House Oversight Committee seeks documents from SEC

Economy and Society is Ballotpedia’s weekly review of the developments in corporate activism; corporate political engagement; and the environmental, social, and corporate governance (ESG) trends and events that characterize the growing intersection between business and politics.

ESG developments this week

In Washington, D.C., and around the world

House Oversight Committee seeks documents from SEC

House Oversight Committee Chairman James Comer (R) sent a letter late last week to Securities and Exchanges Commission (SEC) Chairman Gary Gensler saying the committee would subpoena the commission if it did not comply with congressional document requests:

A top House Republican is threatening to subpoena the Securities and Exchange Commission for any documents about US involvement in crafting European Union environmental, social and governance regulations that GOP lawmakers say harm American businesses.

House Oversight Committee Chairman James Comer expressed concern to SEC Chairman Gary Gensler in a letter Thursday that the agency is trying to “stonewall” the Republican panel’s investigation into whether the US cooperated with the EU on its climate directives.

Republican lawmakers, including Comer and Tim Scott, the top Republican on the Senate Banking Committee, have charged EU policies to counter climate change harm US companies that do business in Europe.

Unless the SEC produces documents by Oct. 19, Comer warned, “I will consider other measures, including the use of the compulsory process, to gain compliance.”

Last month, House Financial Services Committee Chairman Patrick McHenry also threatened to subpoena the SEC over documents he asserted the agency has failed to produce.

European regulators factor ESG risk in revised guidelines

The European Banking Authority—headquartered in Paris—has announced that it will be revising its guidelines for capital requirements to account for client-related ESG risks.  Unsurprisingly, financial institutions are leery of the proposed changes:

In a world first, the European Banking Authority is revising the framework that sets industrywide capital requirements for lenders — known as Pillar 1 — to incorporate environmental and social risks. Some of the obligations will be enforced immediately, while others will be rolled out over time and will in some cases lead to new legislation, according to the EBA.

For banks, the regime means they’ll have to review default and loss probabilities, as well as the risk weights that go into determining how much capital they set aside for each client account. The development may have major implications for high-emitting sectors such as oil, gas, cement, steel and mining.

Cracking down on such risks will be “a key area” for banks under the new framework, said Jacob Gyntelberg, director of economic and risk analysis at the EBA. Current rules already allow banks to “take a forward-looking perspective,” and this is “one of the areas where we should be able to move a little bit faster,” he said in an interview. …

The European Banking Federation, an umbrella organization for lender associations across the region, is worried there’s inadequate data to justify imposing Pillar 1 ESG adjustments, rather than so-called Pillar 2 rules, which are specific to individual banks, said Denisa Avermaete, senior adviser at the EBF.

The EBF’s key concern now is that the prudential framework “remain evidence and risk based,” she said. “It is also crucial that once the EBA considers a more comprehensive revision of Pillar 1 or a macroprudential framework, this is done at a global level to ensure a level playing field for EU banks.” …

The EBA says ESG-related losses are set to become more correlated, which is “changing the risk profile for the banking sector. The development is expected to become more pronounced over time and has implications for “traditional categories of financial risks, such as credit, market and operational risks,” according to the watchdog.

The EBA’s report contains more than five pages of instructions to banks and national supervisors for short and longer-term changes. Banks and their national supervisors will be expected to reassess collateral values and incorporate environmental risks into trading book budgets. That includes internal trading limits and the creation of new products, the EBA said.

In the states

Oklahoma legislative study claims law opposing ESG helps state economy

Oklahoma lawmakers were recently told in a legislative study that their efforts to push back against ESG have helped the state’s fossil-fuel-heavy economy:

A state law that prohibits Oklahoma government entities from using investment firms that boycott energy companies is having a small but positive impact on Oklahoma’s economy, lawmakers were told at a legislative study.

“It is having an effect,” said Corporation Commissioner Kim David, who supported the law when she was a state senator. “It’s having a positive effect for Oklahoma.”

She said global investment companies continue to stick to their “Environmental Social Governance” (ESG) policies, but that “the banking community as a whole” is starting to become more welcoming to oil-and-gas companies. The rising price of oil and rising interest rates are also playing a role in that trend, she said.

House Bill 2034, which created the “Energy Discrimination Elimination Act of 2022,” required the office of the state treasurer to conduct a review of investment firms to identify those that boycott investments in oil-and-gas companies regardless of the impact on investment returns.

State entities cannot contract with firms on that list. …

A number of studies have shown that ESG investing policies have worse rates of return than what occurs when companies focus on growth potential. For example, a study by UCLA and New York University found that over five years ESG funds underperformed the broader market. Additionally, in comparison to other investment plans, ESG investors generally end up paying higher costs for worse performance. …

When HB 2034 was being debated, David said there were an estimated 1,192 institutions that held $14 trillion in assets worldwide that were divesting from fossil fuels.

