Seeking Common Ground in the Politicized Debate About ESG

On July 12, 2023 the House Financial Services Committee (HFSC) held a hearing entitled “Protecting Investor Interests: Examining Environmental and Social Policy in Financial Regulation,” chaired by HFSC Chair Rep. Patrick McHenry (R-NC),which can be viewed here. The July 7, 2023 Memorandum explains the purpose of the hearing and lists the witnesses:

• James Copland, Senior Fellow & Director, Manhattan Institute
• Benjamin Zycher, Senior Fellow, American Enterprise Institute
• Lawrence Cunningham, Special Counsel, Mayer Brown
• Ted Allen, Vice President, Society for Corporate Governance
• The Honorable Keith Ellison, Attorney General, State of Minnesota

ESG has become a very politicized topic in polarized America. That said, when one goes beneath the level of political theater, I think there is to be found. The first step in doing so is to distinguish between values-based and value-based investing. The foundation of the latter is “materiality,” the basis for determining which ESG issues matter to value creation. One of the topics at the center of the ESG debate is climate change. Here there are  number of prominent conservative voices who recognize the urgent need to address this challenge. The Securities and Exchange Commission is feeling pressure across the political spectrum regarding its climate disclosure rule. I argue that it has the authority to require disclosure of Scope 1 and 2 emissions but suggest that it not attempt to include universal disclosure of Scope 3 at this time.

Values-based Investing

Professor Jill Fisch and I have written about the difference between values-based and value-based investing. The ESG debate would benefit from taking this into account. In values-based investing, investors can invest their values (be they political or religious or whatever) regarding ESG topics even if this hurts returns through lack of diversification (although some of these funds claim they improve them). Examples of this are the “Point Bridge America First ETF” (MAGA), the “American Conservative Values ETF” (ACVF), the “Democratic Large-Cap Core Fund” (DEMZ) and the “S&P 500 Catholic Values ETF” (CATH).

Value-based Investing

Value-based investing integrates the financially-material ESG issues which matter to financial performance and value creation. Taking account of financially-material ESG factors that matter to risk and return is no different from other risk factors such as liquidity risk, interest rate risk, brand equity risk, and political risk. In truth, there is no need for the term “ESG investing.” More useful would be to distinguish between value-based investing and values-based investing.

The value relevance of financially-materially ESG factors has been recognized by a number of prominent conservatives. In a piece for the Harvard Business Review, “Rescuing ESG from the Culture Wars,” Dan Crowley, a life-long Republican and partner at K&L Gates, and I note that “ESG is simply about identifying material risk factors that matter to company profitability and shareholder value over time.” Similarly, Eli Lehrer, co-founder and President of the center-right think tank The R Street Institute, and I have written that “any number of ESG-related considerations can have strong connections to investment return.” Finally, writing about how the political winds blow back and forth in the ERISA Rule from one administration to the next based on slight changes in the language of the Rule, Tim Doyle of the Bipartisan Policy Center and I conclude that “If the purpose of ERISA is to protect retirement savings, both sides of the aisle should focus on the duties of loyalty and prudence owed to beneficiaries and plan participants, and less on an Administration’s policy agenda. Ironically, this is what ERISA was originally intended to protect against.”

Materiality

When it comes to value-based investing the key issue is which ESG factors are financially material. Good guidance on this is provided by the “Sustainability Accounting Standards Board” (SASB), now part of the International Sustainability Standards Board (ISSB). , can be quite helpful if this bill is passed. The SASB website explains that “the SASB Standards identify the sustainability-related risks and opportunities most likely to affect an entity’s cash flows, access to finance and cost of capital over the short, medium or long term and the disclosure topics and metrics that are most likely to be useful to investors.”) With the input of companies, investors, NGOs, and industry experts, SASB has developed guidance on the financially relevant material ESG issues for 77 industries organized in terms of 11 sectors. There are 26 categories organized in terms of environment, social capital, human capital, business model & innovation, and leadership & governance. SASB has developed a “Materiality Finder” which enables anyone to identify what it considers to be the material issues for any listed company.  The work of SASB is at the core of the ISSB which currently has a consultation on how these standards can be adapted for international use.

When looking at ESG through the lens of materiality rather than ideology, it can be seen that so-called anti-ESG initiatives really aren’t at all. I have written favorably about that with respect to Florida House Bill 3 “An act relating to government and corporate activism” and the same for the American Legislative Exchange Council’s (ALEC) model legislation entitled “State Government Employee Retirement Protection Act.”  Crowley and I are supportive of S. 5005, the “Mandatory Materiality Requirement Act of 2022,” which was introduced by Senator Mike Rounds (R-SD) and seven other senators in September 2022. Companion legislation, H.R. 9408, was introduced by Congressmen Bill Huizenga (R-MI) and Andy Barr (R-KY) in December 2022. One last example is Congressman Andy Barr (R-KY) has introduced “H.R. 7151-Ensuring Sound Guidance (ESG) Act” introduced in 2023 by Representative Andy Barr (R-KY). This bill distinguishes, in different words, between values-based investing and value-based investing. The former is allowed as long as this is made clear to the investor. For value-based investing ESG factors must be pecuniary, i.e., material.

