ESG – A Good Deed With An Incentive To Scam

Environmental and Social Governance (ESG) is the buzzword in the investment community. The value of an investment is no longer about returns; it is to make a difference in society and the world. The true purpose of ESG hinges on the 13 principles drafted by Kofi Annan, the father of the modern-day ESG.

The global shift in investors' and consumers' attitudes has forced corporations to embrace ESG as a part of their value. Unfortunately, it is not simple. ESG is complicated, confusing, and political. Global compliance on ESG means that countries need to understand and abide by the rules of the global stage – an impossible, political nightmare.

ESG compliance requires all investors and companies to embrace the hard fact that it significantly increases business costs. Further, investors must understand the impact of the high costs on the corporation's bottom line. Most importantly, corporations and investors need to make a choice between shareholder fiduciary or political activism.

During 2004, Kofi Annan wrote to over 50 CEOs of major financial institutions, inviting them to participate in a joint initiative under the UN Global Compact's auspices and the International Finance Corporation (IFC) and the Swiss Government. The goal of the initiative was to find ways to integrate ESG into capital markets. Currently, ESG themed investing is estimated to have captured US$20 trillion in assets under management (AUM) or around a quarter of all professionally managed assets worldwide.[i]

Thus far, 9,500 companies and 3,000 non-business signatories based in over 160 countries – mainly in the developing countries - have signed up.

The resurgence of "socialistic impulse" in the global political stage is unsettling. ESG forces investors and corporations to choose between fiduciary responsibility and social capitalism.

Countries across the globe are embracing ESG in a way that suits their "values." Corporations and investors in China, Hong Kong and other Asian countries are comfortable in the "Environmental" aspect of ESG investing more so than in the Social and Governance aspect.

Principles Vs Bottom Line

ESG investing is risky for corporations and investors. It forces them to take a social stand, sacrificing the bottom line; especially, when it involves corporation hypocrisy and alienating the consumers who support business.

For instance, companies used to be apolitical and not take a moral stand. However, since 2018, companies like Starbucks, Dick's Sporting Goods, Nike, and other well-known public companies meshed their branding with politics and social cause. Result? Consumers and investors were not happy, and it impacted the companies’ bottom line.

Taking a political stand may be the morally right thing for a company to do but that doesn't mean it won't face the consequences. In China, the government still defines the clean use of coal as "green energy"; however, it is not the definition in Europe and the US.

Lack Of Understanding – ESG's Core Problem

One of the critical ESG challenges is its lack of clarity. According to a sustainability study conducted by BlackRock, embracing ESG in countries like Singapore and Bermuda is gaining momentum; however, roughly 75 per cent of Singaporean investors are unaware of how sustainability is measured. Lack of knowledge leads to misconception. On a recent poll conducted, over half of the Singaporeans think sustainable investing translates to higher costs (63 per cent), sacrificing returns (56 per cent), and higher risk (54 per cent).^[ii]

Bermuda’s Different Approach

It is worth noting that while countries like the US, China, and other Asian countries struggle to pick and choose the ESG parts they want to embrace, at least one international financial centre – Bermuda - is approaching ESG more realistically and holistically.

Stephen Weinstein, chairman of the Bermuda Business Development Agency, told the recent Island Finance Forum that public companies were "hearing ESG pressure from a growing constellation of stakeholders". He said: "Importantly, your team – human capital – is increasingly focused on this topic but your investors, your customers, your stakeholders, the governments with which you deal, want to know about your ESG strategy. They want to see that it's aligned with your medium and long-term sustainability as a firm and aligned with their values."

Ms Phillip-Fairn, CEO of Objective Consulting, said entities in Bermuda had "certainly been increasingly focused on ESG in recent years". "That applies right across the I.B. sector, accounting, and law firms, in regulation via the BMA and even the BSX," she said. "From what I've seen there's a general recognition that implementing ESG policies effectively and realistically is beneficial for businesses, the community, and ultimately the jurisdiction's credibility and leadership position."[iii]

Investor Returns And Valuation Complication

One of the critical questions surrounding sustainable investing has long been whether investors must be willing to take a risk/return trade-off to invest in companies with strong ESG practices.[iv]

Researching this article, I spoke with a few fund managers. Nearly all of them strongly think that sustainable stocks will not underperform in the long run. But here is the catch – asset managers can't unanimously agree on how to pick "good" ESG stocks, whether they are overvalued or undervalued. Now, that is a severe problem.