She noted oil and gas account for roughly 27% of the Oklahoma economy.

State Treasurer Todd Russ said the law has caused some major financial firms to change their rhetoric when seeking contracts from Oklahoma government entities, but that rhetoric is often undercut by those firms’ actions.

“To all of these financial people that come to see me, my statement became, ‘Don’t tell me. Show me. Because when I go look at your website, what you’re telling me is very different from what your history and from what your public statements—publicly facing statements—are actually saying,’” Russ said. “And they couldn’t argue that. It was really like they just kind of got caught red-handed.” …

Several officials at the study noted the environmental goals touted by ESG proponents have little basis in reality.

In the spotlight

Professors argue ESG funds mislead regulators and clients

Two professors from the EDHEC Business School in France have examined in a recent paper the portfolios of funds that claim to consider ESG factors in their investments. The authors argued that many such funds are misleading regulators and clients about their holdings. The paper called the practice of overstating, in their view, ESG investment commitments “Green Window Dressing”:

While certain investors hold the belief that sustainability is a panacea, delivering both superior returns for themselves and a better world for all, academic research has consistently cautioned that there is no free lunch. Scholars have emphasised time and again that ex-ante, a fund cannot be inherently responsible and simultaneously deliver consistently superior performance (Gantchev et al. 2022, Ceccarelli et al. 2023). While responsible investing can align with ethical values and promote positive societal impacts, it forces fund managers to shun high-performing yet controversial assets, such as those issued by polluting firms or by businesses operating in ‘sin industries’ (Hong and Kacperczyk 2009, Kacperczyk and Bolton 2021). …

Yet, sustainability used to be in the eye of the beholder. Is Tesla sustainable? While Tesla cars do not pollute, Tesla’s record on workplace practices and occupational safety is unimpressive. It is easy enough for asset managers to make an argument in favour of Tesla stock if they wanted to buy it, or against it if they did not want to. This changed in 2016, when Morningstar became the first company to start assigning ratings to funds based on how sustainable their disclosed portfolios were. In its most popular version of such ratings, Morningstar ranks funds from one globe (the least sustainable funds in their category) to five globes (for the most sustainable funds). These objective and easy-to-interpret metrics have been a game-changer for a segment of the industry still lacking regulation and transparency.

The ratings also changed managers’ incentives: it doesn’t look good if you run an environmental, social, and governance (ESG) fund and you are ranked poor in sustainability. Despite the positive impact on the industry, sustainability ratings have one limitation: they rely on portfolios disclosed by the funds themselves. In the US, funds are legally required to disclose their portfolios four times a year (at the end of each fiscal quarter), with some voluntarily disclosing more frequently, up to 12 times per year. In most European countries, disclosure is obligatory at least twice a year. Although this provides some transparency, it still means that investors only know with certainty the assets held by their funds on four days per year in the US and two days per year in Europe.

What assets do ESG funds hold during the rest of the time? The infrequent disclosure of portfolios poses a challenge as it opens the possibility for a fund to strategically purchase ESG stocks just before disclosure, thereby earning a high sustainability rating, and subsequently shifting to higher-yielding yet less responsible assets when detection is unlikely. In Parise and Rubin (2023), we explore this trading practice, which we refer to as ‘green window dressing’. Due to the lack of daily observations of fund holdings, we infer them from fund returns, as returns are reported daily. The intuition behind our approach is as follows: if a fund primarily invests in ESG stocks, its performance should closely correlate with the main ESG indexes. When ESG stocks perform well, the fund should also excel, and vice versa. However, we demonstrate that the correlation with ESG indexes drops significantly right after mandated disclosure, while a sudden increase in correlation appears with stocks of high CO2 emitters. This behaviour indicates that some funds engage in green window dressing with benefits for their performance and ability to attract investors.

We also document substantial but short-lived asset pricing implications. Figure 1 shows that high-ESG stocks deliver positive cumulative abnormal returns (CARs) in the days leading up to fund disclosure, consistent with the notion that fund managers bid up their prices when attempting to greenwash their portfolios. Yet, the sudden surge in prices swiftly reverts after disclosure, suggesting that fund managers either cease to purchase high-ESG assets or divest from them altogether.

As a final piece of evidence, we calculate the hypothetical returns a fund would earn based on the disclosed portfolio and compare them to its realised returns. In Figure 2, we observe that in the ten days leading up to disclosure, funds tend to underperform the portfolio they are about to disclose. This observation is consistent with the idea that, during this period, they incur meaningful transaction costs as they adjust their portfolio to include more environmentally friendly and sustainable assets. However, following the disclosure event, we notice a shift in performance dynamics. Funds begin to outperform the portfolio that they have just disclosed, indicating that they are now holding higher-paying assets than the ones they have recently made public. This trend is in line with the hypothesis that after the disclosure event, funds might replace some ESG assets with higher-yielding but less sustainable assets.