ESG Developments This Week

In Washington, D.C.

SEC Commissioner Lee delivers speech about board’s role in ESG oversight

On June 28, SEC Commissioner (and former acting director) Allison Herren Lee delivered the keynote address at the 2021 Society for Corporate Governance National Conference. In her speech Lee encouraged corporations to make wise decisions when choosing, compensating, and utilizing their directors. Increasingly, Lee noted, “boards of directors are called upon to navigate the challenges presented by climate change, racial injustice, economic inequality, and numerous other issues that are fundamental to the success and sustainability of companies, financial markets, and our economy.”

Given that many corporations—American corporations, specifically—are responsible for more global economic activity than many smaller countries, Lee argued that corporations also need to be more responsible and effective at addressing global problems than some smaller countries. And the key to being thusly effective is a useful and adept board:

“Historically, many ESG issues were seen as not within the purview of the board of directors. These matters, referred to as “corporate social responsibility” or CSR issues, were largely treated as if they were separate and apart from the business of generating revenue and earning profits. Debates about director duties around climate and ESG often centered on whether directors were even permitted to consider issues that previously fell under the rubric of corporate social responsibility. In that Milton Friedman era, risks like climate change and many other issues we would now call ESG were characterized as topics that could bear on the public good, but were not relevant to maximizing value for shareholders.

Those days are over….

There is, for example, broad consensus regarding the physical and transition risks associated with climate. SASB (now the Value Reporting Foundation), the Global Reporting Initiative, and many others have clearly set forth financially material ESG risks for companies. There is tremendous and growing investor demand for climate and ESG disclosure. The world’s largest asset managers and other institutional investors have been direct and vocal in conveying that they consider ESG material to their decision-making. No matter the view of regulatory involvement in climate and ESG disclosures, directors must reckon with this growing consensus and growing demand from the shareholders who elect them. 

Accordingly, boards increasingly have oversight obligations related to climate and ESG risks – identification, assessment, decision-making, and disclosure of such risks.  These obligations flow from both the federal securities laws and fiduciary duties rooted in state law.”

Commissioner Lee concluded with several suggestions about how corporate shareholders could ensure that their boards of directors are properly positioned to accomplish their ESG tasks:

“This year, BlackRock emphasized that it expects “boards to shape and monitor management’s approach to material sustainability factors in a company’s business model” and will hold directors accountable where they fall short. Similarly, State Street announced that it will start voting against the boards of companies that underperform their peers when it comes to ESG standards. Proxy advisory firms ISS and Glass Lewis have announced new voting policies that include director accountability for ESG governance failures.

As shareholders and others increasingly emphasize the need for climate and ESG to be incorporated into risk management and governance practices, they have mechanisms to hold companies accountable where they fall short of expectations. They can put pressure on boards to act through shareholder proposals. They can replace directors, as we saw with Exxon. And ultimately both investors and consumers can take their capital elsewhere.

Importantly, all of these risks also present great opportunities. Boards that proactively seek to integrate climate and ESG into their decision-making not only mitigate risks, but better position their companies and business models to compete for capital based on good ESG governance.

So what are some key steps for boards that seek to maximize ESG opportunities, message their commitment on these issues, and position themselves as ESG leaders?

Enhance Board Diversity….

Increase Board Expertise….

Inspire Management Success….”

Republicans question Federal Retirement Thrift Investment Board about BlackRock, State Street’s voting guidelines

On June 30, two Republican Senators, Pat Toomey (PA) and Ron Johnson (WI)—the ranking members of the Senate Committee on Banking, Housing, and Urban Affairs and the Permanent Subcommittee on Investigations of the Senate Committee on Homeland Security and Governmental Affairs, respectively—sent a letter to David Jones, the Chairman of the Federal Retirement Thrift Investment Board (FRTIB), with questions about the federal Thrift Savings Plan and the use of its invested funds by its contracted asset managers to pursue what they deem to be their own personal and political agendas. Specifically, they wrote:

“We are writing to you regarding troubling statements by the companies that manage federal employees’ retirement investments suggesting those asset managers are not putting federal employees’ retirement security first. Specifically, recent statements by the CEOs of BlackRock and State Street Global Advisors (SSGA) indicate they are using their control of proxy votes for federal employees’ Thrift Savings Plan (“the Plan”) investments to pressure other companies to adhere to their own environmental and social policy views. We are concerned that BlackRock and SSGA may be prioritizing their CEOs’ personal policy views over retirees’ financial security. Federal law explicitly requires all fiduciaries of the Plan, including BlackRock and SSGA, to discharge their responsibilities “solely in the interest of the participants and beneficiaries and for the exclusive purpose of providing benefits to participants and their beneficiaries.”

After noting that BlackRock and State Street manage a combined $42 billion in federal employee retirement funds—just over 60% of all funds in the plan​​—Toomey and Johnson continued:

“While federal law bars the Federal government from exercising voting rights associated with funds in the Plan, FRTIB has taken the position that this prohibition does not apply to third-party investment managers serving as stewards of a large portion of the Plan’s assets. In fact, it appears that the only restriction on BlackRock and SSGA’s voting authorities is whether a vote is taken in accordance with each entity’s respective proxy voting guidelines.

Further, while these proxy voting guidelines are ostensibly focused on the investor’s fiduciary advantage, both entities are increasingly incorporating left-leaning environmental, social, and corporate governance (“ESG”) priorities into these guidelines. For example, BlackRock announced that in 2021 “key changes” in its voting guidelines “address board quality; the transition to a low-carbon economy; key stakeholder interests; diversity, equity and inclusion; alignment of political activities with stated policy positions; and shareholder proposals.” Not to be outdone, SSGA’s CEO stated “our main stewardship priorities for 2021 will be the systemic risks associated with climate change and a lack of racial and ethnic diversity.”