ESG resides on three pillars and 10 core principles.

The 10 Principles Of ESG And Its Impact On Investors

Most organisations use ESG to greenwash investors and consumers into believing they are investing in a socially responsible manner. For simplicity and clarity, let us take a brief look at the first principle of ESG: Respect Human Rights.

Despite the recent friction, the majority of US companies are not planning to leave China. China is the go-to source for ibuprofen, hazmat suits, rubber gloves, surgical masks, ventilators. Moreover, the US companies that claim to be ESG compliant are still doing business in China. In fact, many companies that source from China, like Apple, are part of so-called ESG mutual funds that invest in what that acronym stands for: companies good on the environment, good on social responsibilities, and with good corporate governance.[v]

It is tough to take ESG compliant corporations and investors too seriously. Former Goldman Sachs executive and head of the US Navy, Richard Spencer, encapsulates the investor dilemma nicely:

"China doesn't fit nicely into an ESG box, to say the least. "If I'm doing business with China, how am I staying within the guidelines of ESG?" [vi]

Hypocrisy In ESG Investing – A Sample

The Vanguard Group owns approximately 8.7 per cent of The Hershey Company. Vanguard is touted as an industry leader in providing ESG investment funds. The Hershey Company is a leading chocolate manufacturer. In 2018, they held over 43 per cent of the US market. In addition, it is estimated that around 1.56 million children, as young as five years old, participate in harvesting cocoa.[vii] So what happened with Hershey? NOTHING. The Supreme Court ruled 8-1 that while these companies allowed the farms to remain in operation by financially supporting them, there was no evidence that business decisions made in the United States led to slavery.[viii]

There is a fragile difference between "it is good for business" (legal) and a "good business” (ethical).

ESG is a good business. However, whether an ESG compliant organisation stays true to its 10 principles is questionable. Do all corporations that are ESG compliant on paper do any good to the environment, social and governance? Unfortunately, there is no definite answer to the question.

Presently, Hershey, on its investor page, touts itself as ESG compliant – "We've long believed in doing well by doing good and have a proven track record of reaching our ambitious commitments for our planet, people, and business."[ix]

Two million children are still working on cocoa farms.

ESG Ratings And Authenticity – What Investors Need To Know

Presently, all large institutions utilise ESG ratings and research to some degree while making their investment decision. The belief is that ESG data has value and  that it drives the investment outcomes – not in every case but enough that the entire investor community and companies begin to care. Here lies the challenge. While ESG factors impact a company's bottom line, they also impact a company's reputation...

In 2019, The Harvard Law Forum on Corporate Governance engaged with companies and investors and  found that many companies encounter corporate reputation challenges. It became increasingly clear that factors which fall within the 'S' of ESG are as common as (and for some companies more so than) those within 'E' and 'G' in contributing to business risk and, in turn, causing lasting damage to a company's reputation.

Factors that fall within the 'S'—frequently customer or product quality issues, data security, industrial relations or supply-chain issues—commonly impact businesses and destroy value.[x]

Ratings, Authenticity, And Transparency

There are no standard measurements available to measure Social Governance in the ESG. Why? Because it is hard to measure a corporation or a country at a social level.

