Economy and Society: SEC Chairman signals deeper look into ESG investing

ESG Developments This Week

In Washington, D.C.

SEC Chairman signals deeper look into ESG investing 

In a speech last week to London City Week, SEC Chairman Gary Gensler explained to the audienceand to the financial services world more broadlythat he does not intend for sustainability and climate disclosures from publicly traded companies to constitute the entirety of the Commission’s agenda for ESG this year. His ambitions are, he noted, much larger and much broader and will touch on nearly every participant in American capital markets.

First, Chairman Gensler was clear that he intends to ensure that companies that have told investors (and others) that they are green or that they intend to make environmentally friendly changes to their behavior and products are, in fact, keeping their promises: “I’ve asked staff to consider potential requirements for companies that have made forward-looking climate commitments, or that have significant operations in jurisdictions with national requirements to achieve specific, climate-related targets.”

Second, Gensler noted that he does not intend for the SEC’s ESG regulations to begin and end with sustainability and climate change and that he wishes to pursue the “S” (Social) and “G” (Corporate Governance) in ESG, in addition to the “E” (Environmental):

“[I]nvestors have said that they want to better understand one of the most critical assets of a company: its people. To that end, I’ve asked staff to propose recommendations for the Commission’s consideration on human capital disclosure.

This builds on past agency work and could include a number of metrics, such as workforce turnover, skills and development training, compensation, benefits, workforce demographics including diversity, and health and safety.”

Finally, Gensler warned asset managers that they are not the investors whose interests the SEC seeks to protect; that the SEC intends to exercise its mandate to protect small and individual investors from those asset managers when necessary: “I’ve also asked staff to consider the ways that funds are marketing themselves to investors as sustainable, green, and ‘ESG,’ and what factors undergird those claims.”

Country’s largest pension plan now offers ESG funds

Last year, the Trump administration attempted to compel the federal government’s Thrift Savings Planwhich covers federal employees and members of the armed servicesto quit offering funds that could invest in Chinese companies whose goals are perceived to be inimical to those of the U.S. government and its military. This year, with a new administration, the Thrift Savings Plan will now offer ESG funds:

“The federal government’s Thrift Savings Plan will begin offering environmental, social, and governance funds in 2022, the latest sign of the growing acceptance of sustainable investing by retirement plans.

The ESG funds will be available in a new “mutual fund window,” similar to a brokerage option, for the plan, a Thrift Savings Plan spokesperson told Barron’s.

The move is “huge” for the plan, the spokesperson said, but it is also significant for sustainable investing—and for the asset management industry, which is betting on growth in ESG. After all, the TSP is the U.S. largest retirement plan: It has about $760 billion in assets and covers about 6.3 million federal employees and service members. The window, which will include 5,000-plus funds, and will be run by Alight, will go live in summer 2022….

Lisa Woll, CEO of US SIF, the trade group for the sustainable investment industry, said the group has been in talks with TSP about adding sustainable offerings for more than a decade. “We’re really really pleased. The [participants] can’t get ESG options until they have that platform.”…

“This is a sea change,” says Matt Patsky, CEO of Trillium Asset Management, a sustainable investing specialist. “We’ve opened the floodgates to people feeling safe to select ESG options for retirement plans broadly.””

On Wall Street and in the private sector

Activist hedge fund that won three Exxon Mobil seats launches ETF

Last month, Engine No. 1, a small, activist hedge fund, shook up the energy and investment worlds by mounting a challenge to several of Exxon Mobil’s board seatsand then winning three of them. Last week, Engine No. 1 decided to launch its own, activist-centered exchange-traded fund:

“Earlier this month, Engine No. 1 came out of nowhere and won three Exxon Mobil board seats after a six-month proxy fight. The company says Exxon needed to significantly reduce emissions and move toward a cleaner energy strategy.

Now, they are starting an ETF to promote their methods. Engine No. 1 Transform 500 ETF (VOTE) begins trading Wednesday.

The company says it is seeking “to encourage transformational change at the public companies” and that it will try to “measure the investment made by companies in their employees, communities, customers and the environment with financial, operational, and environmental, social and governance (‘ESG’) metrics.”

