ESG Investing and Government Regulation

November 29, 2018

By: Daniel Stanley

Environmental, Social and Governance or ESG investing uses non-financial data to assess a company’s financial prospects. As an investment discipline it has steadily grown in popularity over the last decade[1]. ESG investors examine a company’s environmental, social, and corporate governance record to form a holistic conception of a company’s financial future. Although ESG investing is commonly perceived as a semi-philanthropic venture, in reality it is profit-driven. Sustainable and ethical actions are indicators of long-term profitability[2]. As a profitable practice, ESG investing needs no special encouragement to make investors embrace it; unlike philanthropy, it does not require sacrifice. The practice currently has some ambiguities and obstacles. ESG is difficult to quantify, and legal and cultural barriers hinder its further adoption.

ESG investing could become more profitable and widespread through targeted government regulation. The government need not be heavy handed and ESG investing could benefit greatly from clarifications regarding its implementation and legality. The most important thing to understand about ESG investing is its profitable nature. ESG investing operates within the traditional landscape of return-driven investment. It does not subordinate profits to social or environmental factors.

WHAT IS ESG INVESTING?

ESG investing is the inclusion of certain non-financial elements—such as a company’s sustainability and ethics record—into investment criteria. ‘Ethical investing’, ‘impact investing’, and ‘socially responsible investing’, which attempt to contribute to social change through financial action, often use ESG metrics to evaluate different companies. But ESG metrics are also useful for investors wholly concerned with the bottom line. Recent research indicates a relationship between a company’s long-term success and its ESG record[3]. ESG investing attempts to incorporate ethical and financial perspectives, two realms previously perceived as distinct. By combining these two perspectives, ESG investors attempt to gain a more holistic image of investment opportunities.

ESG investing has grown rapidly in recent years: in 2016, investors “consider[ed] environmental, social and governance (ESG) factors across $8.72 trillion of professionally managed assets, a 33 percent increase since 2014.”[4]

Some common factors ESG investors consider are:

*Environmental*	*Social*	*Governance*
Greenhouse gas emissions	Working conditions	Political lobbying
Deforestation	Impact on communities	Executive pay
Pollution	Animal welfare	Corruption
Resource depletion	Human rights	Tax strategy
Waste management	Hiring practices	Board composition

DEVELOPMENT OF ESG INVESTING

Governing one’s behavior within the market along moral lines is nothing new. For centuries, some groups sanctioned certain areas of the market as moral and immoral. Religious groups especially have defined what areas of the market are acceptable or unacceptable to finance[5]. Products, services, and business practices deemed sinful, such as alcohol, gambling, and usury, have been taboo for believers of some sects of Christianity and Islam[6]. By regulating the behavior of believers, religious leaders have attempted to make the market serve morality.

But ESG investing as a modern phenomenon is something different – for ESG investors, morality serves the market. The traditional view of the market defines it as an essentially morally-neutral zone, at least in theory. The market operates along a financial axis, not a moral one. People bring their moral perspectives with them, but morality itself is incapable of determining what is profitable. This view, propounded by economic luminaries like Milton Friedman, believes the market operates on the axis of profitability, which is independent of morality.

In recent years, changing circumstances have weakened the traditional view that profit is independent of morality. Overtly moral behaviors are now seen as essential drivers of profit. The rapid rise of ESG behaviors and investing has been due at least in part to:

Research showing a relationship between ESG and long-term profits
A more transparent market
A market more responsive to public opinion, made possible by new technology like the Internet
A public more aware of environmental, social, and ethical concerns in finance
Changing regulation that puts more emphasis on environmental effects

The rise of ESG now begs the question: what should the government’s role be in regulating this new/old phenomenon?

ETHICS OF ESG INVESTING

ESG investing rewards ethical behavior but does not view such behavior as inherently valuable. ESG investing is distinct from ethical investing. Ethical investing considers financial success separately from ethical success; it has two goals and is willing to sacrifice oneto serve the other. ESG investing has a single goal: profit. Encouraging a company’s ethical behavior is a means to that end; by linking ethical behavior to financial success, the ESG investor uses ethics to profit. The results of ESG investing—a healthier environment, robust social programs, principled corporate behavior—are beneficial, but peripheral, effects of profit-driven investing.

