Roll with the changes

Part 2: An analysis of Congress's ESG Working Group shows a limiting perspective

In case you missed last week’s read, we are covering the US Congress’s report on ESG titled The Failure of ESG: An Examination of Environmental, Social, and Governance Factors in the American Boardroom and Needed Reforms.

Let’s pick up where we left off last week and jump in!

The Power of the Big Three

As a reminder, we were getting into the power of the biggest three asset managers on the planet, who own significant investments on behalf of their clients. As a result, whatever voting policy they use on resolutions is pretty substantial because they own so much. When aligned with the perception of a political play (which ESG is not), you end up with an easy target, despite that critical phrase, ‘on behalf of.’’

Many of these resolutions are more activist and less material, but it can be challenging to determine which, as materiality is in the eye of the beholder. What one investor might believe to be material and valuable in a decision, another may not. For example, is a racial equity audit material for a company with a diversified global supply chain? Would that focus be more or less material for a streaming service with diverse customers?

This is why I tend to go to the 10K to see what the company believes are material issues and then see if the leap can be made from the resolution to what the companies prioritize, as I did last week with the three company examples in the report.

The Working Group aligns more with the concerns around activist proposals and asks for more transparency around the immense power wielded by these firms in proxy voting. When shareholders own over 5% of a stock, they must file a Schedule 13G with the SEC. The Working Group asks Congress to review these filings to “help develop a more complete understanding of the extent to which the Big Three exercise influence over the management and corporate policy of their portfolio companies.”

Here is an example of a Schedule 13G form. These forms are publicly available on the SEC’s EDGAR database to transparently disclose ownership already, which translates to this influence. However, other than revealing how much stock was purchased and when, determining how influence is used through the form is useless as it does not include a voting record. There is a more qualitative and robust Schedule 13D (example) for significant ownership. Still, the forms are too boilerplate to be helpful unless you suspect something like a hostile takeover to be in the works, which is not the focus of the Working Group’s inquiry here.

Many recognize that significant ownership by these institutions may create problems. In 2018, Jack Bogle, who created Index Funds and founded Vanguard, warned about this consolidation of control in a WSJ op-ed.

It seems only a matter of time until index mutual funds cross the 50% mark. If that were to happen, the “Big Three” might own 30% or more of the U.S. stock market—effective control. I do not believe that such concentration would serve the national interest.

For now, the various proxy voting choice programs could help if they scaled, and the sooner, the better, perhaps. In the meantime, the Working Group should review the proxy voting choice programs with each firm’s proxy voting guidelines, which can help us understand each firm’s approach (State Street, BlackRock, Vanguard). Regardless, Schedule 13G is not the answer here, nor is ESG the reason to examine the issue of control.

ESG Raters and their Impact on U.S. Public Companies

Last week, we looked at the criticism of proxy advisors, which attempt to scale recommendations to institutional investors who invest in too many companies to do bespoke research. We’ve now covered the influence of the Big Three institutional investors and arrived at another ESG player in the markets: ESG rating agencies.

These rating agencies analyze ESG, and in some cases, the impact of these companies on the world, to give institutional and retail investors ESG-related information. However, due to the subjectivity of materiality, the assessments of companies vary across agencies. The Working Group calls out, as many do, the variability in these ratings as an issue of reliability and claims the inconsistency is a detriment.

The Working Group cites Phillip Morris, a tobacco company, as an example of how it gets higher ESG ratings than Tesla, an electric vehicle company. I cover this use case in depth in ESG Mindset, but here, I recommend that the reader look closely at Phillip Morris’s Annual Report (pages 7-19) and assess how well the company understands its risk.

In reality, inconsistencies in ESG ratings are to be expected since materiality is subjective. The rating agencies’ diversity and perspectives can be viewed as a benefit. The rating agencies have in-depth and often overlooked explanations of how the scores are arrived at, including broad issues of materiality by industry in some cases. Still, a surface-level examination of the public scores only, which is what the Working Group has done here, yields surface-level understanding.

If your company or firm is purchasing ESG scores for investing, it would likely be in your interest and your fiduciary duty to review the methodologies used (S&P Global, MSCI, and LSEG publish their methodologies, for example).

In the conclusion of this section, the Working Group calls out that:

Recent studies and analyses have also cast doubt on the effectiveness of ESG ratings in predicting financial performance. For example, one study examined the relationship between fund sustainability and performance and found that funds with low sustainability ratings perform better than those with high ratings.