It is attracting outsized attention because it is the intersection between three hot investing themes: ETFs, ESG and activist investing….

One thing’s for sure: With intense interest in ESG and a very low fee structure (0.05%), VOTE is likely to start off strong, with north of $100 million in assets. Others are eager to join. Digital investment firm Betterment has already said it will add VOTE to its large-cap portfolio.

There is little doubt that the moment for investor activism has arrived.”

To address ESG disclosure needs, Price Waterhouse Cooper adding 100,000 jobs worldwide 

On June 15, accounting firm PwC (Price Waterhouse Cooper) announced that it expects to add as many as 100,000 jobs worldwide and spend as much as $12 billion over the next five years to address the needs of clients in navigating the waters of ESG disclosures:

“The new hires will come from mergers and acquisitions PwC completes and direct hires from competitors, Global Chairman Bob Moritz said in an interview. Of the 100,000 people PwC will hire, about 25,000 to 30,000 will be in the United States, and 10,000 of those will be from Black and LatinX communities, Moritz said.

At present, the firm employs about 284,000 people globally.

Moritz said PwC had approached ESG more “narrowly” before, focusing on reporting frameworks.

“Now every employee of PwC has to be familiar with the issues,” he said, adding that ESG will be embedded in the firm’s work….

PwC is increasing training for partners and staff in ESG in areas such as climate risk and supply chains and creating an ESG academy.

PwC will also set up new leadership institutes that help executives, boards of directors and C-Suites create diverse workforces and manage in uncertain times.”

Elsewhere, last week, the American Institute of Certified Public Accountants (AICPA) released the results of a study (conducted in conjunction with the International Federation of Accountants and the Chartered Institute of Management Accountants) that suggests that PwC is making a smart choice in choosing to pursue ESG matters:

“Interest in environmental, social, and governance (ESG) disclosures has risen dramatically during the past year, presenting great potential for CPAs to provide assurance on these disclosures as they become more common and as stakeholders are focusing on the quality of such disclosures.”

It’s an area of opportunity for CPAs to meet the public interest and provide value….

“The report found that, in the United States, of the companies included in the study that obtained assurance over their disclosures, nearly 90% of sustainability assurance is done by other service providers. But those outside the CPA profession aren’t necessarily governed by the same ethics and quality requirements, said Scott Hanson, director, Public Policy & Regulation at IFAC.

That means there are practice opportunities for CPAs in this area. Practitioners can help educate clients about ESG reporting and disclosures, including the consideration of risks related to climate that can be material to the financial statements, said Jennifer Burns, CPA, the AICPA’s chief auditor.

“CPAs are uniquely qualified, based on their understanding of their clients, to enhance the reliability of ESG-related disclosures. The auditor’s knowledge should be leveraged to deliver assurance over ESG,” she said.”


MIT study: “ESG funds often fail to vote their values, research shows” 

An article published June 21, by MIT’s Sloan School of Management, citing research published late last year, suggests that the SEC is right to be worried that ESG mutual funds and ETFs are overpromising and underdelivering. According to the Sloan article, many ESG funds talk the talk but fail to walk the walk in any consistent way:

“People who put money in vehicles like ESG index funds expect that their money will be invested in alignment with values such as a commitment to renewable energy or equal pay for women. But new research finds that even though these funds have an explicit ESG mandate, their proxy voting records often contradict their stated objectives. 

“As individual investors, we are not aware of how funds are voting,” said Gita Rao, an MIT Sloan senior lecturer in finance who conducted the research. “We are putting our money into these ESG funds, but they’re voting against what we believe in.”…

Reasonably, people investing in ESG index funds assume that the funds would vote in favor of ESG issues. “If a fund’s prospectus states that it is paying attention to environmental, social, and governance issues, then the fund’s voting should reflect that objective,” Rao said.

Yet little attention has been paid in the past to how these passive funds actually vote their proxies on ESG matters….