The difference between the ‘good’ (ethics) and the ‘useful’ (profit) is a much-discussed topic in moral philosophy. Immanuel Kant sharply divided the two, writing the useful effects of an action have no bearing upon its moral character; an action is moral only if it is undertaken solely out of respect for the moral law[7]. Morality is an end in itself, never the means to anything else.

If we were to apply Kant’s moral philosophy to investing, we would find that ESG investing is not moral because the investor acts out of concern for profit, not morality. If the investor were to act out of morality, he would be willing to sacrifice profits. This type of investing is more accurately named ethical investing or impact investing.

One should think of the morality of ESG factors like the morality of car safety features. Car manufacturers that provide good seatbelts, airbags, and crash mitigation do not act out of a sense of moral duty; they provide these features because they are selling points, because they decrease liability, because regulators force them to. In short, they do so because it is good business. The outcome is a clear positive: people are safer when they drive. But calling good business sense morality confuses and degrades morality. ESG investors have good business sense; moral character is sold separately.

ESG’s outcomes are positive, but because morality is just a means to the end of profit, ESG investing lacks morality. But because the end of ESG investing is the same as the end of the traditional capitalist, profit, ESG investing is attractive to a broader range of people than ethical investing. Investors can use ESG factors but not have social or environmental benefits as paramount goals. Thus, an industry giant like Goldman Sachs, a temple of capitalism, can engage in ESG investing without sacrificing its financial commitments. Goldman Sachs, which releases annual reports on its ESG behaviors[8], approaches its ESG investing “on an investment basis, not a philosophical one, and target[s] institutional grade, market rate of return investments”[9]. The lack of commitment to moral behavior, regardless of advantage, only contributes to ESG’s wider adoption.

Because ESG does not demand a commitment to morality for morality’s sake, the emerging popularity of ESG into the marketplace should not be envisioned as the intrusion of morality into a (wrongly) perceivedmoral-free zone. Rather, it is the expansion of what factors are regarded as financially relevant. The collateral results of ESG are beneficial, but the plain profitability is what allows it to function so well in the marketplace.

PROBLEMS FACING ESG

Three major problems limit the proliferation and effectiveness of ESG investing in the status quo:

Quantification
Profitability
Legality

Government regulation can alleviate each of these problems. In each case, the novelty of ESG investing has led to confusion over how it should be implemented. The government should provide clarity and a level playing field for this new investment strategy to flourish.

Quantification

The greatest challenge ESG investors face is the quantification of ESG. What factors make a company ESG? How should these factors be measured and weighed to make comparisons between companies possible? There are two problems in the quantification of ESG: information acquisition and analysis.

Regulations regarding ESG vary with locality, meaning companies lack a universal mandate to report ESG information. Whether companies have to disclose, and what they have to disclose, is different in different places. And the analysis of available information is exceedingly difficult. ESG factors are numerous and difficult to measure, and the financial sector lacks an objective metric with which to weigh ESG information. The dual problems of information acquisition and analysis limit investors’ ability to compare companies using ESG factors. Fortunately, clear and consistent government regulation could make ESG investing a more precise and profitable practice.

The first problem in ESG quantification is the lack of a universal mandate to report. Regulations mandating corporate disclosure of ESG information vary with location. Even when companies do disclose, the information they view as relevant varies: “Corporate disclosure regimes vary substantially in terms of what data must be reported and how it should be calculated. … [R]eporting requirements are usually voluntary … and are not prescriptive on the methods or metrics to be used. This means that data are incomplete and not directly comparable across companies, sectors and countries.”[10]

But even if the financial sector had all the information, rating and comparing companies using ESG metrics would still be a daunting task. ESG is so new that “there is no definitive terminology to describe the components of ESG and interpretations of ESG vary within the investment communities and across jurisdictions.”[11]Integration of ESG into investment decisions “is hampered by the lack of commonly-accepted analytical methods”[12]

Private ratings agencies currently provide metrics to compare companies, but they have their shortcomings. Environmental, social, and governance factors incorporate a vast range of issues, many of which are subjective or difficult to measure. As a result, “traditional ESG scores are broad, often aggregating hundreds of individual indicators into a single score, diluting financially material information”[13].

