The accountability processes of government and business are each ideal for optimising different policy issues, and we get into trouble when we let one take on the role of the other.
What has made the US capital markets the most robust and respected in the world is the combination of market- and government-based structures and especially the comprehensive transparency of our public companies. The nature of capitalism is to maximise profits, and it is up to the government to make sure that happens without externalising costs onto the public who have no capacity to provide a market-based response.
Corporate executives would always prefer less disclosure. Investors would prefer more. Because of the collective choice problem, there is no way for investors to make a market-based demand for more information as effectively and efficiently as having the government set the floor for what must be disclosed.
It is within this context that the questions will always arise about when it is time to add more to the already extensive information that issuers must provide to investors. That time has come for ESG. The reason it is the fastest-growing sector of investment vehicles is a reflection of increasing concerns about the inadequacy of Generally Accepted Accounting Principles (GAAP) numbers in assessing investment risk. Let me emphasise that; ESG and climate change disclosure concerns are entirely and exclusively financial. That is what makes them a have-to-have, not a nice-to-have.
Evaluating the risks of tomorrow
This is not surprising. After more than a century of working with GAAP, there is still a lot of inconsistency in the way accounting rules are applied. GAAP may allow for a lot of options in disclosing the value of factory equipment, but at the end of the process, hard assets are something you can count and the tax code is helpful, too, in validating those numbers.
And GAAP is based on data that corporations are already required to disclose in fairly consistent apples-to-apples form. ESG, which is a recent response to the inadequacy of GAAP in assessing investment risk, is still in its earliest stages. ESG factors are inadequately and inconsistently disclosed and harder to quantify. Even so, they are already vitally important in providing guidance that traditional GAAP cannot. GAAP is focused on what values are today. ESG is about evaluating the risks of tomorrow and five and ten years from now.
There is one thing ESG is unequivocally not: non-financial. Imperfect and inconsistent as ESG data are, they are entirely and exclusively methods for better assessing investment risk and return. The comments that claim otherwise, like those of the fossil fuel companies, have failed to provide a single example to prove that there is any trade-off in shareholder value. And when it comes to what shareholders need, the Commission should rely more on what investors say they need than what issuers would prefer to give them. As a matter of law and economics, investors have the fewest conflicts of interest in determining what they need to make a buy/hold/sell decision.
ESG is focused on factors that will affect the enterprise as a sustainable concern. BlackRock, for example, announced that it has added 1200 “sustainability metrics” to its calculus in 2020. The UK’s Task Force on Climate-Related Financial Disclosure (TCFD) was created by the Financial Stability Board (FSB) to develop consistent climate-related financial risk disclosures for use by companies, banks, and investors in providing information to stakeholders. In the US, the Sustainability Accounting Standards Board (SASB) is merging with the International Integrated Reporting Council (IIRC) to provide investors and companies a comprehensive corporate reporting framework to drive global sustainability performance.
Admittedly, there is no consensus and a lot of inconsistency in defining what ESG is, which is another reason to be grateful for the Securities and Exchange Commission’s involvement. The interest in ESG is far ahead of the capacity to assess or evaluate it. And, as with any topic that has reached the tipping point, a lot of people and organisations are slapping ESG labels on themselves to get a piece of the action, all the more reason for additional guidance from the Commission.
I have a brokerage account. The online interface now includes what they call an “ESG” analysis and a separate “impact analysis” tied to goals like ethical leadership and racial equality. It is not clear what data or which data providers are used for these assessments. There are ads on television now for “ESG-neutral” investment funds. “ESG-neutral” is a meaningless term. The offerings include pro-gun and anti-abortion ETF filters that can only be categorised as Social. These are unquestionably ESG funds; the managers just assign different weights to the ESG factors than funds based on analysis that gun stocks, for example, may be a sub-optimal investment.
That is fine, of course. Just as some portfolio managers may be buying a stock as others, even in the same organisation, are selling it. What is important is making sure that investors have a clear idea of what factors and investment goals are the basis for those decisions.
All of this further shows why we need clearer, more consistent information. When consumers demanded organic foods, government standard-setting was the only way to make sure that term was used only when it meets some consistent and supportable standard. That is where we are with ESG. The exponential increase in the use of ESG and related terms in investment and corporate communications makes it an urgent priority for guidance from the Commission to prevent misleading or confusing investors.
The differences between E, S, and G
We sometimes forget that the “E”, “S”, and “G” are three very different categories, with very different levels of consensus and understanding about them.
For example, look at one small part of the almost catch-all category, S, for Social. The annual reports that accompany proxy statements almost always claim that the company’s greatest asset is its people. But GAAP tells us almost nothing about how to assess their value. How many PhDs? How many economists/MBAs/programmers/sales representatives? What incentives are provided for worker education and promotion? How is diversity supported by management?
Other questions that might fall into the S of ESG could pertain to whistleblower protection, supply chain issues, cybersecurity, and the increasingly controversial issue of political contributions. Or the possibility of a pandemic, a risk only a small fraction of issuers were prepared for in 2020.
The E can be misleading. Companies that have to disclose problems, violations, and fines may appear higher-risk than those that have not (yet) been the subject of investigations. As some of the commenters have already said, it is important that the E not be limited to a company’s carbon footprint. Every company has environmental risk, whether it is the direct result of operations or products, as in the fossil fuel industry, or the impact of climate change on supply chains, coastal properties, or insurance.
There is more consensus at the moment around the G factors. Many are thoroughly covered by state law and current SEC disclosure rules, like those pertaining to executive compensation, related party transactions, board member stock ownership and meeting attendance. I find, though, that the best way to judge governance effectiveness is to look at the results, rather than the policies, and “resume independence” does not always translate to more effective oversight. So, some improvement there might also be called for.
In all three categories, the Commission must make sure the focus is on what counts, not just what can be counted.
Nell Minow is vice chair at ValueEdge Advisors. This is an edited extract from Minow’s submission to the US Securities and Exchange Commission consultation on climate change disclosures. Download the full document here.