Using the Money of Investors to Promote the Theory of Man-Made Warming

The House Subcommittee on Investor Protection, Committee on Financial Services, held a hearing earlier this month on environmental, social, and governance disclosure rules and possible legislation requiring the Securities and Exchange Commission to mandate ESG standards for all publicly-traded firms. This would include a requirement that companies disclose in their annual reports the financial and business risks created by climate change, thus supposedly improving the information environment within which investors, future retirees, and fund managers make investment decisions.

Who could object to that? Put aside the very substantial climate uncertainties discussed in the scientific literature, including those outlined by the IPCC itself. The resulting impacts on business risks extending far into the future would be deeply speculative, and the level of detail and the scientific sophistication that would be needed to insulate firms from future shareholder lawsuits is far from clear. One could easily imagine that such self-protective “disclosures” might run thousands of pages, with references to thousands more, and the idea that this “disclosure” requirement would facilitate improved decision making by investors is difficult to take seriously. It is clear, however, that this kind of requirement would create a full-employment system for the attorneys.

That the SEC would be required to promulgate “climate-related” risk metrics and disclosure requirements is only the beginning of the administrative problems attendant upon this policy proposal. Is it reasonable to believe that the SEC has the needed expertise or that it would be able to sort through the conflicting testimony of experts to arrive at reasonable disclosure paths for businesses?

That is only the first of many operational problems that would be created by an ESG disclosure requirement. What information would be deemed “material” for the protection of investors’ interests? Moreover, gathering, evaluating, organizing, and disclosing material information is hardly costless, a reality that will induce some firms that otherwise would opt to acquire capital in public markets not to do so, substituting such alternatives as venture capital. Under such circumstances the aggregate allocation of capital will be made less productive, not a salutary outcome for the investors that are the supposed beneficiaries of ESG disclosures. And at what point would the provision of ever-more information yield “overload” for investors, thus actually reducing the protections that ostensibly are the central objective?

At a broader level, ESG requirements by their nature are highly subjective. (As an example, “sustainability” is a common ESG disclosure objective.) This is a central reality discussed clearly in a recent talk by Securities and Exchange Commissioner Hester M. Peirce, at an eventhosted by the American Enterprise Institute. Her observations merit close attention from policymakers, journalists, and interested observers. In summary:

* Pressures for ESG disclosures would add a broad, poorly-defined, politicized, and ambiguous set of criteria for business decisions to the narrower and traditional fiduciary interests of investors and current and future retirees.

* Despite that deep ambiguity, firms and funds failing to satisfy the ESG demands of outside advisers and interest groups (“stakeholders”) can be labeled miscreants despite important attendant adverse consequences.

* Even apart from the ambiguity and subjective nature of ESG criteria, such “shaming” of business firms often is the result of information that is incomplete, factually incorrect, and/or out of context; and the willingness of ESG rating firms to address such information problems is limited at best.

* The ESG advisory and rating industry has evolved into a very big business comprising developers of ESG scorecards, proxy advisers, investment advisers, shareholder advocates, and government organizations. “The problem perhaps begins with non-shareholder activists---the so-called stakeholders---who identify the controversial issues du jour.” Such ESG issues can conflict, and “people do not agree on which way they cut, and they may not cut the same way at every company.”

* “The ambiguity and breadth of ESG allows ESG experts great latitude to impose their own judgments, which may be rooted in nothing at all other than their own preferences.”

* Poor ratings for a given firm or fund can lead investors to avoid that stock, even though the ratings can vary so sharply and indeed yield “such bizarre results that it is difficult to see how they can effectively guide investment decisions.” But such inaccuracies and ambiguities matter “because a growing number of investors pays attention to ESG scores.”

* Accordingly, the ESG ratings can have a substantial impact upon the market allocation of capital, with adverse effects inflicted upon consumers, employees, communities, and investors.

* The proxy advisory process has evolved into a mechanism in which firms’ investment advisers can avoid accusations of conflicts of interest by outsourcing voting decisions on proxy statements to “experts” at outside firms, who can substitute their own ambiguous ESG preferences in place of narrower business criteria. The empirical evidence is that the proxy advisors’ recommendations have had a substantial effect on such voting.

Commissioner Peirce drew an interesting analogy between ESG ratings, which attempt to capture complex business tradeoffs and highly-ambiguous and subjective ESG criteria in a simplistic rating, with the scarlet letter “A” forced upon Hester Prynne in Nathaniel Hawthorne’s Scarlet Letter. The “adultery” label was woefully inaccurate as a description of Prynne, who conducted herself with tremendous dignity, worked hard, and devoted herself to her daughter and her community. The ESG labeling system of evaluating business behavior is worse: It can and does mean different things to different people, it evolves over time in ways difficult to predict, and is so subjective that it cannot be defended either in total or in its individual components without evaluation of the tradeoffs that are unavoidable. Above all, the ESG system of shaping business and investment behavior at its core is an effort to use other people’s money to achieve some set of politicized ends, and thus is inconsistent with the interests of investors and retirees.