ESG Developments This Week

In Washington, D.C.

SEC continues internal debate about its role in ESG investing

On July 20, SEC Commissioner Hester Peirce delivered an address at the Brookings Institution in which she again made the case that the SEC’s current leadership is overstepping both its regulatory mandate and the bounds of what is objectively knowable about corporations and their impact on aggregate measures of environmental, social, and corporate governance (ESG) well-being. Peirce’s address, which is the latest public airing of grievances on the part of SEC Commissioners, conceded that SEC Chairman Gary Gensler and his supporters on the Commission have their hearts in the right place, seeking predictability for investors, but warned that, in her view, outcomes and intentions are often at odds. As a framework for her critique of proposed new disclosure mandates, Peirce presented ten theses that she argues all interested parties must consider before the Commission votes to make new disclosures compulsory:

“I. ESG as a category of topics is ill-suited, and perhaps inherently antithetical, to the establishment of clear boundaries and internal cohesion.

II. Many ESG issues lack a clear tie to financial materiality and therefore do not warrant inclusion in SEC-mandated disclosure.

III. The biggest ESG advocates are not investors, but stakeholders.

IV. ESG rulemaking is high-stakes because so many people stand to gain from it. 

V. “Good” in ESG is subjective, so writing a rule to highlight the good, the bad, and the ugly will be hard.

VI. An ESG rulemaking cannot resolve the many debates around ESG models, methodologies, and metrics. 

VII. Emotions around ESG issues may push us to write rules outside our area of authority. 

VIII. ESG issues are inherently political, which means that an ESG rulemaking could drag the SEC and issuers into territory that is best left to political and civil society institutions.

IX. ESG disclosure requirements may direct capital flows to favored industries in a way that runs counter to our historically agnostic approach.

X. An ESG rulemaking could play a role in undermining financial and economic stability.”

Peirce concluded, arguing that the SEC’s probable contravention of its statutory bounds could be remedied, if the Commissioners decided to take a more cautious, less over-optimistic approach to its regulatory limitations:

“You have made it with me through ten theses, so I will quickly draw to a close. I do not want to do so without first offering a potential better path forward. Rather than embarking on a prescriptive ESG rule that departs from and undermines our agency’s limited, but important, role, we could work within our existing regulatory framework. We could put out updated guidance to help issuers think through how the existing disclosure regime already reaches many ESG topics and to address frequently asked questions that arise in connection with the application of the existing disclosure regime. We also might consider whether we can give any Commission-level comfort about forward-looking statements along the lines of what former Chairman Clayton, Corporation Finance Director Bill Hinman, and Office of Municipal Disclosure Director Rebecca Olsen did in connection with COVID-19. Finally, we can work with investment advisers using ESG strategies and products to ensure that investors understand what that adviser’s brand of ESG means in theory and practice. I am looking forward to hearing other suggestions in the discussion that follows.”

On Wall Street and in the private sector

European ESG assets take a tumble—by design

According to the Global Sustainable Investments Alliance, the amount of money held by Europeans in sustainable investments fell from $14 trillion to $12 trillion. Given the relative stability of the bull market and the flood of funds into ESG, that seems counterintuitive at best. But it’s not, according to a Bloomberg Green story. The drop was not caused by decreasing value or a change in priorities but by an intentional reclassification of assets. Bloomberg Green reports:

“The decline isn’t the result of dampened investor enthusiasm for ESG investments, it’s because policy makers have tightened the parameters for what can be considered a responsible investment, said Simon O’Connor, chair of the GSIA….

Europe has led the global charge into ESG investments and its banks and fund managers are most advanced in calculating the impacts of their operations on climate change and biodiversity. The bloc’s politicians also have embraced sustainability by developing the world’s most ambitious climate strategy and a suite of new rules to bring the world of finance in line with its carbon neutrality target.

The EU’s anti-greenwashing rules known as the Sustainable Finance Disclosure Regulation, or SFDR, were introduced in March and require fund managers to evaluate and disclose the environmental, social and corporate governance features of their financial products. They require fund managers to classify funds, with Article 8 funds defined as those that actively promote environmental or social characteristics, while Article 9 funds have sustainable investment as their objective, with both categories subject to higher standards of disclosure under the SFDR.”

Meanwhile, in the rest of the world, sustainable assets continued to grow unremittingly:

“[S]ustainable investment assets in the U.S. increased to $17 trillion last year from $12 trillion two years earlier. Canada recorded the largest proportional gain in ESG assets between 2018 and 2020, with a 42% jump to $2.4 trillion.

The sustainable investment industry grew 15% in the two-year period to $35.3 trillion, and now accounts for 36% of all professionally managed assets across the U.S., Canada, Japan, Australasia and Europe, GSIA said.”

The Financial Times reports two stories of dissent

First, on July 18, FT reported that the private equity business appears, on paper at least, to have become a hub of counter-cultural investing, in which ESG issues are treated with rather less deference than they are in the world of publicly traded companies:

“Done well, private equity has a crucial role to play in modernising economies, helping companies to restructure efficiently away from the short-termist glare of public markets. Buyout firms rightly pounce on listed companies that they deem undervalued or bloated. In so doing, they keep capitalism efficient and act as a positive reactionary force.

