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.
SideBar
In 2019, the Business Roundtable created quite a buzz when it
released a new Statement on the Purpose of a
Corporation that moved “away from shareholder
primacy” as a guiding principle and opted in to a kind of
“stakeholder capitalism” (see this PubCo post). Then, in 2020, in another
striking sign of changing perspectives, the BRT released a
new principles-and-policies guide endorsing a
new approach to action on climate change. According to the press release, the BRT is advocating
“new principles and policies to address climate change,
including the use of a market-based strategy that includes a price
on carbon where feasible and effective. Such a strategy would
incentivize the development and deployment of breakthrough
technologies needed to reduce greenhouse gas (GHG)
emissions. To combat the worst impacts of climate change,
Business Roundtable CEOs are calling on businesses and governments
around the world to work together to limit global temperature rise
this century to well below 2 degrees Celsius above pre-industrial
levels, consistent with the goals of the Paris Agreement. In the
United States, this means reducing net-greenhouse gas emissions by
at least 80 percent by 2050 as compared to 2005 levels.”
As this article in
the WSJ observed, it’s not that the
principles and policies break new ground—they
don’t—rather, “the significance of the statement is
that it shows how business is shifting from a source of resistance
to a force for action on climate.” (See this PubCo post.)
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.”
SideBar
Of course, there is a significant body of research that supports
the “widespread claims” of long-term financial benefit.
For example, with regard to board diversity, the findings in
California’s board gender diversity bill, SB 826, identified a
number of studies that found economic benefits in gender
diversity:
“numerous independent studies have concluded that publicly
held companies perform better when women serve on their boards of
directors, including:
(1) A 2017 study by MSCI found that United States’
companies that began the five-year period from 2011 to 2016 with
three or more female directors reported earnings per share that
were 45 percent higher than those companies with no female
directors at the beginning of the period.
(2) In 2014, Credit Suisse found that companies with at
least one woman on the board had an average return on equity (ROE)
of 12.2 percent, compared to 10.1 percent for companies with no
female directors. Additionally, the price-to-book value of these
firms was greater for those with women on their boards: 2.4 times
the value in comparison to 1.8 times the value for zero-women
boards.
(3) A 2012 University of California, Berkeley study called
“Women Create a Sustainable Future” found that companies
with more women on their boards are more likely to “create a
sustainable future” by, among other things, instituting strong
governance structures with a high level of transparency.
(4) Credit Suisse conducted a six-year global research
study from 2006 to 2012, with more than 2,000 companies worldwide,
showing that women on boards improve business performance for key
metrics, including stock performance. For companies with a market
capitalization of more than $10 billion, those with women directors
on boards outperformed shares of comparable businesses with
all-male boards by 26 percent.
(5) The Credit Suisse report included the following
findings:
(A) There has been a greater correlation between stock
performance and the presence of women on a board since the
financial crisis in 2008.
(B) Companies with women on their boards of directors
significantly outperformed others when the recession occurred.
(C) Companies with women on their boards tend to be
somewhat risk averse and carry less debt, on average.
(D) Net income growth for companies with women on their
boards averaged 14 percent over a six-year period, compared with 10
percent for companies with no women directors….
2) (A) A 2016 McKinsey and Company study entitled
‘Women Matter’ showed nationwide that companies where women
are most strongly represented at board or top-management levels are
also the companies that perform the best in profitability,
productivity, and workforce engagement.”
(See this PubCo post.)
Similarly, the Nasdaq proposal on board diversity cited a
number of studies, including research from the Carlyle Group
(2020), which “found that its portfolio companies with two or
more diverse directors had average earnings growth of 12.3{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} over
the previous three years, compared to 0.5{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} among portfolio
companies with no diverse directors”; FCLTGlobal (2019), which
found that “the most diverse boards (top 20 percent) added 3.3
percentage points to [return on invested capital], as compared to
their least diverse peers (bottom 20 percent)”; and McKinsey
(2020), which found “a positive, statistically significant
correlation between company financial outperformance and [board]
diversity, on the dimensions of both gender and
ethnicity.”
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.)
SideBar
With the increased focus on sustainability reporting, as
discussed in this article in the WSJ,
also comes increased scrutiny, especially of ESG hype and
greenwashing. While positive reports and ratings “can attract
investments and sales,… along with heightened interest comes
heightened scrutiny. Indeed, misleading claims can backfire if they
are called out as inaccurate or misleading. Investors are quick to
punish companies for transgressions across the landscape of ESG
issues.” “‘The stakes are just much
higher,'” according to one commentator, citing a
2019 report from a large bank “that showed 24 major
controversies related to ESG topics erased more than $500 billion
in market value of S&P 500 companies from 2014 to September
2019.” Another survey of 250 institutional investors showed
that over half “believe companies are presenting misleading
environmental credentials, and 84{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} think the practice is becoming
more common.” While regulation of claims about products
varies, the article contends that there is less regulatory scrutiny
of voluntary sustainability reports, and companies have more
flexibility in the selection of information they present in these
voluntary reports, especially to the extent that the statements are
considered vague “marketing speech” (provided it’s
not false). But where ESG intersects with financial information,
such as details about their investments in sustainability projects,
the disclosures tend to be more rigorous.