To better understand how ESG funds vote on proxy resolutions, Rao focused her research on the Vanguard Social Index Fund, the oldest and largest ESG fund, with more than $13 billion in assets under management, and the BlackRock DSI exchange-traded fund, which has assets of about $3 billion. She worked with the New York-based hedge fund Quantbot Technologies to create datasets and manually classify ESG shareholder resolutions appearing on proxies between 2006 and 2019.

Surprisingly, Rao found that the Vanguard Social Index Fund voted against almost all environmental and social resolutions over the time examined. The fund also voted against shareholder resolutions requesting disclosure of board diversity in every single instance since 2006. 

In addition, both Vanguard and BlackRock in 2019 voted against proposals requesting disclosure of board diversity and qualifications at Apple, Discovery, Twitter, Facebook, and Salesforce.“What we found was really not good,” Rao said. “I would give Vanguard a D. Their social index fund is one of the largest ESG funds in the market, particularly in the retirement space. It’s the oldest fund, and it votes most of the time against disclosure on environmental and social issues.””

In the spotlight

Alignment theory, again

Over the weekend, the Wall Street Journal published an essay by Alex Edmans, a professor of finance at London Business School, arguing that the efforts underway (and documented repeatedly in this newsletter) to align executives’ pay with ESG performance benchmarks is mistaken and could, potentially, undermine the entire ESG project:

“Executive pay has been the poster child for everything that’s wrong with capitalism. Chief executive officers are paid millions, while some of their employees make minimum wage. Bonus targets often tempt executives to take short-term actions that mortgage their company’s future.

But change is afoot. A rapidly growing trend is for executive pay to be tied not only to financial numbers, but to environmental, social and governance (ESG) targets as well. Two recent studies found that 51% of large U.S. companies and 45% of leading U.K. firms use ESG metrics in their incentive plans.

The rationale seems obvious. First, many advocates have claimed that good ESG practices will boost a company’s bottom line, so incentivizing ESG performance also will improve financial performance. This may be why even private-equity investors have started to mandate ESG targets.

Second, it is commonly believed that rewarding performance is the best way to ensure performance. Conversely, if a company won’t pay for an outcome, that is a telltale sign that it doesn’t actually care about it. Companies are making grand promises about diversity, decarbonization and resource usage—but these promises are hollow if they don’t affect CEO pay….

The evidence shows that paying for targets encourages executives to hit those targets. But it doesn’t necessarily encourage them to improve performance. The crux of the problem is that you can’t measure many of the performance dimensions that you care about—“not everything that counts can be counted,” as stressed by sociologist William Cameron (and commonly misattributed to Albert Einstein)….

Importantly, the problem of “hitting the target, but missing the point” occurs for any target—whether financial or nonfinancial. Binary thinking often equates “financial” with “short-term” and “nonfinancial” with “long-term.” But nonfinancial targets can be short-termist. Paying teachers according to test scores encourages them to teach to the test even at the expense of teaching students to develop critical thinking skills. Rewarding CEOs according to average employee pay may encourage them to outsource or automate low-paid jobs, or focus on salary rather than meaningful work, skills development and working conditions.

These unintended consequences might be even worse for ESG than financial targets….

A second problem is measurement. For a financial target such as earnings-per-share, there’s consensus on how to measure it. But that isn’t the case for an ESG metric. Should ethnic diversity be captured by the number of minorities on the board, in senior management, or in the workforce—or other factors such as the ethnic pay gap, or the proportion of minorities who get promoted from each level? Even ESG-rating agencies disagree significantly on how to measure ESG performance, so any measure might be perceived as unfair or ignore important dimensions.

Finally, let’s turn to the first rationale, which holds that boosting ESG performance will always boost financial performance. The evidence is far less conclusive than often claimed. In fact, only performance related to material ESG dimensions (those that are relevant to the company’s specific business model) ultimately pays off; boosting immaterial factors doesn’t. Thus, if ESG targets are to be used, they should be selected carefully based on materiality. Instead, they’re often a knee-jerk reaction to the demands of pressure groups or whatever issue happens to be the order of the day.”