As we anticipate new proposals from the SEC on human capital and climate disclosure, this recent paper from the Rock Center for Corporate Governance at Stanford, Seven Myths of ESG, seems to be especially timely. The trend to take ESG into account in decision-making by companies and investors, not to mention the focus on ESG issues by regulators and even associations like the Business Roundtable, is “pervasive,” say the authors. Still, ESG is subject to “considerable uncertainty.” In the paper, the authors set about debunking some of the most common and persistent myths about what ESG is, how it should be implemented and its impact on corporate outcomes, “many of which,” they contend, “are not supported by empirical evidence.” Their objective is to provide a better understanding of ESG so that companies, institutions and regulators can “take a more thoughtful approach to incorporating stakeholder objectives into the corporate planning process.” The authors’ seven myths are summarized below.

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In 2019, the Business Roundtable created quite a buzz when it released a new Statement on the Purpose of a Corporation that moved “away from shareholder primacy” as a guiding principle and opted in to a kind of “stakeholder capitalism” (see this PubCo post). Then, in 2020, in another striking sign of changing perspectives, the BRT released a new principles-and-policies guide endorsing a new approach to action on climate change. According to the press release, the BRT is advocating

“new principles and policies to address climate change, including the use of a market-based strategy that includes a price on carbon where feasible and effective. Such a strategy would incentivize the development and deployment of breakthrough technologies needed to reduce greenhouse gas (GHG) emissions. To combat the worst impacts of climate change, Business Roundtable CEOs are calling on businesses and governments around the world to work together to limit global temperature rise this century to well below 2 degrees Celsius above pre-industrial levels, consistent with the goals of the Paris Agreement. In the United States, this means reducing net-greenhouse gas emissions by at least 80 percent by 2050 as compared to 2005 levels.”

As this article in the WSJ observed, it’s not that the principles and policies break new ground—they don’t—rather, “the significance of the statement is that it shows how business is shifting from a source of resistance to a force for action on climate.” (See this PubCo post.)

Myth #1: We Agree on the Purpose of ESG

While the desire to consider ESG as part of the decision-making process seems to be almost inescapable, the authors contend that there is no consensus on the precise nature of the problem that ESG is supposed to address. In this context, the authors cite a survey of over 436 mostly small and mid-sized companies, which found that “only 8 percent say that ESG encompasses a generally understood set of issues and can be easily defined by regulators; 61 percent say it is a subjective term that means different things to different companies and is difficult to define by regulators.” The authors identify three perspectives on the purpose of ESG. To one group, investing in ESG is offered as a way to defeat short-termism—the pervasiveness of which the authors question in a related note—and to increase long-term value by reducing “long-term risk, thereby leading to future profits that are larger and more sustainable.” The idea is that attending to environmental issues helps to lower future remediation costs; investing in employees leads to higher job satisfaction, lower turnover and higher productivity in the long run. The authors call this the “time-horizon argument.” The second view is that “corporate profitability and stakeholder betterment work in opposition to one another”; that is, it’s generally a zero-sum game and maximizing shareholder value results in “reduced welfare for others (evidenced through income inequality, environmental damage, etc.).” In other words, this view suggests that there is a profound issue of companies “profiting at the expense of other stakeholders.” The answer for the proponents of this approach is to “find an equitable balance” between investor interests and social or stakeholder interests through a more inclusive kind of capitalism. The third perspective that the authors identify is consistent with a “corporate social responsibility” approach—that is, companies should promote favorable ESG practices “because it is the right thing to do,” without regard to the economic consequences. Why are these distinctions important? Because, the authors believe that, “without agreement on the fundamental problem that ESG is addressing, corporations, investors, and stakeholders will not be able to agree on what ESG activities to pursue, how much to invest in them, and what outcomes to expect.” How will anyone be able to determine, they ask, “how successful these initiatives are without first understanding what ESG is expected to accomplish”?

Myth #2: ESG Is Value-Increasing

The second myth that the authors highlight is that “ESG improves outcomes for shareholders and stakeholders (so-called ‘doing well by doing good’).” This myth is consistent with the time-horizon perspective of the first myth. But does ESG really increase corporate value or is it “an incremental cost incurred for the betterment of society?” The authors don’t seem to buy the “widespread claims” that ESG increases long-term corporate value, arguing instead that the “evidence is extremely mixed and very dependent on the setting.” In support they cite several analyses and meta-analyses purporting to show that corporate social responsibility is not associated with improved performance. For example, they refer to a 2021 “literature review of over 1,100 primary peer-reviewed papers and 27 meta-analyses,” which found “that ‘the financial performance of ESG investing has on average been indistinguishable from conventional investing.’” (They note that financial performance can also vary significantly depending on the particular element of ESG involved—investing in human capital might lead to higher returns, while, for example, some green investments may not.) Similarly, they cite a 2019 survey of over 200 CEOs and CFOs of companies in the S&P 1500, in which the executives were almost equally divided on the question of whether ESG investment produces net long-term benefits or net long-term costs for the company. The authors’ conclusion: “we do not know the financial impact of ESG.”