But here’s the thing: ESG is not sustainability. Logically, why would a company that focuses on potentially non-material sustainability issues outperform? I often argue this with those in the financial markets. A material approach, or one that matters to the company, would likely yield more of an impact on outperformance or at least resilience in the long term. Meanwhile, let’s remember that credit ratings, which will never go away and are a market staple of financial analysis, failed to predict the 2008 Financial Crisis.

A Politicized SEC

From the markets, we move to the agency responsible for ensuring that the markets operate transparently in the US to protect investors: the Securities and Exchange Commission (SEC).

The overarching argument is that the SEC has overstepped its authority by creating its Climate Rule, which forces companies to disclose potentially non-material climate risk information while opening the door for non-material proxy resolutions with its change to rule 14a-8.

The SEC launched its final Climate Rule, focusing on material Scope 1, 2, and climate risk disclosures, in the spring of 2024. In the subsequent weeks, the rule was paused, facing criticism and litigation. The Working Group’s criticism of the rule is that climate risk is not material. I’ve argued about these disclosure rules, exploring whether or not carbon is universally material (it isn’t), but it can indicate a focus on the energy transition. Still, there is a need for some investors to have consistent information as, again, materiality is subjective.

One stat that jumps out is this:

In their testimony, witnesses detailed the practical challenges companies must face to quickly achieve compliance with a rule that, by the SEC’s own estimates, would increase the costs associated with being a public company by at least 21 percent.

What are these costs exactly? No dollar amount is included, and I couldn’t track this down, even though it appeared in Hester Pierce’s dissent on the rule. In her footnote, “The “typical” numbers refer to the external cost burden of filing the Form S-1 and the Form 10-K.” So, 21% of the cost of preparing these two documents. As a reminder, a WSJ article in April 2023 put the average price of complying with the SEC Climate Rule at $750,000 in the first year. The 21% stat looks higher than you might think it is.

Despite the cost, the Working Group’s argument here makes little sense. The SEC rule attempts to drive comparability around material climate risk issues. It doesn’t force companies to do anything other than consider the materiality and disclose the related information. One of the footnotes of the Working Group’s report (67) states:

The SEC’s estimates are likely too low because they exclude, for example, the considerable costs companies must incur to make “materiality” determinations when deciding whether certain disclosures are necessary.

The Working Group's statement that the costs might be too low reveals the importance of materiality. Regardless of the SEC’s climate rule, this work would need to be undertaken because determining materiality is a key issue for any company and would, therefore, already be an incurred cost. This might be why 80% of companies are proceeding with net-zero plans anyway.

Admittedly, one of the reasons shareholder activism has increased is the changes to rule 14a-8, which allows more proxy resolutions to come to a vote at the annual general meeting. The company has small costs addressing these issues in their proxy statement, but the door here swings both ways. There has been an uptick in both ESG and anti-ESG proposals. Unfortunately for conservatives, anti-ESG proposals are receiving abysmal support (4% or less typically). If the Working Group were aligned with American interests, one might expect support for the anti-ESG proposals to be much higher.

The Extraterritorial Impact of EU Disclosure Regulations on U.S. Public Companies

This section builds on the argument that the SEC’s climate rule doesn’t matter. There are indeed other global regulations, and with the rise in globalization, these regulations are unavoidable.

The EU has launched two directives on climate disclosure. CSRD is focused on single materiality and comparable financial disclosures for shareholders and other stakeholders. CSDDD is a little more complex, focusing on double materiality, which includes the company's impact on the world.

Yet, the Working Group misses the point under the guise of protecting American interests.

…the Biden Administration has exacerbated the burdens and made it harder for U.S. companies to compete globally by failing to represent U.S. interests and negotiate an equivalence agreement with the EU.

If your company wants to enter or play in a global market, you need to play by those rules. While diplomacy has its place, fighting ESG makes companies less competitive by removing a depth of understanding. Actively fighting extraterritorial regulations is still not going to stop companies from having to disclose to stakeholders. If companies don’t at least meet the table stakes that their competitors follow, they will be at a disadvantage. Just ask any seller at a company that receives RFPs. Buyers are factoring in ESG data points into their buying decisions.

While the Working Group argues that “ESG initiatives…harm American businesses and their investors,” its efforts harm American businesses by fighting against potentially material climate risk assessment and disclosure and putting those companies at a global disadvantage.

No disclosed information is less informative than any disclosed information from a competitor.

