American companies face increasing pressure from activist investors to pursue more noble purposes than profit. In response to this clamor, virtue-signaling by corporations has run amok. Starbucks is the poster-child for self-styled sustainable companies, issuing $500 million in “green” bonds and pledging a “commitment to create global social impact.”
The coffee conglomerate announced earlier this month it will phase out plastic straws after caving to pressure from environmentalists. Nevermind that Starbucks, by ditching straws in favor of plastic “nitro” lids, will almost certainly increase its use of plastics by volume. Moreover, the Associated Press reported that plastic straws account for just 0.02 percent of plastic waste estimated to litter oceans each year. Starbucks’ decision to go suckless received fawning coverage in media outlets, many of which cited a debunked “study” by a then-9-year-old claiming that Americans use more than 500 million straws per day to justify the initiative.
This policy will have a negligible, or perhaps negative, environmental impact while imposing real costs on Starbucks as a profit-generating enterprise. This example illustrates one of the most challenging aspects of Environmental, Social and Governance (ESG) investing: How can a company’s social responsibility be accurately and fairly measured for investors?
The quality of information investors and fund managers of 401(k)s and pensions use to deploy ESG-focused capital and vote stock options is unreliable and varies widely, according to a report released this month by the American Council for Capital Formation, an economic policy think tank.
ESG rating services are used by many of the world’s largest investment firms. Four major rating agencies dominate this market. Each uses a customized scoring method that evaluates different non-financial metrics and topics ranging from gender discrimination to business ethics.
To attract ESG-orientated capital, companies often make selective and unaudited disclosures, which the rating agencies evaluate without standardized rules or an auditing process to verify company data. Dramatically different ESG ratings exist for the same company, indicating that the value of the ratings may be effectively meaningless.
Just one example: Bank of America earns a “below average” score from RepRisk while Sustainalytics, evaluating many of the same indicators, gave the bank a “well above average” score, according to the ACCF study. ESG industry researcher CSRHub found a weak correlation between the two firms’ ratings, an indication that the scores are subjective, not substantive.
ESG ratings agencies tend to favor global companies with robust reporting functions, regardless of a company’s actual practices or risk. Companies in the European Union, which mandates ESG reporting, score meaningfully better than their U.S.-based peers. Small and mid-sized American firms often receive lower scores because it’s more challenging for them to marshal limited resources for unnecessary ESG reporting to myriad ratings agencies. This hurts those companies, shareholders, and employees by deterring investment.
Nonetheless, investment decisions are increasingly driven by ESG concerns. The number of investment funds incorporating ESG criteria ballooned from 260 in 2007 to more than 1,000 in 2016, according to the Forum for Sustainable and Responsible Investment. More than 25 percent of the $88 trillion assets under management globally are now invested according to ESG standards.
A growing body of academic research is challenging claims that ESG investment strategies don’t reduce or lower the growth potential of shareholder returns. A study by Harvard University professor Joseph Kalt and Adel Turki released last month and published by the National Association of Manufacturers examined the expanded use of politically-charged proxy proposals on ESG issues. Companies that passed climate-related shareholder resolutions simply did not perform better based on market benchmarks, either in the short run or the long run.
The opaque, unfair state of the ESG industry has spurred investors and legislators to seek reform of corporate laws and regulations affecting socially conscious investment practices. At the very least, the SEC should adopt a recent Labor Department bulletin requiring fiduciaries to not “sacrifice investment returns, or reduce the security of plan benefits in order to promote collateral goals.” The Senate should also join the House in passing the Corporate Governance Reform and Transparency Act, which would establish basic transparency requirements for proxy firms that have pushed companies to enact ESG policies.
Jeff Patch is an analyst with Capital Policy Analytics.
