Lerner Experts Discuss Significance of ESG

ESG, the little acronym that could, is suddenly everywhere in discussions of how investors and companies should make decisions.

The letters stand for Environmental, Social and Governance, and searches for the term on Google shot through the roof over the past few years as it became a political sparring point.

What is ESG and why does everyone want to talk about it now? Experts from the Alfred Lerner College of Business and Economics at the University of Delaware weigh in on what to know about this trending term driving conversation among political activists and business leaders alike.

First off, what is ESG?

Environmental, Social and Governance refer to key factors that some believe businesses should consider as they make decisions. The idea is that investors can push companies to be responsible in these areas.

“ESG investments consider a company’s climate change initiatives, diversity and corporate transparency as financial factors,” the Wall Street Journal wrote earlier this year. “Some of the largest asset managers, including BlackRock Inc., have said that taking such things under consideration is good business.”

That could play out in different ways, like hiring more women and minorities or nominating more of them to boards, investing in technologies that reduce carbon emissions, or pulling investments from fossil fuel companies, among many other considerations.

Is this new?

Not really, although political tensions have increased over the core issues at stake.

“We live in a very polarized society right now,” noted Hamed Mahmudi, an assistant professor of finance at Lerner who has followed the ESG trend.

Ideas of good corporate governance have been discussed for decades, said Justin Klein, director of Lerner’s John L. Weinberg Center for Corporate Governance, and climate change isn’t a fresh topic in the news either. But increasingly, the broader focus under the ESG umbrella has shown up in shareholder proposals recently.

“It’s taken on a life of its own over the last several years,” he said.

Even the acronym is not new. An article in the New York Times, “Funds join in social pressure,” mentioned the term 17 years ago, reporting, “Asset managers are increasingly incorporating social, environmental and governance factors into their investing strategies, with institutional investors becoming more active as shareholders, pushing the boards of their core holdings to improve their practices.”

Who is driving the ESG movement?

While some fear that ESG is a result of corporations pushing a political agenda, Lerner experts point to a more complex scenario.

Pressure is coming from a number of quarters, Klein said. This can include insurance firms that want to see ESG policies in place to reduce their risks, and lenders or purchasers who want to know the company isn’t going to deal with a significant number of ESG-related issues. Pressure is also coming from the ground up through shareholders, he said, as demonstrated by the increased number of shareholder proposals and votes on those proposals.

It’s the latter, Mahmudi thinks, that will be most effective.

“I would argue that as long as it’s driven by shareholders and stakeholders, the likelihood of backlash is lower,” he said.

Why all the backlash?

“There is a significant anti-ESG movement emerging, where business leaders have said, ‘I don’t like these woke trends, and I just want to worry about financial performance,’” Klein said. He also noted that multiple states have waded into the fray, with attorneys general opposing the ESG movement, and state treasurers removing their pension funds from asset managers who consider ESG factors.

Conservative activists are driving a lot of the pushback on ESG. The Wall Street Journal reports that the Marble Freedom Trust, a funder of groups like the Heritage Foundation, has been a leader in the fight. The argument is that the ESG movement is driven by liberal, “woke” policies that could harm people’s investments and promote policies they didn’t sign up for.

Much of the emphasis in the discussion is on the environment part of the equation, said Fei Xie, Chaplin Tyler Professor of Finance at Lerner and research associate at the European Corporate Governance Institute. He added that as large investors divest from coal, oil and natural gas companies, those industries and states where those industries have a large presence have resisted.

Part of the resistance also comes when regulators try to enforce these principles, Mahmudi said. He cited California’s law to mandate a certain number of female directors on boards (later struck down in court) as an example. People who disagree with the policy may find legal ways to resist, he said. One recent study found that in general, circumstances get worse for women in the job market when quotas like these are put in place, and in California specifically, the demand for female employees in the workforce dropped.

Mahmudi, who has been doing related research with Lerner’s Donald J. Puglisi Professor of Finance Laura Field, suggested that a more effective way to avoid some of this backlash is to simply require transparency from companies, or “governance by sunlight.” Regulators could lay out ideal principals, like having a certain percentage of women on a board. Companies would not be required to meet the quota, but they’d have to explain why they didn’t.

That could promote more organic change, he said, with unhappy shareholders applying the pressure.

How do you measure ESG factors?

Like other broad concepts, ESG can get a bit squishy in the definitions, and companies can also choose from different reporting frameworks for their disclosures.

If regulators or stockholders are pushing for what they see as improvement in this sector, how are they going to measure it? What counts as an ESG-friendly investment? A term like “environmentally sound” or “carbon neutral” can mean different things to different people (and corporate lawyers).

Some companies game the system, Mahmudi said, because they have leeway to choose how they measure ESG. For example, they may make a big announcement that they are tying the pay of their executives to ESG. Then, they pick easily achieved targets to focus on that make them look good.

Some reporting guidelines have begun to see wider usage, but there’s no universal standard.

“We need uniform measures,” Mahmudi said.

In general, ESG results seem mixed. There is evidence that publicly held companies have reduced their greenhouse gas emissions as a result of ESG, Xie said. There’s also evidence that many of these firms are reducing emissions by offloading polluting assets or operations to private companies, which may not be as transparent and don’t face the same pressure from investors.

Of course, “E” is only one of the letters, and other categories are more easily measured. Klein noted that he has seen real progress on companies adding women and minorities to leadership positions and boards.

Regardless, investors can’t just make assumptions. Funds with “ESG” in their names may not actually focus on those goals, Xie said. “It is important for investors to do their homework and peruse fund portfolio holdings to determine whether a fund actually puts its money where its mouth is.”

Is ESG good for business?

Whether pushing for better ESG standards results in financial profit depends on who you ask.

“For firms outside of the fossil fuel industries, one concern that has been raised about carbon transition is that it may increase, at least in the short run, firms’ production costs and the prices of their products,” Xie wrote, “thereby making them less competitive.”

Pick your study: Some argue that ESG investments perform better, and others provide evidence that they don’t. But it’s difficult to tell for sure in the absence of clear definitions and accounting.

“I am not aware of any standard ways of defining or measuring ESG costs,” Xie said.

It can also be tricky to tease out the effects of ESG-conscious investments from a tangle of other factors. Xie noted fund managers can pick all the right stocks, but if their timing is bad, a fund can still perform worse. “As a whole, the mutual fund industry does not have a very good record of consistently beating their benchmarks. That’s true for ESG-focused funds as well.”

What is good business, anyway?

At the heart of the debate over ESG is how much profit should count in the equation at all. Is a healthier environment a less important value for shareholders than stock prices?

Complicating the debate is the legal concept of “fiduciary duty,” which holds that decision-makers at a publicly owned company must take their shareholders’ best interests into account.

To some, Mahmudi said, the answer is clear: ESG policies benefit companies financially, and so fiduciary duty isn’t an issue. Others say no — directors should ignore some environmental and social considerations because they would cost shareholders money.

And some call for a focus on other benefits to investors. Companies may decide to consider environmental and diversity factors that cost shareholders, Mahmudi said, because they believe it makes society better.

It doesn’t look like this is going anywhere

As of February, per the Wall Street Journal’s count, legislation to ban ESG considerations had been introduced in at least 16 states. Some legislation is already in place to that effect, and other states have adopted or are considering pro-ESG measures.

Business leaders are keeping a close eye on all this, whether it’s the actions of regulators, investors, or lawmakers and activists.

The Weinberg Center hosted a conference on ESG this past February, and according to Klein it won’t be the last.

As far as trends, “I think that (ESG) movement is likely to continue, notwithstanding the anti-ESG movement,” Klein said.

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