US Senator Marco Rubio sent a letter to SEC (US Securities and Exchange Commission) Chairman Gary Gensler and Commissioner Allison Herren Lee regarding the impact of the SEC’s agenda on so-called ESG metrics and whether those same standards would apply to companies based or operating in the People’s Republic of China (PRC). Rubio highlighted the potential hypocrisy of requiring disclosures related to ESG without disclosing companies’ human rights practices in China. “Previous positions taken by the Commission indicate that the consistent application of its policies to the PRC is not guaranteed,” Rubio wrote. “In recent years, the Commission has created arbitrary exceptions to its general rules for activities in the PRC.”[xi]

ESG investors do not factor authoritarian regimes like China and Russia while measuring environmental and social governance. This is absurd as China and its neighbouring countries are huge in the global economy and investing. Removing the authoritarian regime means that the data collected and relied on is biased. The Rhodium Group estimates that US investors held US$1.1 trillion in equities issued by Chinese companies, and that there was as much as US$3.3 trillion in U.S.-China two-way equity and bond holdings at the end of 2020. [xii]

Moral values that are behind the ESG craze are shrouded with tax credits and government subsidies.

A classic scenario is when Bank of America Corp. sparked a stir in January 2021 – and a little envy – with just a few lines of disclosure in its fourth-quarter earnings report. The lender revealed it had slashed its 2020 corporate tax rate to 5.8 per cent from what would have been 21 per cent, thanks to finance work involving environmental, social, and governance projects. That didn’t go unnoticed by Bank of America’s competitors.[xiii]

Immediately following BOA’s disclosure, Wall Street’s new trillion-dollar ESG club was born.

JPMorgan Chase & Co. announced a pledge to finance and facilitate at least US$2.5 trillion of sustainable and climate-friendly deals over the next decade. Bank of America set a target of US$1.5 trillion, and Citigroup Inc. and Morgan Stanley said they would be mobilising US$1 trillion each.[xiv]

Bank of America’s annual report cited tax credits offered by US law to investors in projects including affordable housing and renewable energy which “generally involve substantial pretax losses”. Nevertheless, they saved the bank US$3 billion on its tax bill last year. The promises on clean energy are the flip side of the industry’s other significant role in the climate crisis. Banks extended more than US$3.9 trillion of loans to companies that are ESG focused.

Maybe Milton Friedman’s realistic view is accurate; and Kofi Annan’s imaginative take on business has inadvertently exposed investors to be ‘creative’ in manipulating the word ‘ESG.’

ESG Investing

In simple terms, people put their money to work in companies that positively impact the environment and society by having conscious governance. However, overwhelming data supporting ESG makes us question the underlying reality of the metrics.

The ESG concept gets tricky and complicated when it comes to investing. Investors are ecstatic and pour their money into the ESG funds – which in turn reaps more returns. Hence the headlines you keep seeing in the news are “ESG funds produce increasing returns.”

The reality is that the majority of ESG funds' top five holdings are in the technology sectors. The returns the funds made investing in the technology companies were impressive. However, it has nothing to do with ESG as they "claim" it to be.

Like any other type of fund, ESG funds adopt one of two possible approaches to portfolio construction. They passively track an index or actively pick investments based on their research.

Active ESG mutual funds and Exchange Traded Funds (ETFs) conduct their research to identify funds that meet their criteria. Passive ESG funds rely on third-party indexes to screen companies for compliance with different environmental, social, and governance requirements. These indexes choose companies whose ESG scores are above a set threshold and ESG fund managers build a portfolio of investments that track the index's performance.

Understanding the ESG methodologies used by each fund is critical for investors who want to align their choices with their views on environmental, social, and governance issues.

ESG Investing, Global Standards, And Regulation

We are witnessing global energy and digital transition with an ESG theme. The rise of ESG investing creates an urgent demand for definitive, measurable global standards and oversight to protect investors. During June 2021, more than 500 investors, regulators, and others involved in environmental, social, and governance investing, mainly in Europe, North America, and Asia, urged the International Financial Reporting Standards Foundation (IFRS Foundation) to develop a single set of globally accepted ESG accounting standards.

The Brussels-based European Fund and Asset Management Association represents managers of 18.8 trillion euros in European investment funds. It is encouraging that the European Union's push for standardisation of sustainability disclosures at a global level appears to be gaining traction under US President Joe Biden's administration.

