Take it on the run
Part 1: An analysis of Congress's ESG Working Group shows a quick and dirty job
While the world constantly changes, and the early 2020s proved to be a pivotal time for change. There's no going back: COVID, the death of George Floyd and subsequent polarized social sentiment, tipping points for extreme weather reaching into the global north, and the release of new, powerful AI models. Businesses are now more globally connected than ever, risks are more interconnected, and the opportunities seem endless.
In ESG Mindset, I argue that ESG is one tool businesses can use to help think through this new world of complexity. The same goes for investors.
While ESG often connects with broad themes around sustainability and DEI on the surface, it is about the material intersections of the planet, people, and quality processes and controls around the company. These issues matter, meaning paying attention to them is good business. Yet, due to its varied opportunistic meanings, it has become a convenient boogeyman for conservatives in the US.
In February 2023, Chairman Patrick McHenry of the United States House Committee on Financial Services created an ESG Working Group to examine ESG. In early August 2024, they released their findings in a report titled The Failure of ESG: An Examination of Environmental, Social, and Governance Factors in the American Boardroom and Needed Reforms.
The report is only 37 pages long and contains the typical anti-ESG talking points but also includes an indictment of the current state of the capital markets. Since I somehow missed this report, I figured readers probably have, too. Let’s take a look!
I will divide the report’s analysis into two parts, with the second coming next week. For ease of reference, the report’s section titles will be included with this assessment.
Introduction
Fundamentally, there is a misunderstanding of what ESG is and isn’t. While the report calls out that ESG “measures are falsely portrayed as advancing financial returns or being necessary for investor protection,” that is sometimes how it is referred to, but not actually what it is. The indictment of the capital markets and others comes early. The premise is that elected officials cannot pass liberal policy and legislation to force companies to transition or manage impact. As a result, agencies like the SEC pass climate rules to force companies to disclose, subverting the democratic process.
Only this isn’t what is happening.
The SEC is trying to do what others have: Pass guidelines to create comparable datasets for investor and stakeholder analysis. For example, the EU’s CSRD website states:
This helps investors, civil society organisations, consumers and other stakeholders to evaluate the sustainability performance of companies, as part of the European green deal.
The rules concern consistent data for comparable and accurate stakeholder analysis. If only it incentivized companies to do something!
Yet, despite the reality, we arrive at the two primary objectives of the ESG Working Group:
• Examine the implementation of a far-left ideological agenda on businesses and investors; and
• Identify solutions to protect investors and our capital markets from this misaligned and divisive agenda.
In searching for the definition of ESG that can explain the forces at work, we find a definition of ESG in footnote #8:
For purposes of the discussion and analysis in this Final Report, the Working Group defines “ESG” as a fund, corporate, or regulatory focus on so-called broad corporate social responsibilities and non-pecuniary measures, including in the form of environmental, social, governance, or political factors.
However, footnote #9 is also relevant to the definition, as it calls out how the US Department of Labor defined ESG as part of considering the impact on economically targeted investments (ETIs). The report brings this up because “for purposes of this memorandum, we have restricted our analysis to the SEC and not specifically other federal agencies.”
Ah, it must be the SEC that is forcing non-pecuniary measures and misdefining ESG. Well, in the SEC’s climate rule, we find materiality throughout:
The rule proposal would have required a registrant to describe any climate-related risks reasonably likely to have a material impact, which may manifest over the short, medium, and long term.
Further, there is a recognition in footnote #2743 that investors may want this information for pecuniary and non-pecuniary matters, noting that:
…research shows that publicly available climate-related information is reflected in asset prices, which is an indication that such information affects the prices at which investors are willing to buy or sell assets (i.e., their investment decisions).
And so, the ESG Working Group isn’t writing about ESG at all, but a very narrow definition that not even the DOL, SEC, or capital markets have ascribed to it. No evidence is offered as to where this definition has come from other than a specter of imagined fear.
The Problem: An Environment Ripe for Abuse
In this shadowy place with a misaligned definition, the core problem statement is “unelected bureaucrats and private sector activists force progressive ESG policies on the private sector.”
Only one of these actors is pressuring anyone to improve. There are no unelected bureaucrats pressuring companies to do anything around ESG other than report so interested stakeholders can understand what to do.
There are elected bureaucrats moving to incentivize companies to transition, and they are in Congress. For example, the Bipartisan Infrastructure Law and the Inflation Reduction Act cover transitional activities and are being deployed in conservative states. Lately, 18 Republican representatives have expressed concern about Trump's repeal of the IRA and the specific rollback of energy credits.
While the California State Bills, which are also focused on disclosures and climate risk, are mentioned, these, too, were set by elected officials.