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Of course, there is a significant body of research that supports the “widespread claims” of long-term financial benefit. For example, with regard to board diversity, the findings in California’s board gender diversity bill, SB 826, identified a number of studies that found economic benefits in gender diversity:

“numerous independent studies have concluded that publicly held companies perform better when women serve on their boards of directors, including:

(1) A 2017 study by MSCI found that United States’ companies that began the five-year period from 2011 to 2016 with three or more female directors reported earnings per share that were 45 percent higher than those companies with no female directors at the beginning of the period.

(2) In 2014, Credit Suisse found that companies with at least one woman on the board had an average return on equity (ROE) of 12.2 percent, compared to 10.1 percent for companies with no female directors. Additionally, the price-to-book value of these firms was greater for those with women on their boards: 2.4 times the value in comparison to 1.8 times the value for zero-women boards.

(3) A 2012 University of California, Berkeley study called “Women Create a Sustainable Future” found that companies with more women on their boards are more likely to “create a sustainable future” by, among other things, instituting strong governance structures with a high level of transparency.

(4) Credit Suisse conducted a six-year global research study from 2006 to 2012, with more than 2,000 companies worldwide, showing that women on boards improve business performance for key metrics, including stock performance. For companies with a market capitalization of more than $10 billion, those with women directors on boards outperformed shares of comparable businesses with all-male boards by 26 percent.

(5) The Credit Suisse report included the following findings:

(A) There has been a greater correlation between stock performance and the presence of women on a board since the financial crisis in 2008.

(B) Companies with women on their boards of directors significantly outperformed others when the recession occurred.

(C) Companies with women on their boards tend to be somewhat risk averse and carry less debt, on average.

(D) Net income growth for companies with women on their boards averaged 14 percent over a six-year period, compared with 10 percent for companies with no women directors….

2) (A) A 2016 McKinsey and Company study entitled ‘Women Matter’ showed nationwide that companies where women are most strongly represented at board or top-management levels are also the companies that perform the best in profitability, productivity, and workforce engagement.”

(See this PubCo post.)

Similarly, the Nasdaq proposal on board diversity cited a number of studies, including research from the Carlyle Group (2020), which “found that its portfolio companies with two or more diverse directors had average earnings growth of 12.3% over the previous three years, compared to 0.5% among portfolio companies with no diverse directors”; FCLTGlobal (2019), which found that “the most diverse boards (top 20 percent) added 3.3 percentage points to [return on invested capital], as compared to their least diverse peers (bottom 20 percent)”; and McKinsey (2020), which found “a positive, statistically significant correlation between company financial outperformance and [board] diversity, on the dimensions of both gender and ethnicity.”

Myth #3: We Can Tell Whether a Claimed ESG Activity Is Actually ESG

The authors contend that many corporate initiatives that appear to be undertaken to promote ESG are often indistinguishable from “standard business decisions to maximize shareholder value” under the company’s normal business model, making it difficult to assess the impact of initiatives characterized as ESG initiatives. To what extent, they ask, are ESG investments new investments or are companies just “repackaging and rebranding” regular business investments as ESG? The fuzziness may be compounded by companies’ desires to “demonstrate a commitment to social and environmental causes.” For example, a company may decide to use recycled packaging. Is that an ESG initiative or a financially-motivated decision it might have made anyway. The authors also point to “greenwashing”—such as when a company incorrectly promotes a new product as more environmentally friendly—as a “more extreme form of misrepresenting ESG efforts.” Among other things, the SEC’s recent formation of an Enforcement Task Force focused on climate and other ESG issues suggests that securities regulators, and perhaps others, “will become more aggressive in challenging ESG claims.” (See this PubCo post.)

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With the increased focus on sustainability reporting, as discussed in this article in the WSJ, also comes increased scrutiny, especially of ESG hype and greenwashing. While positive reports and ratings “can attract investments and sales,… along with heightened interest comes heightened scrutiny. Indeed, misleading claims can backfire if they are called out as inaccurate or misleading. Investors are quick to punish companies for transgressions across the landscape of ESG issues.” “‘The stakes are just much higher,’” according to one commentator, citing a 2019 report from a large bank “that showed 24 major controversies related to ESG topics erased more than $500 billion in market value of S&P 500 companies from 2014 to September 2019.” Another survey of 250 institutional investors showed that over half “believe companies are presenting misleading environmental credentials, and 84% think the practice is becoming more common.” While regulation of claims about products varies, the article contends that there is less regulatory scrutiny of voluntary sustainability reports, and companies have more flexibility in the selection of information they present in these voluntary reports, especially to the extent that the statements are considered vague “marketing speech” (provided it’s not false). But where ESG intersects with financial information, such as details about their investments in sustainability projects, the disclosures tend to be more rigorous.