Unlike the United States, the EU is adopting standardised definitions in a Taxonomy Regulation and standardised processes in a Sustainable Finance Disclosure Regulation that aims, in part, to prevent greenwashing by companies that appear environmentally aware in order to drive advertising and revenue.[xv] 

The Future Of ESG

Corporations and investors can drive environmental and social change through proper enforcement of internal corporate governance. However, the present state of ESG is confusing and complicated. With the EU's lead, a precise definition, global standards, and regulation are critical for monitoring the application of ESG by global corporations.

As we entered 2021, there were strong signals of meaningful change in the sustainability reporting world. Three main trends have been emerging:

1. Mandatory disclosure.
2. Investor demand - Major asset managers such as BlackRock use their ownership stake to pressure companies to improve their ESG disclosures.
3. Consolidated ESG standards.

However, there are critical challenges concerning ESG that need to be addressed for ESG to be practical:

1. Validity of the ESG measurements: This will be attained through properly defining ESG and setting global standards.
2. Materiality: Transparency, accountability, and measurability. ESG disclosures and measurements are not clear-cut. Hence, there is an urgent need for global standards.
3. IFRS needs to forge a path toward a global common language for sustainability.

In addition, in this environment, ESG cannot be adequately considered without reference to the broader sustainability agenda and the role of public policy in driving a fundamental change to the relationship between economies, society, and the environment. ESG is now clearly mainstream to corporate strategy.

Against that backdrop, factors relating to 'S' are now among the most pressing issues for companies globally.

A 2019 Global ESG Survey by BNP Paribas revealed that 46 per cent of investors surveyed (covering 347 institutions) found the 'S' to be the most difficult to analyse and embed in investment strategies.

For now, ESG greenwashing is omnipresent amongst corporations both domestic and foreign. As a result, investors are left to do their diligence before investing in an ESG fund or ESG 'compliant' corporations.

As a result of not understanding ESG (who does?) and greenwashing, the ESG litigation is red hot. Poor definitions tied with corporate overclaims; the language not understood by investors is a litigator's dream. Corporations are being sued for misrepresentation and breach of warranty with challenges to misleading ESG statements, unfair and deceptive business practices, and securities fraud. To embrace ESG in its entirety, it needs to be properly defined, regulated and standardised globally. Until then, it is a Wild West in the global ESG investing.

 

Endnotes:

[i] https://www.forbes.com/sites/georgkell/2018/07/11/the-remarkable-rise-of-esg/?sh=58c09f391695

[ii] BlackRock

[iii] https://www.rgmags.com/2021/07/esg-goes-mainstream-and-bermuda-is-embracing-it/

[iv] https://www.morningstar.com/insights/2020/02/19/esg-companies

[v] https://www.forbes.com/sites/kenrapoza/2019/09/03/why-american-companies-choose-china-over-everyone-else/?sh=4064e58d71de

[vi]https://www.afr.com/companies/financial-services/investor-hypocrisy-on-china-esg-ex-us-navy-boss-says-20210924-p58udg

[vii] Chocolate: Brought to You by Child Slavery | Her Campus

[viii] Chocolate: Brought to You by Child Slavery | Her Campus

[ix] Environmental, Social & Governance | The Hershey Company

[x] https://corpgov.law.harvard.edu/2020/06/28/time-to-rethink-the-s-in-esg/

[xi] https://www.rubio.senate.gov/public/index.cfm/2021/10/rubio-to-sec-how-will-esg-rules-apply-to-doing-business-with-communist-china

[xii] https://www.brookings.edu/blog/order-from-chaos/2021/08/12/the-new-normal-in-us-china-relations-hardening-competition-and-deep-interdependence/

[xiii] https://www.bloomberg.com/news/articles/2021-04-23/wall-street-s-trillion-dollar-esg-club-comes-with-huge-tax-perks?sref=STgRbYaw

[xiv] https://www.bloomberg.com/news/articles/2021-04-23/wall-street-s-trillion-dollar-esg-club-comes-with-huge-tax-perks?sref=STgRbYaw

[xv] https://aretenews.com/europe-leads-on-esg-as-global-rules-sought/