The lack of an objective means of analyzing ESG factors encourages “greenwashing”, falsely claiming a corporate behavior is ESG. Greenwashing “undermines investor confidence in the market for sustainable investments”[14]. In the same vein, some mutual funds have labelled themselves ‘socially responsible funds’, claiming to act more ethically than many of their competitors. However, the label ‘socially responsible’ has been “more of a marketing tool than a guarantee for complying with ethical principles”[15], as many such funds fail to differentiate themselves from the ethics of the market at large. As long as the market lacks the tools to recognize true ESG behaviors, investors will continue to be taken advantage of by false rhetoric.

What can government do to fix the problem?

The government can and should take steps to create and police a fair marketplace for ESG investing. Relevant information must be readily available and comparable across companies and national boundaries. Company and institutional investor claims of ESG status must be backed by specific practices and verifiable data. And investors must have an accurate, objective, standardized method of evaluating companies’ ESG factors. The government should provide a classificatory system for ESG investing, just as the USDA’s National Organic Program provides a set of “consistent, uniform standards”[16]for organic produce. Without clear and consistent systems, fraud and confusion inhibit the abilities of ESG investors to make informed decisions.

In March 2018, the European Commission adopted the “action plan on sustainable finance”, one of the main goals of which was the creation of “an EU-wide classification system or taxonomy to provide businesses and investors with a common language to identify what degree economic activities can be considered environmentally-sustainable”[17].

Corporate claims of ESG behaviors are not merely cosmetic; such behaviors are linked to long-term financial success, and investors make use of that fact. False claims of ESG behaviors are fraudulent attempts to exaggerate the value of a company and deceive investors. The government should stamp out such deception by providing an accurate and fair means of measuring corporate claims. Through regulation, governments should either create their own objective taxonomies, or encourage the private sector to do the same, and demand any company seeking to profit on the appearance of ESG backs its claims with evidence.

Profitability

The second major problem facing ESG investing is profitability. The issue is not ESG investing is unprofitable. The problem is perception. Confusion surrounds the definition, goals, and effects of ESG investing.

It is a myth that ESG trades off with profits. Numerous studies attest to a relationship between ESG behaviors and financial performance[18]. While ESG performance alone is not enough to determine a company’s financial future, ESG metrics are useful indicators of long-term viability.

Some of the reasons behind ESG profitability are:

Risk reduction[19]
- Physical risk directly affecting earnings
- Liability risk from compensation claims due to damages
- Transition risks from changes in policy, technology, and public opinion
Ethical corporate structures avoid scandals, corruption, and conflicts of interest
Better employee relations lead to better financial returns[20]

Considering these factors, and the wealth of data linking ESG with profits, the overall conclusion is: “ESG factors appear to have at best a positive relationship with corporate financial performance and at worst a neutral relationship”[21].

Nevertheless, many perceive ESG investing as antithetical to profits. This may be due in part to confusion as to what ESG investing is. ESG investing is commonly confused with ethical investing, impact investing, and socially responsible investing. These other types of investing attempt to generate both financial returns and social progress, incorporating financial and moral values. Morally-motivated investors are willing to accept lower returns in exchange for progress in their advocacy[22]. ESG investing carries no such trade-off[23]. In recent years, as ESG integration has grown more popular[24], asset managers have endorsed ESG as a method of attaining long-term investment success[25]. Retirement plans have served as the proving grounds of ESG integration: 30% of corporate plans incorporate ESG factors. Despite such growth, misconceptions remain prevalent.

What can government do?

