The Corner

Economy & Business

The SEC, ESG, and Unbundling

A trader wears a mask on the floor of the New York Stock Exchange, March 20, 2020. (Lucas Jackson/Reuters)

Increasingly, those looking for “socially responsible” investments (to use the usual dishonest and self-congratulatory term) are checking to see how companies measure up to various (ill-defined) environmental, social, and governance (“ESG”) criteria.

But bundling these three criteria together makes little sense. A company can be, say, transparent (an element in the ‘G’) without being too concerned about the effect that its activities may have on the climate (part of the ‘E’).

And the SEC is now onto this.

The Financial Times reports:

Jay Clayton, chairman of the Securities and Exchange Commission, said any analysis that combined separate environmental, social and governance metrics into a single ESG rating would be “imprecise”.

“I have not seen circumstances where combining an analysis of E, S and G together, across a broad range of companies, for example with a ‘rating’ or ‘score’, particularly a single rating or score, would facilitate meaningful investment analysis that was not significantly over-inclusive and imprecise,” said Mr Clayton.

The SEC has asked for feedback from asset managers about ESG ratings as concerns rise about the spread of so-called greenwashing by companies that make misleading claims about their environmental credentials to appeal to unsuspecting investors.

I agree that the SEC is right to worry, even if I see things from a different perspective. If I was looking at a company in which I might invest, the ‘G’ would matter to me, whether the company was carbon-neutral (part of the ‘E’), not at all. In fact, if it were a company where management spent time and money worrying about whether the business was carbon-neutral, that would (to me) be a very good reason to want to invest elsewhere.

Equally, if I did want to invest in a company dedicated to doing its bit to save the planet from a fiery finale, I wouldn’t want to find myself investing in a company where the high ESG score came from protecting shareholders (‘G’) rather than from its efforts to rein in the climate (‘E’).

The Financial Times:

The concerns expressed by Mr Clayton over combining E, S and G scores have previously been described as “aggregate confusion” by academics. One example of this is the electric car maker Tesla. The business, which scores highly on environmental metrics, has often been criticised for its record on workers’ rights. As a result, different ratings providers give it wildly different scores.

And the problems may go deeper that. In the course of a recent piece for Bloomberg on ESG John Authers noted this:

It is possible that ESG is undermining itself — or at least that the E and the S are in conflict with each other. Vincent Deluard, of INTL FCStone Inc., suggests that ESG funds are people-unfriendly. Tech and pharma companies tend to look good by ESG criteria, but they tend to be virtual as well as virtuous. These are the kind of companies that need relatively few workers and which churn out hefty profit margins. When Deluard looked at how the big ETFs’ portfolios varied from the Russell 3000, the results were spectacular. They are full of very profitable companies with very few employees . . . A further look at companies’ market cap per employee showed that investing in the current stock market darlings who are making their shareholders rich is a very inefficient way to invest in boosting employment. They include hot names like Netflix Inc., Nvidia Corp., MasterCard Inc. and Facebook Inc. . . .

The problem, Deluard suggests, is that ESG investing, intentionally or otherwise, rewards exactly the corporate behavior that is creating alarm. Companies with few buildings, few formal employees and a light carbon footprint tend to show up well on ESG screens. But allocating capital to them leads to a deepening of inequality, and intensifying the problem of under-unemployment. On the face of it, they aren’t the companies that should be receiving capital if employment is to recover swiftly. If investors want to behave with the interests of “stakeholders” rather than “shareholders” in mind, and that is surely central to the ESG philosophy, then their current approach is directly counter-productive. No good turn goes unpunished.

Another consequence of unbundling E, S, and G might be to give a clearer idea of what they meant for shareholder returns.

Writing for the IFC Review a month ago, Julian Morris:

A 2016 paper from group of researchers from the European Parliament and Bournemouth Business School sought to look more deeply at the relationship, using disaggregated data from Bloomberg’s ESG Disclosure form for the S&P 500 for the period 2007 to 2011. The researchers found that the relationship between ESG and financial performance in general was indeed U-shaped. However, they found that the environmental and social components were linearly negatively related to performance. It was only the governance component that drove the U-shape relationship. This governance-dominated U-shape relationship between ESG and financial performance has since been confirmed in other studies.

In other words, if it’s financial performance you are after, focus on the ‘G’.

Unbundling E, S, and G seems like an excellent idea.

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