Myth #4: A Company’s ESG Agenda Is Well-Defined and Board-Driven

The fourth myth that the authors identify is the belief that companies have developed “rigorous, well-defined ESG frameworks” after conducting broad evaluations of their business activities, identifying stakeholder interests and related risks and opportunities and evaluating their potential impact on strategy and operations. Surveys show otherwise, the authors contend. The authors point to a number of surveys showing that boards acknowledge that they don’t really understand ESG risk very well and don’t have much confidence in their ESG programs and that many companies don’t have formal ESG frameworks or even track performance on metrics. Rather, the authors suggest, “most companies appear to develop ESG priorities and investment in reaction to internal and external pressure.” For example, a recent study by the Rock Center found that 80% of companies in the study faced pressure in the last year to increase their commitment to diversity, equity and inclusion, and 96% made either significant (46%) or some changes (50%) in response. Likewise, 67% faced pressure over environmental or sustainability issues and 98% took significant (40%) or some (58%) action in response. What’s wrong with that you ask? Responsiveness to employees, institutional investors, customers, local communities and other stakeholders to enhance diversity and sustainability and address product social impact seems like it might be a good thing—even just from a business relations perspective. According to the authors, the problem is the potential for “ESG drift.” Without a “rigorous ESG framework, organizations risk being pulled into unexpected directions that weaken both ESG and corporate performance.” From a governance perspective, the authors advocate, to best guide decision-making, the “boundaries of the company’s ESG agenda [should] be well-defined.”

Myth #5: G (Governance) Belongs in ESG

The authors are puzzled by the inclusion of governance as part of ESG. As defined by the authors, governance is a “system of checks and balances to ensure that corporate managers make decisions in the interest of the corporation”; in the absence of appropriate incentives and controls, such as independent boards, proper compensatory incentives and internal controls, self-interested management would “have a tendency to make decisions to further their own interests, even when this conflicts with the interests of the organization.” Although “ESG advocates describe the ‘G’ in ESG as involving board quality, appropriate compensation, accountability to ownership, and ethical business practices,” good governance is important irrespective of ESG, the authors maintain.

Myth #6: ESG Ratings Accurately Measure ESG Quality

Apparently, some view ESG ratings as valuable indicators. However, while investors may rely on third-party rating agencies when making investments and companies may use ratings to establish their ESG credentials, the authors contend that these ratings “have only a weak (if any) association with corporate outcomes such as performance, risk or, failure thought to be indicative of ESG quality.” Citing piles of research, the authors conclude that, not only is there an “unproven correlation with performance,” but the ratings are also “not correlated with one another.” For example, a 2020 study of the ratings from three providers demonstrated an “extremely low” correlation of “aggregate scores (overall ESG ratings) and component scores (environment, social, and governance separately)” and that “these firms’ methodologies differ in most every relevant aspect: input metrics, how metrics are evaluated relative to peers and the industry, how missing data is treated, and the treatment of specific companies.” Moreover, the authors contend, the complexity of the methodologies of these ratings firms “illustrates the challenge of developing reliable ESG metrics”: “The number of input variables is daunting. Rigorous measurement of each dimension constitutes a significant research challenge. Measuring all of them accurately and combining them into an overall composite ESG score that is predictive of outcomes is likely not possible.”

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There seems to be some agreement with the contentions of the authors on this point. According to the WSJ, many companies provide volumes of environmental data that are used by rating firms to give companies ESG grades used by investors. However, those ratings are “inconsistent and incomplete.” The WSJ analyzed ESG ratings from three ratings agencies for 1,469 companies and found that 942 companies were graded differently by different raters: “Nearly a third of the companies were deemed ESG leaders by one or more rating firms, but labeled ESG laggards by one or another rater. Credit ratings, by contrast, are broadly consistent.” Only about a third of the companies had consistent scores. Why? Because the agencies use different methodologies and attribute different weights to issues, such as environmental or social. (See this PubCo post.)

