ESG: Still Coercive

ESG: Still Coercive

The following commentary/analysis is one I wrote in my capacity as a senior fellow at “the nation’s oldest consumer protection agency,” Consumers Research, where, among other things, I compile a weekly letter for public pension-fund managers.  I am sharing it here today because I thought it might be useful to some of you.

 

To ESG or Not to ESG?  What Is the Difference?

In this space last week, I noted that a recent paper by Alex Edmans, Tom Gosling, and Dirk Jenter reaches several interesting conclusions about ESG: that E&S considerations play a lesser role in investment decisions than do returns; that investors and investment managers are motivated by a variety of beliefs; that there is less difference between sustainable and traditional investors than was previously thought; and, most importantly, that the investment industry is unlikely to change the way corporations behave on E & S considerations, essentially making ESG investing a futile endeavor.

Also last week, Bloomberg’s Merryn Somerset Webb addressed the same paper by Edmans, et. al, finding her own, even more discomfiting conclusion, particularly for those who believe that ESG investing should be a voluntary choice made with full knowledge and full disclosure.  She wrote:

[M]ost of the managers surveyed had changed their behavior — not because they they believed in it but more because they were forced to. Among traditional managers, 61% said they had been made to give up portfolio diversification and to avoid stocks they thought might outperform. But — and this is a very big but — the majority of both sustainable and traditional managers said that it wasn’t as a result of wanting to affect the cost of capital for firms, about having a positive impact on society or even about constraints specific to their fund — but as a result of “firm-wide ES policies.”

There are lots of caveats to these results – and the averages disguise significant variations. But the essence seems to be this: Most fund managers, however their fund is labeled, don’t consider E and S to be a top performance driver, and they “do not put significant weight on ES objectives beyond what is required to improve financial returns.”

But look at the last bit of the survey – even traditional fund managers are already constrained by the “firmwide ESG policies” pushed on them by increasingly vast ESG departments. It isn’t in the label, sustainable or otherwise, where the real constraints lie, as the fund managers told Edman and Gosling’s survey; it is in their employers’ policies, which affect all funds.

For years, one of the biggest knocks on the assessment management industry – particularly those firms heavily involved in ESG – has been that it uses all investors’ money to pursue ESG ends, even those who are explicitly opposed to ESG.  Such is the nature of engagement and proxy voting in the ESG-era.

In 2020, for example, Larry Fink (the CEO of BlackRock, the largest asset management firm in the world) wrote in his famous letter to CEOs, “We believe that sustainability should be our new standard for investing.”  By that, Fink meant that all of his firm’s investment decisions – ESG or not – would be guided, first and foremost by environmental sustainability criteria.

Fink and BlackRock, of course, put that “new standard for investing” into practice in 2021, when they joined Engine No. 1, CalPERS, CalSTRS, Vanguard, State Street, and others in voting to replace three of the board members at Exxon-Mobil with “energy transition” advocates.  BlackRock (and the rest) voted the shares of ALL their funds, not just their ESG funds, to enact what was essentially an ESG-driven engagement effort.

This act and countless others like it eventually backfired on the Big Three and other passive asset managers, who were accused of breaching their fiduciary duties by treating ESG investors and non-ESG investors the same.  If the point of ESG is engagement – and in many ways, it is – then how do firms distinguish between ESG and non-ESG investments, when all assets are being used to advance ESG engagement goals?

The ”solution” the massive passives invented to address this problem – and I use those scare quotes advisedly – was to offer “vote choice,” e.g. the opportunity for fund owners to decide how their proxy votes should be used.  As those scare quotes suggest, this isn’t much of a solution and serves mostly as CYA (“cover your…uhh…assets”) for the big firms.  At the same time, though, at least vote choice serves as an acknowledgment that doing nothing to distinguish ESG from non-ESG is a fiduciary issue that requires at least superficial addressing.

Now, the situation described in the paper by Edmans et, al and explained by Merryn Somerset Webb is clearly different.  The issue in this case is active asset management companies using ESG screens to blacklist/de-capitalize certain companies.  This is about divestment rather than engagement, and it’s about the entire investment process rather than just proxy voting.

Nevertheless, the same basic question can be asked here. “How do firms distinguish between ESG and non-ESG investments, when all assets are being used to advance ESG goals?”  I would argue, in fact, that this example demonstrates a more serious breach of fiduciary duties than the proxy/engagement issue because ESG screens, by definition, limit return in an immediate sense.  Or as Webb put it (this time with emphasis added):

Among traditional managers, 61% said they had been made to give up portfolio diversification and to avoid stocks they thought might outperform…. the majority of both sustainable and traditional managers said that it wasn’t as a result of wanting to affect the cost of capital for firms, about having a positive impact on society or even about constraints specific to their fund — but as a result of “firm-wide ES policies.”

Almost two-thirds of traditional asset managers have been “made” to give up stocks they believed would “outperform.”  Read that again.  And again.  And again.  That’s egregious.  More to the point, it’s deceptive and potentially fraudulent.

It (almost) goes with saying that I am not what you’d call a “fan” of ESG.  Nevertheless, I believe that socially responsible investing can and does have a place in free and fair capital markets.  But in order for it to work, in order for it to be fiduciarily responsible, it has to be voluntary.  The involuntary – and presumably surreptitious – practice of ESG/SRI in non-ESG portfolios is just wrong, whether it’s done by giant passive fund companies using non-ESG investments for engagement and proxy-vote purposes or by active firms that pre-screen and pre-exclude companies for ESG compliance.

People would be far more likely to accept ESG investing and to “live and let live” if ESG were strictly voluntary and entirely transparent.  But it’s not, and that, more than anything, is why it’s so deeply problematic.

Stephen Soukup
Stephen Soukup
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Steve Soukup is the Vice President and Publisher of The Political Forum, an “independent research provider” that delivers research and consulting services to the institutional investment community, with an emphasis on economic, social, political, and geopolitical events that are likely to have an impact on the financial markets in the United States and abroad.