The Way Forward

According to the Working Group, there are three paths to address the ‘market dangers’ of ESG.

First up are the courts. The big one here is the Supreme Court’s reversal of the longstanding Chevron deference, which allowed federal agencies to interpret laws for enforcement, like the SEC Climate Rule. Interestingly, in the next section, the call is to have the SEC regulate proxy advisory firms. Having a federal agency have some rule setting is beneficial when it suits the report’s argument.

The report also refers to one company that chose to push back against activist investors through litigation in the first case of its kind from Exxon Mobil against Arjuna Capital. The resulting litigation led to further shareholder activism with a call from CalPERS (the largest pension fund in the US) and Glass Lewis recommending votes against board members. As always, proxy resolutions and voting are part of the benefits of ownership. Yet, this case also intersects with the SEC 14a-8 rule since the original resolution from Arjuna was allowed to proceed and then was pulled due to the litigation. The Working Group’s report calls out the legal right of companies to challenge activists while completely ignoring the rights of shareholders.

The last court reference is to the various challenges of the SEC’s Climate Rule. This is inconsequential as the rule is paused already, and companies continue to assess their environmental metrics at a minimum, as mentioned above.

The following section focuses on targeted legislation. Four proposed bills are mentioned. Two of these bills (H.R. 4767 and H.R. 4655) focus on the proxy advisory ecosystem, with the latter bizarrely deferring to state laws to prevent “discussions regarding politically motivated proposals, nor should it mandate that public companies subsidize activists’ speech by publishing environmental and social proposals in their proxy materials.” Besides being a complete nightmare to navigate, this would also prevent anti-ESG proxy resolutions from being filed. This latter bill seems to be a more egregious overreach of law, as a judge would need to determine whether a proxy resolution is political. For example, ESG is not a political concept, yet here we are.

Another bill, H.R. 4790, targets focusing on material disclosures and proxy resolutions. Materiality is ESG, and companies should be focused on their material issues. But again, there are two points to consider. First, part of ownership is being able to vote on proxy resolutions so activists can initiate change. Second, materiality can be subjective. Again, are we heading to a future where judges determine materiality?

One of the callouts in H.R. 4790 is for an SEC study on the effects of CSRD on US companies, but again, not complying with global regulations in jurisdictions where you operate would put a company at a competitive disadvantage as this is table stakes.

Lastly, H.J.Res. 127 disapproves of the SEC Climate Rule. The framing is that “the Climate Disclosure Rule is among the most expensive rules in the SEC’s 90-year history. Nullifying the rule would save companies costs that could otherwise prevent them from going or remaining public.” Refer to my notes above on the cost as a reality check.

The last section is about Congressional oversight. The ESG Working Group has already been working to hold hearings over the past 18 months or so. They’ve also conducted interviews with the SEC. An interesting note here is that the SEC believes the Climate Rule will stand up to scrutiny. While I’m not so sure, without the SEC rule in place, companies won’t be able to provide what the financial markets are seeking—comparable data.

The last two targets of oversight should cause any American pause. First, the Working Group suggests a review of the two most powerful proxy advisory firms (with 97% of the market): ISS and Glass Lewis. This duopoly could have problems, but it is worth remembering that ISS has an “ESG Skeptic” offering that firms can use. Even if you believed that ESG was political, there is another option. As with the power of the Big Three asset managers, there are good questions to ask here that have little to do with ESG.

The second target is the top ten US asset management firms surrounding questions of their fiduciary responsibilities and transparency. This last target is a question of its own making and one reason I wrote ESG Mindset. There are too many varying definitions of ESG out there. By defining ESG clearly and placing activist resolutions alongside ESG without differentiation, the market ecosystem has not only opened the door for a target to be put on their backs but perpetuated the problem.

While I disagree with the report’s suggestions for the way forward, I believe a consistent and precise definition of ESG would serve the best interests of firms and their investors.

The other strong disagreement is with the reversal of 14a-8 or its scrutiny. Investors are changing sentiment, and ESG-related proxy resolutions are gaining support. Part of stock ownership leverages this influence. By removing this ability, Congress would push more short-termism in the markets. The US economy needs resilient companies, not ones that chase quarterly metrics.

Rather than viewing ESG as a political problem, the Working Group would do well to understand that the nature of business has changed over the past decade, and they should roll with it instead of rolling it back. This shift would support US businesses and the markets, rather than hinder them with a limited view.