In Part 2 of this two-part interview, Assoc. Professor Panos Patatoukas shares insights on the SEC’s new rules around the marketing of investment products marketed as socially responsible, as well as disclosure rules around companies’ ESG (environmental, social, and governance) activities. The interview also covers ESG valuation and investing, as well as divestment versus engagement—two different investor approaches to pressuring
The interview follows the Center for Financial Reporting and Management’s (CFRM) annual conference, which brought together high-level ESG investing thinkers with a wide range of perspectives on the direction of the industry. Among them were SEC Commissioner Hester M. Peirce, a Republican appointed by former President Trump; Janine Guillot, CEO of the Value Reporting Foundation and former CEO of the Sustainability Accounting Standards Board (SASB), which has developed the leading framework for ESG data; Andrew Behar, CEO of shareholder advocacy nonprofit As You Sow, AJ Lindeman, who leads index and ESG quant research at Bloomberg; Karen Wong, who leads ESG & Sustainable Investing for State Street Global Advisors; and Wall Street Journal Senior Columnist James Mackintosh, an ESG investing skeptic.
Haas News: The Securities and Exchange Commission (SEC) is considering a host of new ESG disclosure rules. What will they do?
Panos Patatoukas: There are two new policy proposals (both released in May 2022) that would require additional disclosure regarding ESG strategies in fund prospectuses, annual reports, and adviser brochures. The SEC also proposed amendments to what’s called the fund names rule. Under the proposal, a fund that considers ESG factors alongside non-ESG factors may not be permitted to use ESG or similar terminology in its name, if doing so is materially deceptive or misleading. The idea behind these amendments is to prevent potential greenwashing or ESG lip-servicing, so that Main Street investors will not be deceived or misled.
At the conference, we heard from SEC Commissioner Hester Peirce argued that existing rules already allow the SEC to go after companies for any misrepresentations or omissions of “material” information? Do you agree?
I think it was important to have her perspective. Our conversation with Commissioner Peirce indicated that she is opposed to the rules not because she doesn’t think that greenwashing isn’t happening, but because she thinks we already have the regulatory tools to address it.
One good example of what she is talking about: The SEC recently fined Bank of New York Mellon Capital $1.5 million for misleading investors on false ESG quality reviews of some of the firm’s mutual funds. Of course, the $1.5 million fine is just a slap on the wrist, but it’s a signal that says the SEC can go after fund managers who make ESG claims but aren’t true to their promises. Consistent with the idea that the Bank of New York Mellon Capital case may provide a roadmap for future enforcement cases, the SEC has now taken on a much bigger player, looking into whether some of Goldman Sachs’ mutual funds don’t meet the ESG metrics proclaimed in their marketing materials.
If you scratch the surface of Commissioner Peirce’s argument, we get to the old question of: What’s the point of having rules and more rules if we don’t have sufficient enforcement? Should we allocate more resources creating new rules, or should we allocate those resources on enforcing existing rules—to the extent that the old rules are still relevant and effective?
My view is that the recent SEC proposals on funds and advisers that market themselves as having an ESG focus respond to the need for more transparency. More regulation in this regard might actually facilitate more enforcement. The bottom line is that unless we have both meaningful regulation and enforcement, we’re not going to achieve real progress.
But will these new disclosure rules actually make it easier for investors to, as you say, invest with their values?
In the absence of standardized and informative disclosures, in my opinion, it’s not entirely surprising that an ESG fund could exaggerate its actual consideration of ESG factors. If adopted, the proposed rules would require ESG-focused funds to provide more detailed information in a standardized tabular format. By providing information prominently, in the same location in each fund’s prospectus, the idea is that more disclosure would help improve investors’ understanding of ESG investment strategies and would assist them in comparing ESG-focused funds at a glance. The SEC also proposed amendments to existing rules to address materially deceptive or misleading ESG fund names. This new regulation basically says that fund managers who make ESG claims better be true to their promises. Because if not, that’s the definition of greenwashing.
I believe that a common, standardized disclosure framework tailored to ESG investing makes sense. So overall, I am in favor of providing more standardized disclosures about fund performance, investment strategies,and portfolio characteristics.
But we need to be careful. More disclosure will not automatically level the playing field for individual investors allowing them to make more informed decisions while investing in alignment with their values. If investors don’t have the financial acumen to process the disclosed information, then disclosure on its own may not be as impactful. Remember, while we are all investors, not everyone can access financial education. One of the things that preoccupies me is finding ways to make financial education and the power of financial data more accessible to everyone.
Critics of ESG investing say that it limits the universe of available stocks, which will negatively impact performance. You asked some of the panelists: “Can investors have their ESG cake and eat it too?” Can they do well by doing good?
I asked that question to the representatives from State Street and Bloomberg. State Street has been a leader in the ESG investment sector. They have all kinds of financial products, including scoring models, indices, and fund offerings using ESG data. For example, a key premise of State Street’s “Responsibility-Factor”—or “R-Factor”—scoring model is that it allows investors to identify companies that score higher on material ESG metrics. State Street’s R-Factor is also the ESG scoring model powering the Bloomberg/SASB ESG indices, which are used as ESG investing benchmarks.
