by Nell Minow

ESG has passed the tipping point. For investors, ESG, which stands for Environmental, Social, and Governance factors, has gone from a nice-to-have to a have-to-have. ESG is the fastest growing area of investment, with every major financial institution and every significant institutional investor having one or more ESG options. U.S. ESG index funds reached over $250 billion in 2020. More significantly, ESG factors are permeating every aspect of even the most traditional investment vehicles. A 2020 survey of 809 institutional asset owners, investment consultants and financial advisers found that 75 percent of them use ESG factors in their investment strategies, up from 70 percent in 2019. Nearly 13 percent of respondents were pension plan sponsors. Corporate executives and board members are scrambling to catch up.

There are two major factors behind the new centrality of ESG. First, there is growing recognition that current financial reporting according to Generally Accepted Accounting Principles (GAAP) is not adequate. The upheavals of the dot-com bubble, the Enron-era accounting scandals, the 2008 financial meltdown, and the failed public offering of WeWork serve as reminders that there is a reason that accounting principles are called “generally accepted” and not “certifiably accurate.” GAAP is fairly good at reporting the value of hard assets and computing present value of future income. It is less reliable in evaluating the worth of today’s key assets like intellectual property and not of much use in informing investors about the asset almost all companies claim is their most valuable: their employees. GAAP is structured to externalize costs off the books as much as possible, driving corporate strategy in that direction. ESG is about the information GAAP leaves out or underweights.

The second major factor is market-driven, based on demographics. Millennials and Generation Z are vastly more concerned with ESG issues like climate and social justice than their parents, harking back more to the boomer generation activism that led to the creation of the Environmental Protection Agency and other regulatory agencies devoted to health and safety concerns. As employees, consumers, and investors, they are insisting on better information and more explicit strategy relating to ESG.

The problem is that the market for ESG is far ahead of the ability to supply it. We are better at understanding the importance of ESG than we are at computing and understanding the data. There is no consensus and a lot of inconsistency in defining what ESG is. That has led to a lot of opportunistic grabs for fees and market share for services and products that are based on what can be counted, not on what counts. It has led to a lot of push-back from corporations and their service providers, as we see in the comments filed with the SEC in response to the Commission’s request for feedback on climate change and ESG disclosures. And that includes messaging in support of myths designed to undermine legitimate efforts on ESG. Here are three of the most widely disseminated.

1. ESG is new. In the collection of The British Museum is a blue glass jar dating back to the early 19th century. The label identifies the company and the product: East India sugar. And then, in bigger letters, it has an ESG disclosure: “not made by SLAVES.” The East India Company distinguished itself from its competition in the West Indies in response to the world’s first grass-roots political movement and consumer boycott. This led to the abolition of slavery in the United Kingdom more than 30 years before it took a war to stop it in the United States. ESG is sometimes similarly dismissed as a fad. While fads are very popular in finance and investing, ESG is unlikely to disappear. It will continue to be refined, but it will not disappear. For example, the largest institutional investor in the U.S. is BlackRock, which has announced that 100 percent of its approximately 5,600 active and advisory BlackRock strategies are ESG integrated—covering U.S. $2.7 trillion in assets. Reflecting the demand, BlackRock introduced 93 new sustainable solutions in 2020, helping clients allocate U.S. $39 billion to sustainable investment strategies, which helped increase sustainable assets by 41 percent from December 31, 2019. 
2. ESG is monolithic. It is critical to remember that ESG encompasses three enormous categories: environment, governance, and a catch-all category referred to as “social.” Each is a moving target with constantly evolving ideas about what information is relevant and reliable and each has to be evaluated separately. “Social” is the wild card in the group. Rising on the list in recent years are #MeToo and #BlackLivesMatter concerns. I predict that there will be increasing attention on political contributions and lobbying expenditures. This scrutiny has been catalyzed by reports from Judd Legum and others about contributions companies have made contrary to their public commitments not to donate to elected officials who supported the January 6 insurrection or who get poor ratings from women’s and racial equity groups. 
3. ESG is “non-pecuniary”—adjacent to or conflicting with financial goals. This was the explicit underlying assumption in the now-suspended ESG rule pushed through the Department of Labor in the last weeks of the Trump administration, directed at pension fiduciaries. The suspension of the rule as the Biden administration examines the issues is based on two key facts. First, the Department already has not just the enforcement authority but the obligation to use it if a pension fiduciary makes an investment decision for any reason other than “the exclusive benefit of plan participants.” Second, the proponents of the anti-ESG rule failed to come up with a single example of any investment made by any fiduciary for other than purely financial reasons. There is a lot still to be determined about ESG and some arguments to be had over long-and short-term calculations, but it is always financial.

ESG is like the use of the term “organic.” Consumer demand has led to unsupported claims, and it is time for the government to establish clear, consistent, and credible guidelines. In the meantime, companies should increase their disclosures about the procedures they have established for self-evaluation on ESG and what their priorities and goals are, putting some reality into a term with too many myths.

Nell Minow is Vice Chair of ValueEdge Advisors, a corporate governance consulting firm. She was previously General Counsel and President of Institutional Shareholder Services, a principal of the activist LENS Fund, and a partner in GMI Ratings. She writes frequently about corporate governance issues.

Disclaimer

The views, opinions and positions expressed within all posts are those of the authors alone and do not represent those of the Program on Corporate Compliance and Enforcement or of New York University School of Law.  The accuracy, completeness and validity of any statements made within this article are not guaranteed.  We accept no liability for any errors, omissions or representations. The copyright of this content belongs to the authors and any liability with regards to infringement of intellectual property rights remains with them.