The report lays out the path the SEC set in easing proxy resolutions. This is where the ‘private sector activists’ pressure comes from. Still, the real pressure for action comes from the private sector. Whether publicly traded or not, every company in a value chain feels pressure to report downstream to its B2B customers. Admittedly, these private sector players wield massive amounts of pressure in inconsistent ways, from engagement to simply requesting disclosures to canceling contracts, which seems like the free markets at work. This pressure is not mentioned in the problem statement.
The Politicized Proxy Voting System
The next part of this section is dripping with irony. Following the concern of unelected regulators, we have another problem: the rise of liberal shareholder activism.
As a reminder, shareholders vote on the board of directors at a public company. In effect, directors are elected officials of the company. Shareholders can also bring proxy resolutions for votes to the annual general meeting (AGM). These votes are non-binding but represent shareholders’ power through ownership.
The lament here is that there is a trend toward progressive resolutions being filed.
But this door swings both ways, so let’s examine the facts.
In 2024, there was a sharp rise in conservatively aligned anti-ESG proposals. Per a report by Heidi Welsh from the Sustainable Investments Institute, there were “more than 100 shareholder proposals, and 81 had gone to votes as of June 30, 2024. Support averaged only 1.9 percent, less than half what they earned just three years ago.”
ESG proxy resolutions are coming back. A report from ISS from May 2024 shows that around 268 governance and compensation proposals gained more support, at around 35%. Governance and compensation don’t sound like strictly liberal topics. On the other hand, there were 130 environmental resolutions, slightly down overall, but support for environmental and social issues was marginally higher, reversing a decline in support since 2021.
Funnily enough, the ISS report, a proxy advisory firm, is cited in this section, stating that this citation shows “environmental and social proposals receiving little shareholder support.” The article states that environmental proposals receive 21% support, whereas anti-ESG proposals receive 1.6% support, so they picked the metrics aligned with their point. This leaves the more exciting increase in support for ESG proposals out.
The increase in ESG and anti-ESG proxy resolutions is due to the change in Rule 14a-8 in 2021, which allows them to be brought to the AGM for a vote. Still, the report boldly states that many of these proxy resolutions have no financial impact. This may or may not be the case. Luckily, the Working Group includes examples we can look at.
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First up is a proxy resolution at Comcast, logged by As You Sow, an activist shareholder organization. The resolution attempted to incorporate ESG options into Comcast’s retirement plan but did not receive support. One could argue that this might help attract talent, but the argument was for a misalignment between the company’s goals and retirement plan.
I like As You Sow’s activist work overall, but in this case, I agree that there are unlikely financial consequences. Further, this doesn’t appear to be very material to the company. The company’s 2023 proxy statement explains the company’s aversion to this resolution and also includes a note that the report leaves out:
…we plan to introduce a new mutual fund investment window later this year that will include fund options that expressly take into consideration climate and other ESG matters as part of their investment mandate, among other options.
It also includes a recognition of ESG’s accurate meaning and its alignment with fiduciary goals:
…our plans’ fiduciary already considers a variety of potential economic risks, reward opportunities and goals – including those related to climate change – in selecting the plans’ investment options, including default investment options. Further, nearly all of the investment managers for funds offered in our retirement plans’ core lineup incorporate and consider ESG factors in their investment policies, processes and practices to varying extents, consistent with their legal fiduciary obligations. Our fiduciary committee reviews the manager’s consideration of such factors as part of its routine due diligence efforts.
Despite this proxy resolution's lack of materiality, some digging disproves the report’s thesis…in their example.
Next is a proxy resolution at Home Depot focused on a Racial Equity Audit. This one does appear material as the company touts its DEI efforts in its 10K. The 10K is how a company reports its financials and material matters to shareholders. In it, they state:
As a Company, we have identified several priorities designed to guide our efforts to enhance diversity, equity and inclusion. We believe these associate-, supplier- and community-focused priorities will further enhance our customers’ experience and make a sustainable difference within the workplace, marketplace, and community.
If this is a company perspective, an audit of these statements would be material and help give an investor more context. Shareholders approved this in 2022 by a 63% margin and pursued it. In 2023, there was an anti-ESG proxy resolution to rescind the previous vote. In its 2023 proxy statement, the board recommended against backtracking since such a large number of shareholders voted in favor of it. So, shareholders voted, and the board moved forward, making this another poor example.
Lastly, we have Costco and the risk around its climate goals, specifically the reporting and reducing its Scope 3 GHG emissions (those in its value chain). These typically account for the majority of a company’s emissions. As with the Home Depot, this issue appears in Costco's 10K as a risk and appears material.
