Two bills surrounding environmental, social, and governance (ESG) criteria towards Kansas’s public investing and government activities – HB 2436 and SB 291 – have had hearings over the last few weeks. Specifically, provisions in these bills would prohibit decision-making based on ESG-criteria in government contracts, require KPERS to invest solely based on the return to pension participants instead of taking ESG into account, and restrict ESG criteria in state agencies, amongst other ideas. These bills are intended to lessen or even prevent the influence of ESG factors that range from environmental footprint to community relations instead of traditional criteria such as low-cost bid or return on investment.
Legislator concern over the lack of transparency and erosion of financial responsibility in ESG is well-founded, but the legislators supporting these bills should proceed carefully. It gets hard to differentiate which mandates should or should not be placed on the private sector by the government. Better to simply avoid mandates of most any sort instead of picking and choosing as political winds blow.
ESG was first used in 2006 in a United Nations’ Principles for Responsible Investment report, and over the past decade and a half, has become an umbrella term to denote “socially responsible” investing. McKinsey, a global consulting behemoth, defines their ESG efforts as follows:
- Environmental – Mainly around energy sources and their consequences, like carbon emissions or contributions to climate change, as well as factors like pollution
- Social – The relationship that the company has with its community, including “labor relations and diversity and inclusion.”
- Governance – The company’s internal decision-making and culture: what values it supports, how it responds to stakeholder interest, and its legal compliance.
Currently, ESG ratings function like a credit score, as investment firms like MSCI weigh a company’s ESG value based on a variety of factors. These range from energy consumption to planned “phase-outs” of fossil fuels, from worker safety to community relations, and from diversity to executive compensation. On average, institutional investors – such as larger Wall Street firms – spend $487,000 a year on external help for calculating these ratings alone. These ratings differ across different private entities’ own analyses — displaying a wide range of what factors are included and how they are weighed. Unsurprisingly, they are highly subjective and prone to favoritism or error.
Half of the companies rated by MSCI were upgraded in ESG rank without substantial change to their daily operations such as a reduction in their carbon footprint. Instead, the changes amounted to methodological changes by the rated companies such as surveying a firm’s employees. Companies often attempt to game the system by doing the bare minimum instead of meeting expectations like reducing carbon output. An MIT study found that there was only a 61% correlation between different ESG ranking agencies such as Moody’s, MSCI, and S&P Global, whereas the credit score correlation between Moody’s and S&P was 99%. Never mind what is promised by a private company to achieve some ESG score versus what is actually delivered by the company when it comes time to change business practices. Essentially, (ESG) talk is often cheap.
For instance, the cigarette company Phillip Morris is part of the Dow Jones Sustainability Index – the top 10% of the 2,5000 companies in the S&P Global Market Index based on ESG factors – despite the fact that the tobacco goods they produce are the subject of “Merchant of Death” satire that ESG proponents revel in. Similarly, Exxon and BP, two oil companies that activists argue are the face of global warming and thus should receive a low rating, are both ranked BBB — that’s the middle of the pack in terms of ESG-investing firms. If two companies expected to be at the bottom of ESG rankings can “public relate” their way into a favorable position in the rankings, it calls Into question the validity of the metrics.
These highly arbitrary ESG ratings are even more unfair since the publicly traded products they “score” are completely legal and, very often, heavily regulatedESG becomes a new form of regulation not by the government, but by a new “bureaucracy” made up of non-elected investment bankers picking and choosing winners based on their own metrics. Investors and shareholders have the freedom to invest in what they please, but ESG creates situations in which partner companies and shareholders are forced to invest or divest just to meet a new nonlegal standard.
According to the Harvard Business Review, as of December 2021, investment funds with low ESG scores financially outperformed those with high scores. They also found that the companies in the ESG portfolios had worse compliance records for both labor and environmental rules and did not subsequently improve compliance with labor or environmental regulations. The poor track record of ESG raises red flags to investors – especially those that are made via public pensions. It also once again calls into question why firms are pursuing ESG scores. Could it be they trying to paper over their labor or environmental issues with a PR campaign instead of actually being good actors? If we’re interested in protecting the retirements of Kansas teachers or firefighters investments should be oriented towards giving public enrollees the maximum financial benefit.
Legislators, companies, and everyday shareholders and investors are right in demanding that the “new status quo” of ESG in investing be more transparent. The goals of ESG are too often used as an excuse for the fact that inefficient, nontransparent market activity is occurring that threatens the security of corporations’ stock and state pensions.
Addressing these transparency issues is not easy though. KPERS testimony on SB 291 warned that the state could lose $3.6 billion over 10 years because they argue that legislation would disqualify current investment managers and would require restructuring of the portfolio. That seems as much a scare tactic as anything else. The definition of “fiduciary” may need to change so that any divestment, if any is needed, is done in an orderly way. It’s important for KPERS to bring up this concern and the legislature can adjust as needed.
ESG has become something of a political football. The key will be to craft carefully-worded policies that focus on substance instead of a headline. Any policy should leave private investors and businesses free to pursue their own interests free from mandates and ensure taxpayer money is invested with an eye solely focused on the bottom line.