Climate Change

Climate change is an existential challenge to America’s future prosperity and security. While it is typically portrayed in the media and in political messaging as a largely liberal priority, the challenges it presents are recognized by conservative executives, conservative politicians, conservative NGOs, conservative investors, and fossil fuel companies alike. Conservative solutions for addressing climate change are typically more market-based than the more government-based liberal ones but this is not a bright line.

In an interview I did with Greg Goff, a former oil and gas CEO and named in 2018 by the Harvard Business Review as one of the top CEOs in the world has stated that climate change “is the biggest challenge of my lifetime.” Elaborating on this he observed, “In addition to having a sense of urgency, it is important there is very well-developed framework to drive change as we decarbonize. I believe we need to strengthen our competitive position in the world. Because energy is critical to our economic well-being as a country, the framework needs to deploy capital effectively and efficiently; support innovation; develop policies that enhance our competitive position; and consider all the consequences of the changes that we pursue. I do not believe that we have the luxury of driving change without considering and managing the impacts of change.”

Three center-right nonprofits are working on policy solutions to the challenges posed by climate change: The R Street Institute (whose Energy and Environment Team includes Beth Garza, Devin Hartman, Josiah Neely, and Phil Rossetti), ClearPath (under the leadership of Rich Powell), and the Conservative Coalition for Climate Solutions (C3S) founded by Drew Bond and John Hart.

In terms of investors, John D. Skjervem is the Chief Investment Officer for the Utah Retirement Systems with assets of around $45 billion has observed that “Now completely politicized, ESG is a waste of time” and is actually impeding a successful response to the climate emergency challenge. Skjervem is also a member of the Investment Advisory Group for the Alaska Permanent Fund Corporation. On September 22, 2022, he gave a presentation (Go to September 22, 2022) and his presentation starts at 1:48:10, accessed July 3, 2023.to them entitled ““Thoughts on Climate Change, Divestment, Energy Transition & Related Challenges.”

Finally, there is the 83-member “Conservative Climate Caucus” started and Chaired by Representative John Curtis (R-UT) with Representative Mariannette Meeker-Weeks (R-IA) as Vice Chair. The caucus expresses six beliefs, the first one being “The climate is changing, and decades of a global industrial era that has brought prosperity to the world has also contributed to that change.

SEC Authority

On March 21, 2022, the SEC issued a proposed rule entitled “The Enhancement and Standardization of Climate-Related Disclosures for Investors.” Alan L. Beller, Daryl Brewster, David A. Katz, Carmen X. W. Lu, Leo E. Strine, Jr., and I have submitted a 51-page comment letter regarding this rule. We are supportive of the rule but have some suggestions about how we think it could be made better. Here are the key points in our letter:

1. The SEC’s statutory authority to require climate disclosure important to investors Is well-established and should continue to be respected by the Judiciary.
2. Universal disclosure by all public companies of Scope 1 and 2 emissions is transformational and the proposal underestimates its benefits—especially if the Commission addresses outsourcing of core economic functions and requires apples-to-apples reporting on Scope 1 and 2.
3. The Proposal can better encourage useful innovation by not requiring (or by postponing) the disclosure of Scope 3 emissions, and by encouraging voluntary disclosure by way of a safe harbor for issuers that choose to make voluntary disclosure. The same is true of disclosure of other innovative techniques such as internal carbon pricing.
4. Make narrative requirements, including those proposed in financial statement notes, sync better with emerging private sector and international reporting regimes, and with principles-based disclosure, such as that found in MD&A.
5. Focus required attestation of Scope 1 and 2 emissions on an even larger size of public companies in the first phase, and phase in attestation requirements as to other specified companies when the market of providers is broader, practices are better established, and implementation costs will be lower; and
6. Emphasize education and facilitation as first priorities, and limit enforcement to the government itself, not by private right of action.

Whether the SEC has the authority to issue such a rule is currently a major point of contention between the parties. In another piece Crowley and I argue that material risk disclosures must be separated from salient political issues. We conclude: “It is thus up to the SEC to determine what additional disclosures companies should provide to investors about material risks. The benefits to investors of these disclosures must be balanced against the costs to the companies for providing them. As the SEC considers the many comments it has received on its promised climate disclosure rule, it must maintain this focus. Policymakers with different views about whether and how to address climate change need to recognize that this legitimate political debate is a separate issue from the need for companies to disclose known, material risks to investors.”

Conclusion

While there are certainly major differences in views between the two parties, such as on the SEC’s authority to issue a rule on climate disclosure, I also see ample opportunity for bipartisan agreement on issues that are at the core of the ESG debate such as materiality and fiduciary duty. Time will tell whether such fundamental concepts transcend partisanship.