In light of these concerns, we ask that you provide a briefing detailing BlackRock’s and SSGA’s policies for using proxy voting rights derived from Plan assets, Board oversight of proxy voting use by Plan investment managers, and Board recourse if an investment manager is found to have violated their fiduciary duty….”

In the States

Bucks County dips its toes in the ESG Waters

Last week, Bucks County, Pennsylvania Treasurer Kris Ballerini penned an op-ed for a local, county newspaper (BucksLocalNews, July 9) in which she announced that she and others in county government have decided to invest a portion of the Bucks County public pension fund in ESG investments. The opportunity to, in her view, try to do well by doing good was, according to Ms. Ballerini, simply too enticing not to grab. She wrote:

“ESG investing concentrates on companies that emphasize sustainability as well as protecting the environment in their manufacturing plants and products. It also looks to see if the company is socially responsible by prioritizing human rights among its dealings with the public, with its employees and even with other countries. In addition, it examines if a company’s management is diverse, if executive pay is reasonable, and if the company responds to their shareholders responsibly. Finally, ESG investing asks whether a company is ethical and transparent in their accounting and business practices.

Along with Bucks County Controller Neale Dougherty, I, as Treasurer, sit on the Retirement Board for the county pension fund, which now has over a billion dollars in investments; and we asked our fund managers about devoting a portion of the fund to investments in ESG companies.

Before committing any funds to such an investment, our board reviewed the returns that such investments have earned. We found that according to the US SIF Foundation’s 2020 trends report, U.S. assets under management using ESG strategies grew by 42% from 2018 to 2020. In addition, a white paper by Morgan Stanley Institute compared the total returns of sustainable mutual and exchange-traded funds and found they were like those of traditional funds. Other studies have found that ESG investments can outperform conventional ones….

As a result, we have voted to devote a small initial portion of the pension fund to ESG companies. If this investment shows a strong upward trend, we intend to increase it. Not only will this benefit the fund financially, but we can also take pride in helping the environment and society at the same time—a “win, win” proposition that everyone can support.

As far as I am aware, we in Bucks County are among the very few innovators to take this approach in Pennsylvania. Hopefully, other public entities with pension funds and other long-term investments will join this trend—that would further benefit our ground floor investments, but also it would encourage more companies to seek to maximize their ESG compliance. That would increase the benefits to our environment and society.”

According to a report published last October by Boston College’s Center for Retirement Research, as of 2018 roughly 60% of the funds invested by public pension entities in the country ($3 trillion, out of $5 trillion total) was already invested in ESG-related products. Public pension investments in ESG accounted for fully 25% of all ESG investments in the country and roughly 33% of all institutional ESG investments.

Research

Are ESG returns about to fall?

In a report published two weeks ago, on July 1, two European researchers—Abraham Lioui of the EDHEC Business School in France and Andrea Tarelli of Catholic University of Milan—argued that the often cited above-average returns associated with ESG might not be entirely accurate or particularly sustainable. The paper, titled “Chasing the ESG Factor,” was summarized by The Financial Times as follows:

“Abraham Lioui, professor of finance at Edhec Business School and an expert in the strategy of investing according to good environmental, social and governance principles, believes he and his co-authors have found signs that the ESG market is reaching maturity and could become a victim of its own success.

“We are going to the zone where the positive impact of the ESG buzz on prices is coming to the end of its cycle,” Lioui said. “Soon we will be at the stage where the relationship between ESG and performance will be negative as it [logically] should be.”…

Lioui and his fellow academics also found that according to most data sets, the accumulated alpha, or outperformance, for the E and S pillars of ESG was above 1 percentage point per year, supporting the thesis that companies can do well by doing good. “However, we identify a downward sloping pattern in this outperformance,” the paper said….

“It should not be a surprise if, in the long term, ESG investing does come at some cost to investors,” said Greg Davies head of behavioural science at Oxford Risk.

He said that while early investors have been able to benefit from the rise in interest in ESG, companies were likely to incur costs by trying to improve environmental and social scores, leading to less profitability in the long term.

In addition, ESG’s popularity was likely to drive up the prices of companies with better scores, without bringing any changes in their profitability. “Paying a higher price for the same profits means lower investor returns. This is true of any assets that are ‘popular’,” Davies said.

Kenneth Lamont, senior fund analyst for passive fund research at Morningstar Europe, agreed.

“The results of the paper suggest that as assets have piled into stocks with the strongest ESG credentials, the expected outperformance of these stocks have dwindled away in recent years,” he said. “To many in the financial industry this news won’t come as a surprise, as an ESG label doesn’t exempt stocks from the fundamental laws of the market.””

These results coincide with arguments made in a May report written by Rupert Darwall for RealClearFoundation and titled “Capitalism, Socialism and ESG.” As noted in the May 18 edition of this newsletter, Darwall argued that:

“ESG proponents claim that investors following ESG precepts earn higher risk-adjusted returns because companies with high ESG scores are lower-risk. Thus, their stock price will outperform, whereas those firms with low ESG scores are higher-risk, leading them to underperform….

This supposition conflicts with finance theory. Once lower risk is incorporated into a higher stock price, the stock will be more highly valued, but investors will have to be satisfied with lower expected returns.”