But is private equity also reactionary in the conservative backlash sense of the word — facilitating a rebellion against some of the progressive constraints of public company existence, particularly the growing demands of complying with standards on environmental, social and governance issues? The evidence is mounting.

More freedom on governance has long been seen as a plus for private companies. As listed company governance has become stricter, so the advantage of private company status has increased. Heads at private equity owned companies relish diminished bureaucracy and the ability to earn more money without critical scrutiny from public company shareholders. Fortress’s agreed £9.5bn buyout of Morrisons this month came with a strong hint that management “incentives structures” would be boosted, only weeks after the listed UK supermarket suffered a shareholder revolt over pay….

Social issues, S of ESG, are also antithetical to much traditional private equity. Many listed companies increasingly trumpet “stakeholder value”, expressing concern for staff, customers and a company’s local area. Private equity remains a safe space for the hard-nosed. Quite rightly in some instances: public-company management may have been loath to take tough decisions on closing shops, factories or offices, and making job cuts.

But it is in the environmental field that a good chunk of the private equity industry is playing its most obviously reactionary role. When oil majors are looking to sell off stranded production assets, private equity are among the readiest bidders.”

On July 22, FT returned to the issue of ESG vs. shareholder value, with a profile of Eiji Hirano, the former chairman of the board of the Japanese Government Pension Investment Fund, the largest pension fund in the world. According to the paper: 

“Though carefully framed, Hirano’s comments highlight increasingly urgent questions over the future direction of the GPIF since the departure in March 2020 of its charismatic chief investment officer Hiromichi Mizuno.”

“The GPIF [Government Pension Investment Fund] must always go back to its investment purpose,” says Eiji Hirano, who stood down from the job three months ago. His comments reflect concerns that too great a focus on environmental, social and governance (ESG) standards can add risk, including a possible collision between the law and the investment philosophy under the GPIF’s previous regime.

According to the law under which the GPIF operates, it must invest with the sole purpose of benefiting Japanese citizens through the returns generated….”

“[A]rguably Mizuno’s boldest achievement, which he proselytised about at Davos and other global financial forums, was yoking the GPIF name to the then fledgling theme of ESG investing. The campaign included what Mizuno himself described as the “epochal” decision to mandate index-compilers FTSE and MSCI to create ESG indices for the GPIF. It sent the message that the GPIF under his stewardship would regard ESG factors as financially relevant.”

“That, says Hirano, is one key area where debate is now focused. While there is increasing evidence that some aspects of ESG-themed strategies boost returns in the long term, he thinks many ESG proponents, including Mizuno, rely on the argument that it is “common sense” that this will be the case across the board.”

EU efforts to compel greater disclosure receive pushback—months ahead of implementation

On July 6, the European Commission finalized its new banking regulation known as the green assets ratio. The regulation will go into effect in 2022, and banks will be compelled to make their first report by 2024. The GAR is designed to measure the green loans and securities a bank possesses (against its total assets). And according to Bloomberg, banks are already crying foul:

“It’s meant to be the ultimate metric for gauging how clean European banks are. But some in the industry say it will be flawed from the get-go.

The European Union’s planned Green Asset Ratio, intended to reveal how much a bank lends to climate-friendly companies and projects, will offer a distorted picture of reality, according to a Bloomberg survey of some 20 major European banks. The firms, which rely on clients for the data they need to calculate the ratio, point out that many small or international companies simply won’t provide it….

Europe is taking a more aggressive approach than the U.S. and other jurisdictions on climate change and will ultimately penalize financial firms that turn a blind eye to global warming. Banks that have long touted their green credentials are now being told to back up those claims with hard data. Lenders perceived to be laggards risk losing investors and depositors.

The European Banking Authority, which mapped out the Green Asset Ratio, says the metric will help compare banks both in terms of their exposures as well as their sustainability strategy and how they plan to mitigate climate-change related risks. The EBA “strongly believes” that the availability, quality and exchange of data can be improved with the right regulatory framework and incentives, a spokeswoman for the Paris-based authority said by email. Banks will also be allowed to use estimates for the environmental impact of their clients, she said.”

In the Spotlight

Moody’s launches new ESG ratings service

Moody’s just launched an ESG ratings service for small and medium-sized companies. But because ESG data is unavailable or limited for smaller companies, Moody’s had to develop a new methodology for estimating or predicting a company’s ESG ratings, which it has done:

“Based on a model derived from Moody’s proprietary ESG scoring methodology for large-cap corporates, the ESG Score Predictor provides financial institutions with essential quantitative data for portfolio and risk management, and helps companies monitor ESG risk across their global supply chains….

Assessing companies’ exposure to ESG risks requires comparable and standardized metrics. Limitations in company disclosures continue to affect data quality and company coverage, especially in the SME space. The ESG Score Predictor leverages state-of-the-art advanced analytics to provide 56 ESG scores and sub-scores for any given company using location, sector, and size. Customers can access approximately 140 million company ESG scores on Moody’s Orbis database, Procurement Catalyst and Credit Catalyst platforms, via an application programming interface (API), or leverage the ESG Score Predictor model with their in-house data to score their portfolios.”

What this means, according to a Moody’s white paper on the subject, is that the number of companies on which it can provide estimated ESG scoring is now infinite. According to the paper, “As long as we have data on a firm’s size, location, and industry, we can use these three factors as inputs to generate predicted metrics using the SP models.”