My question was whether outperformance, relative to passive benchmarks, is a good measure of the effectiveness of State Street’s ESG scoring model. The response was ideally yes, but in practice, it doesn’t usually work that way and that a better measure of effectiveness might be “do no harm.” In other words, just make sure you don’t underperform the market benchmark, but without necessarily outperforming the benchmark.
This response in my opinion deviates from the way ESG scoring models have been marketed to everyday investors. ESG scoring models have often been promoted on the premise that the resulting ESG scores can help investors select stocks that will generate higher future returns.
In fact, the premise that you can “have the ESG cake and eat it too” has proven to be a highly effective narrative for the marketing of ESG funds and indices. Reflecting on these dynamics, I believe that there is a need for caution and more transparency on the part of ESG index providers and fund managers when marketing ESG scoring models and indices to everyday investors.
One of the most interesting discussions of the day centered on ESG strategies of engagement versus divestment. Let’s say we have good data to identify “brown” companies. Does removing them from a portfolio drive change?
The issue of engagement versus divestment is one of the most important, because I think that’s the one that can have immediate, real implications. The goal of ESG investing is not just to make money for ESG-motivated investors but also to change companies’ behavior through engagement and divestment. For example, divestment involves selling fossil fuel companies that have negative environmental impacts and buying “green” companies in other sectors. The idea behind divestment is that it raises the cost of capital for fossil fuel companies, thereby impeding their growth, while helping green companies grow. Based on this, several ESG-motivated investors have called for complete divestment from the fossil fuel sector.
For example, the University of California made the decision to remove all companies that own fossil fuel reserves from the UC Retirement Savings Program (RSP) fund. As of today (June 30, 2022), they sold existing holdings from RSP core funds and will no longer invest in fossil fuel companies.
The UC retirement fund is a relatively small fraction of the total market, and when UC RSP sold stocks of fossil fuel companies, somebody else bought that stock. Nevertheless, it does raise the question: Will divesting from fossil fuel companies accelerate the path to decarbonization of the economy? Where will the technology that will change our lives come from? Will it come from an entirely different sector, or could it also come from leading companies in this sector?
Outright divesting should be contrasted to an alternative approach, let’s call it selective divesting. Consider the fossil fuel sector as a whole. Within the sector, there are leading companies that are innovating, investing in new technologies, and there are lagging companies that are falling behind and continuing their dirty practices. Divesting from all of them is one possibility. An alternative would be to divest only from the laggards and reallocate this capital to the leaders. This approach of selective divesting and tilting may be desirable for an ESG-motivated investor because (a) it would reward companies that invest in transformative technologies and (b) it would penalize companies that do not adopt. This approach effectively blends divestment with engagement. The bottom line: Is indiscriminate divestment from fossil fuel the best way to accelerate progress or is the alternative approach of selective divesting and rewarding change a more effective approach to realizing our sustainability goals?
Wall Street Journal columnist James Mackintosh argued an investor’s role is to make a return within an acceptable level of risk, not push for change. He said it’s more effective to push change at companies through consumer actions, through buying power, or through government. What do you think?
Consumers and investors can be a force for change. ESG-motivated investors are asking for more transparency and verifiable data that they can use to make more informed investment decisions. Consumers are also asking for more transparency, and more reliable, verifiable and standardized data to inform their consumption choices. I believe that change could come from anywhere.
With respect to lawmakers, I agree that they have the power to drive change. For example, as many economists have been arguing for years, introducing a carbon tax in the corporate tax code would effectively change the incentives and behavior of companies by internalizing the negative externalities of carbon emissions. But still, measurement issues may hamper the effectiveness. Suppose we introduce a carbon tax, we still need to measure carbon emissions. Should the measure of carbon emissions include only direct emissions and emissions resulting from the company’s energy use—known as Scope 1 and 2 emissions? Or, should the measure also include Scope 3 emissions, those resulting from activities that the organization indirectly impacts in its value chain? While Scope 3 emissions often account for the biggest part of a company’s emissions, they are also the hardest to measure.
What are you most optimistic about right now in terms of ESG investing?
I think over time, we will have more transparency and more tools that will allow everyday investors to invest with their values and to be more aware of what they’re investing in. And we’re going to have more and better data that will allow us to overcome the measurement challenges, monitor corporate impact, align management incentives with long-term sustainability goals, and facilitate the allocation of capital in ideas and technologies that will drive change for good.
I also think we’ll have the technology required for individual investors to be more active participants in corporate decision-making. For example, I think it’s a matter of time before pass-through voting becomes available to every individual investor. A bit of context: Many of us individual investors participate in the stock market through index funds offered by large asset managers. Stock indexing has enabled us to get access to diversified portfolios at a low cost. The Big 3 asset managers—Vanguard, BlackRock, and State Street—dominate the field, with a collective >80% share of index fund assets. The Big 3 alone manage $20 trillion in assets.
One key implication of the growth in stock indexing among the largest asset managers is the voting power they have amassed over time, since they typically vote on behalf of individual investors. Giving every individual investor the option to participate in the proxy voting process can help them amplify their impact collectively on the issues that matter to them the most. This is an exciting prospect compared to today’s reality where a small set of individuals representing the top asset managers gets to decide on our behalf.
It’s about time to ensure that the voices of everyday investors are being heard.