Myth #7: Mandatory Disclosure Will Solve the Problem

The authors’ view on the final myth—that “more disclosure will solve the problem market participants face in assessing ESG quality”—is especially striking given that we are on the precipice of new ESG disclosure proposals from the SEC. Not that they believe disclosure is unimportant for the capital markets, but rather that “informative ESG disclosure will be difficult to produce in a cost-effective manner.” In the authors’ view:

“ESG disclosure would require a massive expansion of [the current reporting standards] to include environmental and social metrics across dozens of dimensions. These would have to be standardized and audited by independent parties across companies and industries. Regulators would have to weigh the tradeoff between informative disclosure of sensitive areas (such as human capital management, supply chain practices, and product safety) and the protection of proprietary information. Implementation would require a large investment in staff, advisors, and internal and external auditors to track and verify this information. And companies in diverse industries no doubt would have trouble standardizing their reporting to specific metrics whose applicability to their circumstances varies. While the output of this effort might increase information quality at the margin, the cost of doing so will not be trivial.”

The authors note here that, while providing ESG disclosure is likely to be costly for companies, especially smaller companies, outside providers, such as auditors, consultants and rating firms, stand to benefit handsomely. (However, it has not yet been determined whether, under the SEC’s anticipated proposals, any ESG disclosure will require independent audit or attestation.) Of course, the SEC is not taking on all of ESG disclosure in its initial proposal, but rather starting with human capital and climate—two major elements of ESG reporting nonetheless.

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In June of last year, in remarks before the ESG Board Forum, Putting the Electric Cart before the Horse: Addressing Inevitable Costs of a New ESG Disclosure Regime, SEC Commissioner Elad Roisman weighed in with his take on mandatory prescriptive ESG requirements and the likely associated costs. (Roisman has announced that he intends to leave the SEC this month. See this PubCo post.) As he has indicated before, he’s not really keen on the idea, particularly the environmental and social components of potential requirements. But if prescriptive line-item ESG disclosure requirements were imposed, how could the costs be mitigated? In Roisman’s view, the costs are fairly obvious: the costs of collecting (and in some cases, calculating) and preparing the information as well as the costs of increased liability for making the disclosures, both from potential Enforcement actions as well as civil litigation. Although these types of costs are prevalent with most disclosure requirements, he suggests that the scope and novelty of ESG disclosure may increase them. To try to reduce these costs, he offer several ways to tailor ESG disclosure requirements.

  • Scaling. First, he suggested that the disclosure requirements be scaled for smaller companies, an approach that has been taken with a number of other disclosure requirements. He also rejected the idea that has been floated by some that the SEC also impose ESG disclosure requirements on private companies. (See this PubCo post and this PubCo post.)
  • Flexibility. Roisman advocated that the SEC be reasonable in its expectations of “what companies can disclose and how they disclose it.” He cited as an example the difficulty of obtaining reliable information about Scope 3 greenhouse gas emissions, which depends on the company’s “gathering information from sources wholly outside the company’s control, both upstream and downstream from its organizational activities.” Companies may not be in a position to disclose that type of information with much precision and, to provide it at all, may need to access outside vendors, inflating demand and cost for the data. For similar reasons, he expressed concerns about requiring verification through an audit or an attestation.
  • Safe Harbors. To address litigation risk and avoid chilling the disclosure effort, he suggested addition of a safe harbor—much like the safe harbor in the PSLRA for forward-looking statements with accompanying cautionary statements—for good faith efforts to provide the required information.
  • Furnished, not Filed. Again, in light of increased litigation risk, Roisman advocated categorizing environmental and social disclosures as “furnished” to the SEC, not “filed,” comparable to the approach taken with disclosure of resource extraction payments. (See this PubCo post.) In his view, if the argument is that investors want the information and would benefit from the uniformity and comparability, “those benefits can be realized without imposing the level of liability that filing with the SEC presents.”
  • Extended Implementation Period. Finally, he hoped to see a long phase-in and extended implementation period. Companies will need time for the back-and-forth of questions as well as to implement staff guidance, to learn from other companies’ disclosures ideas (another reason, he suggests, for scaling) and to absorb feedback and make improvements. (See this PubCo post.)

Shortly after Roisman’s remarks, Bloomberg reported, at the WSJ’s CFO Network Summit, Commissioner Allison Herren Lee, a strong supporter of mandatory climate and other ESG disclosure (see this PubCo post), appeared to line up with some of his views on cost mitigation. She expressed her view that companies’ compliance with any new SEC disclosure requirements on ESG should not be subject to “gotcha” enforcement, instead indicating that companies will be cut plenty of slack in experimenting with any new ESG rules that the SEC may adopt. Like Roisman, she also advocated that the SEC phase in disclosure requirements gradually over time or “deploy a safe harbor to help companies with compliance.” Is this a signal that we should expect the SEC’s new proposal on ESG disclosure to provide a phase-in, reasonable latitude, and possibly even a safe harbor for complying companies? (See this PubCo post.)

The SEC’s proposals on human capital and climate disclosure are expected to be released early this year.