As the economy transitions to lower carbon intensity we cannot guarantee that we will make adequate investments or successfully implement strategies that will effectively achieve our climate-related goals, which could lead to negative perceptions among members and other stakeholders and result in reputational harm.
It is a pretty good argument, but shareholders disapproved. The board outlines its actions regarding Scope 3 in its recommendation.
The Scope 3 action plan consists of five focus areas: supplier energy transition, regenerative and deforestation-free agriculture, sustainable livestock, energy efficient items, and sustainable packaging. Additionally, underpinning these focus areas will be an emphasis on supplier engagement, buyer education, and IT system development for data monitoring and collection.
So, despite the resolution, Costco is doing work in this area. Regardless of ‘private sector activists,’ progress continues.
So, Rule 14a-8 did open the proxy resolution floodgates, but these examples are only surface-level, and the slightest bit of research shows reality.
The Outsized Role of Proxy Advisory Firms
With so many publicly traded companies, it is difficult for institutional investors to analyze every proxy resolution against materiality for every industry and company. This is where proxy advisory firms come in. They can scale with broad voting policies and make recommendations for investors.
With this power, proxy advisory firms may have an outsized influence on proxy resolution recommendations, especially among passive investors who vote whichever way these firms recommend. I favor an investment firm doing research and conducting engagement, but not every firm has that luxury, especially when investing in funds that include a range of securities.
The report doesn’t cast proxy advisory firms as solely pro-ESG, but it is clear that is why they are included here. Still, this isn’t accurate as ISS offers an ‘ESG Skeptic’ offering.
Prioritizing ESG Factors Over Financial Performance
Quickly, the report moves into the imagined definition here of ESG. The argument is, “By prioritizing social, environmental, and political issues over financial performance, these firms can undermine the fundamental purpose of the proxy voting system.” It also states, “They must provide recommendations that consider the long-term economic value of the company, not recommendations driven by non-economic factors or a one-size-fits-all approach.”
In the original 2004 “Who Cares Wins,” it is noted that:
…many studies confirm that the way a company manages ESG issues is often a good indicator of overall risk levels and general management quality — which are both strong determinants of companies’ long-term success.
ESG favors the long-term. Not all investors do, however.
While pension funds and retirement plans focus on a company's long-term resilience because of their long investment cycles, retail investors are short-sighted. According to Reuters, stocks were typically held for eight years in the 1950s. By 2022, the holding period had dropped to 5.5 months. Yet, in the Working Group’s report, they state:
This disregard for economic considerations can have detrimental consequences for retail investors... Proxy advisors…must provide recommendations that consider the long-term economic value of the company, not recommendations driven by non-economic factors or a one-size-fits-all approach.
In other words, if the argument is that the long-term must be considered, that is ESG. Glass Lewis, a proxy advisory firm, calls out the long-term focus around ESG in its ESG 101 page:
Organizations committed to social and environmental responsibility often display signs of strength and prosperity that attract investors who are focused on long-term returns.
And so, the report’s statement about ESG ignoring the long-term economic value of a company makes no sense because:
Retail investors appear highly speculative and short-term-focused.
ESG is a long-term construct by design.
Proxy advisors DO use ESG to evaluate a company's long-term economic value; further, retail investors may not care because they don’t care about the long term.
Would a retail investor who holds a security even make it to an AGM? With a 5.5-month holding period, it seems highly unlikely.
Institutional Investors: The Role of Fiduciaries
The big three institutions in the US, Vanguard, State Street, and BlackRock, own much of the market on behalf of their clients. I’m not going to argue the merits for or against what is currently happening in that space, but I will call out what the report says:
…there are serious concerns about how these managers employ their voting power to advance political agendas that are unrelated to financial performance.
I am utterly convinced that, due to their immense size, they are not likely to focus on things ‘unrelated to financial performance.’ They certainly wouldn’t be as big as they are if they did.
Companies should be concerned about one thing in this section: There is great concern about the anti-trust implications of some of the ESG and climate consortiums. While this hasn’t been a risk, it is only a matter of time before some anti-ESG group files a suit.
In the meantime, the big three have been experimenting with various flavors of investor voting choices. I don’t expect this concern to continue in the long run (see Vanguard, State Street, and BlackRock).
Conclusion Part 1
Unsurprisingly, the misunderstanding about what ESG is and isn’t informs the perspective of this entire paper. Even the most basic research can disassemble its arguments. Last summer, I wrote about the anti-ESG push in Congress and concluded that financial services firms have an opportunity to define ESG more consistently. Unfortunately, that still hasn’t happened. This report is, in part, a result of that failure.