Last year, ESG investing was caught up in America’s culture wars, as prominent GOP politicians claimed it was a mechanism used by investors to impose a “woke” ideology on companies. The upcoming congressional hearings on ESG present an opportunity to put the facts on the record and to begin the process of working toward a bipartisan consensus that will take political love away from ESG. The key is to return ESG to its narrow and technocratic purpose – as a way to help companies identify and communicate to investors the material long-term risks the company faces from environmental issues, sustainability and governance. It is important to separate discussions about investors’ need for disclosure about material risk factors from debates about important political issues.
Last year, ESG investing was caught up in America’s culture wars, as prominent GOP politicians claimed it was a mechanism used by investors to impose a “woke” ideology on companies. Former Vice President Mike Pence railed against ESG in the talks and in one op-ed. Various Republican governors and red state legislatures are considered executive action and law to boycott asset managers who use ESG as a screening tool in their investments. And in Washington, various Congressional committees have promised to hold hearings where the Securities and Exchange Commission (SEC) and major asset managers will face public questions about the legality of ESG investing.
As a lawyer who is a lifelong Republican and a business professor who is a lifelong Democrat, we are dismayed by the politicization of ESG investing, which until now has been a technical (but important) topic that rarely comes up. outside the academic and investment communities. The upcoming congressional hearings on ESG present an opportunity to put the facts on the record and to begin the process of working toward a bipartisan consensus that will eliminate political passion from ESG. Far from inflaming passions, we hope the hearings will make ESG boring again.
The key is to return ESG to its original and narrow intention – as a way to help companies identify and communicate with investors in material that long-term risks they face from ESG-related issues. Climate change is one such risk for many companies – especially those with coastal assets vulnerable to sea level rise, or those (such as fossil-fuel companies) where future profits will be greatly reduced if governments begin to tax carbon. As a result, greenhouse gas emissions are a material issue for an oil and gas exploration company, as are air quality and employee health and safety. but ACCORDING to the Sustainability Accounting Standards Board (SASB), which helps identify risks in the industry, as well as human rights and community relations and business-model sustainability. Non-material issues include energy management, customer welfare, and systemic risk management.
As we have done before written, for markets to properly allocate capital, investors need companies to disclose material investment risks. For us, ESG is simply the identification of material risk factors that are important to the company’s earnings and shareholder value over time.
Conservatives are quick to complain that ESG is being narrowly broadened and used to promote a progressive political agenda. While some of their arguments seem overheated, they are reacting to a real event. In fact, many prominent liberal voices want to push sustainable investing further than traditional ESG investing allows. For example, the NGO Fossil Free California pushed for state legislation to force California pension funds CalPERS and CalSTRS to divest from fossil fuel companies, which both funds opposed last year. (The legislation was not implemented.) Another example is California law mandated a certain number of women on the board of directors, a law that was eventually struck down by the courts. Investors, not politicians, should decide whether to invest in fossil fuels and whether they want to prioritize diversity across the board.
On a more technical level, there is debate within the ESG community on whether to extend ESG measurements to include not only the risks a company faces from ESG issues, but also account for company’s impact on society and the wider world. Adding fuel to the rhetorical fire on both sides are companies and investors claiming too much for ESG greenwashing acquisition of different types. Our hope is that by asking ESG experts, the House committees will focus back on the original and important purpose of ESG.
Along with committee hearings, there are laws that help clarify the meaning of “ESG” investing: the “Mandatory Materiality Requirement Act of 2022,” introduced by Senator Mike Rounds (R–South Dakota) and seven other senators in September 2022. Accompanying legislation, HR9408 introduced by Congressmen Bill Huizenga (R-Michigan) and Andy Barr (R-Kentucky) in December 2022. The purpose of these bills is to “[t]or amending the Securities Act of 1933 to require that information required to be disclosed to the Securities and Exchange Commission by issuers may be material to investors of those issuers, and for other purposes. ” Although the SEC largely adheres to this materiality focus in connection with other disclosures, clarification may be useful.
This emphasis on materiality also serves to calm a current irritant in the ESG debate – the SEC’s proposed rule of climate-related risk disclosures for operating companies. In our view, critics of this rule on the left who want more disclosure ignore the central principle of materiality. Critics of this rule on the right do not care the truth that investors with trillions of dollars in assets under management, and with a fiduciary duty to maximize long-term risk-adjusted returns, will pay attention to how a company manages the effects of climate change a material issue.
In fact, many American companies are already making climate-related disclosures. As an example, consider ExxonMobil, which is aggressively investing in climate change solutions. It reports on its carbon emissions, along with reduction targets. Currently there are no requirements for this to be done either. It also put a diversity report in the public domain, again without being required to do so. Finally, it publishes a progress report—organized in terms of ESG. Chevron and ConocoPhillips do all this too.
A study at the Governance & Accountability Institute, Inc. found that 96% of the S&P 500 and 81% of the Russell 1000 made such reports. The problem with these reports is that, unlike financial reporting, they are not based on a set of standards. This makes it difficult for investors to evaluate their validity and compare the performance of different companies. However, progress has been made here through the creation of International Sustainability Standards Board (ISSB). Its job is to leverage the SASB, which is now part of the ISSB, to develop the standards for material information defined by the SEC and the proposed law.
People ask us what we think the future holds for ESG. In the near term, it is important to separate discussions about investors’ need for disclosures about material risk factors from debates about important political issues. The pending House hearings could turn into political theater as Republicans attack the policy goals of the Biden administration and Democrats defend them. Or they can be a learning opportunity to clarify what ESG is and what it is not. What it can do, what it can’t do, and what it shouldn’t do. How does this happen? By framing the hearings in terms of “materiality,” not “awakening.”
Without legislation, Congress’ role is to provide oversight of the rulemaking process while the SEC determines which risks are material to investors and balances the need for disclosure with the cost of providing information to companies. The financial-disclosure framework established by Congress nearly nine decades ago has resulted in the largest capital market the world has ever seen. We believe that preserving and strengthening that framework should be a priority for policymakers on both sides of the aisle.