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{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} of
companies in the study faced pressure in the last year to increase
their commitment to diversity, equity and inclusion, and 96{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} made
either significant (46{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a}) or some changes (50{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a}) in response.
Likewise, 67{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} faced pressure over environmental or sustainability
issues and 98{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a} took significant (40{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a}) or some (58{e421c4d081ed1e1efd2d9b9e397159b409f6f1af1639f2363bfecd2822ec732a}) 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.”
SideBar
There seems to be some agreement with the contentions of the
authors on this point. According to the WSJ, many companies provide volumes
of environmental data that are used by rating firms to give
companies ESG grades used by investors. However, those ratings are
“inconsistent and incomplete.”
The WSJ analyzed ESG ratings from three ratings
agencies for 1,469 companies and found that 942 companies were
graded differently by different raters: “Nearly a third of the
companies were deemed ESG leaders by one or more rating firms, but
labeled ESG laggards by one or another rater. Credit ratings, by
contrast, are broadly consistent.” Only about a third of the
companies had consistent scores. Why? Because the agencies use
different methodologies and attribute different weights to issues,
such as environmental or social. (See this PubCo post.)
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.
SideBar
In June of last year, in remarks before the ESG Board
Forum, Putting the Electric Cart before the
Horse: Addressing Inevitable Costs of a New ESG Disclosure
Regime, SEC Commissioner Elad Roisman weighed in with
his take on mandatory prescriptive ESG requirements and the likely
associated costs. (Roisman has announced that he intends to
leave the SEC this month. See this PubCo post.) As he has indicated before,
he’s not really keen on the idea, particularly the
environmental and social components of potential requirements. But
if prescriptive line-item ESG disclosure requirements were imposed,
how could the costs be mitigated? In Roisman’s view, the costs
are fairly obvious: the costs of collecting (and in some cases,
calculating) and preparing the information as well as the costs of
increased liability for making the disclosures, both from potential
Enforcement actions as well as civil litigation. Although these
types of costs are prevalent with most disclosure requirements, he
suggests that the scope and novelty of ESG disclosure may increase
them. To try to reduce these costs, he offer several ways to tailor
ESG disclosure requirements.
- Scaling. First, he suggested that the disclosure
requirements be scaled for smaller companies, an approach that has
been taken with a number of other disclosure requirements. He also
rejected the idea that has been floated by some that the SEC also
impose ESG disclosure requirements on private companies.
(See this PubCo post and this PubCo post.) - Flexibility. Roisman advocated that the SEC be
reasonable in its expectations of “what companies can disclose
and how they disclose it.” He cited as an example the
difficulty of obtaining reliable information about Scope 3
greenhouse gas emissions, which depends on the company’s
“gathering information from sources wholly outside the
company’s control, both upstream and downstream from its
organizational activities.” Companies may not be in a position
to disclose that type of information with much precision and, to
provide it at all, may need to access outside vendors, inflating
demand and cost for the data. For similar reasons, he expressed
concerns about requiring verification through an audit or an
attestation. - Safe Harbors. To address litigation risk and avoid
chilling the disclosure effort, he suggested addition of a safe
harbor—much like the safe harbor in the PSLRA for
forward-looking statements with accompanying cautionary
statements—for good faith efforts to provide the required
information. - Furnished, not Filed. Again, in light of increased
litigation risk, Roisman advocated categorizing environmental and
social disclosures as “furnished” to the SEC, not
“filed,” comparable to the approach taken with
disclosure of resource extraction payments. (See this PubCo post.) In his view, if the argument
is that investors want the information and would benefit from the
uniformity and comparability, “those benefits can be realized
without imposing the level of liability that filing with the SEC
presents.” - Extended Implementation Period. Finally, he hoped to
see a long phase-in and extended implementation period. Companies
will need time for the back-and-forth of questions as well as to
implement staff guidance, to learn from other companies’
disclosures ideas (another reason, he suggests, for scaling) and to
absorb feedback and make improvements. (See this PubCo post.)
Shortly after Roisman’s remarks, Bloomberg reported, at
the WSJ‘s CFO Network Summit, Commissioner
Allison Herren Lee, a strong supporter of mandatory climate and
other ESG disclosure (see this PubCo post), appeared to line up with
some of his views on cost mitigation. She expressed her view that
companies’ compliance with any new SEC disclosure requirements
on ESG should not be subject to “gotcha” enforcement,
instead indicating that companies will be cut plenty of slack in
experimenting with any new ESG rules that the SEC may adopt. Like
Roisman, she also advocated that the SEC phase in disclosure
requirements gradually over time or “deploy a safe harbor to
help companies with compliance.” Is this a signal that we
should expect the SEC’s new proposal on ESG disclosure to
provide a phase-in, reasonable latitude, and possibly even a safe
harbor for complying companies? (See this PubCo post.)
The SEC’s proposals on human capital and climate disclosure
are expected to be released early this year.
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