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The ESG Debate: To Woke or Not to Woke?

ESG—investing and operating according to environmental, social, and governance principles—is having a moment of sorts.

The daily news cycle seems dominated by ESG. One day it’s Gov. Ron DeSantis of Florida saying the state will not “be commandeered by Wall Street financial firms” that “impose an ideological agenda” under the banner of ESG. Another day it’s Alabama Attorney General Steve Marshall dismissing ESG as “the left’s new way of imposing their worldview on the country.” Or, on the Democratic side, it’s California Governor Gavin Newsom, trying to put the state on a path to carbon neutrality but having to purchase power from fossil fuel plants to get the state through summer heat.

Oh, and of course there’s Tesla CEO Elon Musk’s tweet that “ESG is a scam,” liked over 300,000 times and retweeted more than 42,000 times. This followed the company’s removal from the S&P 500 ESG Index due to environmental and social problems cited by the index.

It can be difficult to distinguish between legitimate critiques of ESG and political posturing. Over the next several weeks, through a series of content and conversations, the Bipartisan Policy Center will explore the heated rhetoric around ESG, recent actions of policymakers around the country, and what they mean for corporations, workers, retirees, communities, and the next Congress. We’re kicking off this series, The ESG Debate, with a recent conversation on the subject between BPC Senior Advisor Tim Doyle and SEC Commissioner Hester Peirce, along with the following Q&A addressing points of confusion and debate over ESG.

To get the series started, we tried to address some of the (basic) questions we frequently ask ourselves. We hope it is helpful to others who might get lost in fights over fiduciary duty, materiality, and more.

Is ESG New?

No. The origin of ESG as a formal framework for investment, asset management, and corporate operations traces back to 2005, when the United Nations and others held a conference and subsequently produced a report, Who Cares Wins. Efforts to push corporate social responsibility and “sustainable” investing had been underway for many years. Since then, ESG has grown enormously as both an investment strategy and a corporate guideline. By the end of 2021, ESG mutual fund and exchange-traded fund assets had reached $400 billion—a record. Nearly all companies in the S&P 500 release ESG information of one kind or another.

Financial traction, however, has clearly not translated into universal tolerance.

Why All the Sound and Fury Now?

Politics, naturally. Political polarization, glaringly evident in so much of American life, was bound to reach corporate America sooner or later. Researchers have found evidence that executive teams at large corporations have become more politically polarized. Some high-profile public companies have spoken out against certain state laws, leading politicians, especially at the state level, to blacklist companies that they see as “woke.”

The above statement from Gov. DeSantis was delivered when the governor announced last month that the state’s public pension managers had adopted his proposal to consider only “pecuniary factors [that] do not include the consideration of the furtherance of social, political, or ideological interests.” Texas and West Virginia have said they will not do business with banks that eschew fossil fuel companies. Political statements around ESG have not been confined to red states. Several blue states have made recent changes that require their state pension funds to account for ESG factors.

The politicization of ESG is partly related, too, to the hyperactivity of the Securities and Exchange Commission (SEC). Among the many rules introduced this year, the SEC has narrowed in on ESG practices of asset managers, pushed for climate risk disclosure from companies, and questioned the extent to which funds can use “ESG” in their name and marketing collateral. The Department of Labor has also proposed a rule to encourage retirement plans governed by ERISA to take ESG factors into account. Overseas, the European Union’s push for sustainability reporting requirements is already affecting many U.S. corporations.

Isn’t Corporate Governance Traditionally an Area of State Jurisdiction?

Yes—traditionally. That’s part of what makes the current moment so complex. For most of U.S. history, the law of corporate governance has been an area of state rather than federal jurisdiction. One of the biggest exceptions to this was the creation, in 1934, of the SEC. Two other federal laws, Sarbanes-Oxley in 2002 and Dodd-Frank in 2010, were major steps in expanding the federal government’s role. Yet states have largely continued to be the principal seat of corporate governance law, with Delaware as the benchmark. (ERISA does not apply to state-run public pension funds.)

Yet the U.S. economy is nationally integrated. Most of the large public corporations and asset managers under scrutiny regarding ESG practices operate nationally and even globally. ESG proponents also point to issues such as climate change and investments in workers as issues that transcend state lines. An important subtext of the current ESG debate—even if some of it is clearly posturing—is this question of federalism and the extent to which Congress and federal agencies should be involved.

Do ESG Investing Strategies Make Money?

Yes. And no. A key criticism of ESG is that consideration of non-financial factors by state pension funds could raise costs for retirees without delivering higher returns. Directing pension managers to focus only on delivering the highest returns is a reaffirmation of their core fiduciary duty: Consideration of any “ideological” factors violates that duty. Defenders of ESG point out that many social and environmental factors are financially material to company operations and funds’ returns, and increasingly so. Kicking certain companies out of Texas will reportedly lead to an additional half a billion dollars in interest paid by the state’s municipalities.

In theory, it should be easy to rely on data to resolve this, but comparison of ESG returns depends on the time period selected and what exogenous factors are accounted for. From 2017 to 2021, ESG funds enjoyed returns of 14%, compared to 11% returns for non-ESG funds. This year, just 3% of ESG exchange traded funds (ETFs) have positive returns, versus 9% of all ETFs, while inflows to ESG ETFs have shrunk by nearly a factor of 10. Competing academic analyses of financial data have come to different conclusions about ESG returns.

Are There Valid and Reasonable Criticisms of ESG?

Absolutely. Commissioner Peirce and others have called attention to “greenwashing,” the practice of investment funds “calling their products and services ‘green’ without doing anything special to justify that label.” Or, companies claiming adherence to ESG-based principles in their operations or products when in fact the claim is misleading, ambiguous, or unprovable. Some research looking at ESG rating firms has concluded that such ratings are a “compass without direction.” With no commonly accepted definitions of the E, S, or G and large gaps in standardized and comparable metrics, criticism shouldn’t be surprising.

Questioning can and should lead to improvement, clarity, and understanding. Over the next several weeks, BPC will dig into some of the foregoing issues, talk to more public and private stakeholders, and explore areas where bipartisan agreement might be found.

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