet.

Furthermore, the idea that an underperformer in an ESG ratings framework somehow gets publicly shamed is absurd. Specific company ratings are typically not well known, even within the investment industry.

Take a look at this list of companies and guess which one wears the “scarlet letter” of being an underperformer (gasp!) relative to its industry peers:

• Amazon
• Coca-Cola
• ExxonMobil
• Microsoft
• Procter & Gamble
• Tesla
• Walmart

If you guessed ExxonMobil or Walmart, you would be…wrong. Amazon is the only company on this list that is an underperformer relative to its peers, based on Sustainalytics ESG Rating. And just for kicks, which one wears the “gold star” of being an outperformer? It’s Microsoft. All the others have average ratings relative to their industry peers.

Investors use this data in a variety of ways, also nuanced, whether they are managing active strategies or designing ESG-based passive approaches or using it to inform their stewardship activities. No one is shaming companies or “inflicting unwarranted harm.” Amazon, by the way, is up more than 25% for the first half of the year.

Perhaps most important, companies themselves have become highly interested in their ESG evaluations, but not for the reasons Peirce claims, which is that they are treated so unfairly by ESG ratings.

Companies today face sustainability challenges ranging from how their business is being affected by climate change and the transition away from fossil fuels to how they treat their workers (on safety, pay, supply-chain oversight, and diversity), to the quality and safety of the products they produce. This is happening against a backdrop of heightened expectations for corporate behavior and purpose, driven by consumers and clients, by employees, both current and prospective, and by the public at-large.

More and more, investors are recognizing that ESG evaluations give them insight into a company’s sustainability challenges and how well it is addressing them. Companies themselves recognize that ESG evaluations can not only help them address investor concerns but also help them embed sustainability into their long-term strategy.

But Peirce was just getting started:

As Hester Prynne can attest, the affliction of shame is a group effort. It takes a village. Just as in Hester’s day, in our modern corporate ESG world, there is a group of people who take the lead in instigating their fellow citizens into a frenzy of moral rectitude. Once worked up, however, the crowd takes matters into its own brutish hands and finds many ways to exact penalties from the identified wrongdoers. The motives are often noble, but the methods are not.

What in the world is she talking about here? Some kind of witch hunt? If I had to guess, considering the source, she’s talking about the growing number of stakeholders, which she refers to as “so-called stakeholders” elsewhere in the transcript to signify their illegitimacy, who are demanding stronger standards of corporate behavior and better performance on sustainability issues.

There is indeed growing support for the idea that capitalism needs to be made to work for more people. Pricing externalities used to be a regulatory issue. (You can guess where Peirce stands on regulation. She argued against regulation after the financial crisis.) But today, rising expectations for corporate behavior extend to overall impact and to how companies can proactively mitigate negative externalities. That demand is coming from many fronts, not just ESG investors. And far from regarding addressing such costs as “penalties,” more companies today recognize that at a time when much of their value lies in intangible assets, it pays to build and maintain the trust of customers, workers and the public by being a good corporate citizen that addresses its overall impact rather than foist off the negative costs it produces onto the rest of society.

Even though federal law regards corporations as persons, which means among other things that they can spend unlimited amounts on political issues and candidates, Peirce seems to be suggesting that it is unreasonable to urge corporations to make moral decisions for the greater good.

But she, and we, are getting further afield from the real point here, which Peirce herself uncovers in her speech, when she says:

It is true that ESG issues may well be relevant to a company’s long-term financial value.

That is, of course, the entire point of ESG investing.

If ESG disclosures mean disclosing what is financially material, there is little controversy…

Exactly!

…but 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.

Wait, what? Now she’s back to just making stuff up. No one who does ESG investing, and I mean no one, is asking companies to disclose information that is not material. Apparently she is unfamiliar with the work of SASB, which is unconscionable for an SEC commissioner opining on materiality and ESG. Materiality has been the watchword for ESG disclosure for years now and SASB has developed industry specific recommendations for what should be disclosed.

While it is true that new ESG issues may emerge and become material, what exactly does she mean by “a shifting set of trendy issues”? The rise of customer data privacy and security as an issue for social media and on-line retailers? Or climate change, which has moved from a theoretical concern with impacts years into the future to an issue that is becoming more material and to more companies, it seems, by the day? Maybe she’s talking about gender-diversity issues like equal pay and putting more women in corporate leadership. By calling these issues “trendy” she’s trivializing them and arguing that they shouldn’t be material to investors. But, alas, these issues do exist and therefore investors can’t ignore them.

No right-wing bromide against ESG would be complete without an attack on proxy advisors and shareholder resolutions. Peirce rehearses the argument that proxy advisors have inordinate power by helping asset managers fulfill their stewardship responsibilities. This was never a big concern until proxy advisors started recommending occasional positive votes on matters related to ESG.

Of course they have. As an ESG issue becomes material, it would be irresponsible for proxy advisors to issue blanket recommendations of opposition. Anyway, my observation is that asset managers are spending more time focusing on stewardship because of the growing relevance of ESG issues to company management. And in cases where a significant shareholder vote arises around an ESG issue, asset managers are making their own call, not relying on their proxy advisor. Proxy advisors help with the process and mechanics of proxy voting. They are not a set-it-and-forget-it mechanism for asset managers. At least not today and that’s largely because of the rise of ESG issues.

And finally, Peirce thinks it’s a bad thing that a small investor can file a shareholder resolution. But who’s to say when a part-owner, no matter how small, of a company might have a constructive point to make with management? Besides, the little guy’s or gal’s resolution still has to pass a materiality standard to make it onto the proxy ballot. And if it doesn’t garner any support, that’s the end of it. Even if it does, shareholder resolutions that attract a majority shareholder vote aren’t binding on management.

At a time when there is growing support for corporations to focus on the big picture — long-term sustainable growth and accentuating their positive impact on society — it would be exactly the wrong thing to limit the voice of shareholders who want to encourage them to do so.

In sum, Peirce’s speech casts corporations as helpless victims of ESG activists. Nothing could be further from the truth. For one thing, corporations can take care of themselves. But beyond that, more and more, corporations today want to align themselves with ESG, sustainability, and public purpose. We’re entering a new era where corporations can and should be a force for good beyond the important basics of job and wealth creation. When you can do good and do well, what’s the big issue with that? The more the investor base of the modern corporation consists of shareholders concerned about these things, the more latitude management has to focus on the long term, on sustainability, and on having a positive impact.

Just as Commissioner Peirce noted her remarks represented her views and not those of the Commission or her fellow Commissioners, my views here are my own and not necessarily those of Morningstar, Inc.