Governments could help expunge some of the myths and confusion surrounding ESG investing by adopting the previously-mentioned taxonomic system. Providing more clarity as to what constitutes ESG and how it should be measured would end much of the confusion. Funding more academic research to strengthen the link between ESG and financial returns would also encourage further ESG investment.

Because ESG investing is a profitable venture, governments do not need to strongly push financiers in that direction. When the benefits become manifest, investors will naturally gravitate toward ESG awareness. The primary obstacle is uncertainty, which clarificatory regulation can help dispel.

Legal Obstacles

Finally, there is the legal issue. Here, government regulations themselves contribute to lack of progress in ESG investing. The government should remove the obstacles it has set up and dispel the inhibitory confusion surrounding the legality of ESG investing. The most significant step the government could take is re-clarification of the fiduciary duty.

The fiduciary duty, which only applies to some investors, includes a responsibility to act in the best interests of a fiduciary’s beneficiaries. Traditionally, fiduciaries have excluded ESG considerations from their investment calculus. This is due to the traditional perception of ESG factors as irrelevant, if not inimical, to financial returns. Now that ESG has been proven to be an indicator of financial returns, fiduciaries must re-evaluate their responsibilities.

The US Department of Labor has acknowledged that, in Interpretive Bulletins intended to clarify the responsibilities of fiduciaries, it “has unduly discouraged fiduciaries from considering ETIs [Economically Targeted Investments] and ESG factors”[26]. More recent Interpretive Bulletins, such as IB 2015-01, have sought to clarify that “ESG factors may have a direct relationship to the economic and financial value of [a retirement] plan’s investment. In such instances, the ESG issues are not merely collateral considerations or tie-breakers, but rather are proper components of the fiduciary’s primary analysis of the economic merits of competing investment choices”[27].

The adoption of ESG factors into a fiduciary’s investment calculus is not an intrusion of subjective ethical values into the investment process, but a financial strategy to enhance a fiduciary’s ability to act in the best interests of beneficiaries over the long-term. Government regulators should join the USDOL in explicitly allowing the integration of ESG factors into fiduciaries’ investment calculus.

The fact that “many institutional investors interpret regulatory frameworks as prohibiting the consideration of ESG factors in investment decisions”[28]demands government attention. Regulators do not need to mandate institutional investors report their ESG considerations. But the government should not be an obstacle to anyone seeking to integrate ESG factors into the investment process, in light of new data manifesting the profitability of such practices.

In addition, governments should protect shareholders’ ability to exert influence over company management. One of the primary methods of ESG investing is active shareholder engagement, whereby “investors use their ownership stake in a company to influence its strategy … [and] attempt to persuade management to adopt better ESG policies”[29]. Recent legislation limiting shareholder powers and corporate transparency restrict the ability of shareholders to encourage ESG practices from within the corporate system[30]. By giving fiduciaries and shareholders more leeway, the government can encourage the proliferation of ESG investing.

CONCLUSION

The greatest problems facing ESG are issues of clarity. The novel nature of this investment strategy leaves many questions unanswered, while a mostly unregulated market leaves investors vulnerable to doubt and exploitation.

The good news is ESG investing is profitable. That gives incentive for private individuals, corporations, and governments to assist in the development of ESG investing with capital, corporate reform, and targeted legislation. The creation of a universal taxonomy would allow investors to make smarter, better-informed decisions. As it becomes clearer ESG investing is conducive to financial returns, it will become more widely-adopted.

While ESG investing does not represent a willingness in investors to sacrifice profits for the sake of morality, it does represent an increasing awareness that the market will reward good behavior. This is no doubt comforting for free market capitalists. As moral philosophers throughout the ages have bemoaned, people pursue their self-interest more reliably than their moral codes.

[1]https://www.ussif.org/files/SIF_Trends_16_Executive_Summary(1).pdf

[2]https://www.oecd.org/finance/Investment-Governance-Integration-ESG-Factors.pdf

[3]https://www.oecd.org/finance/Investment-Governance-Integration-ESG-Factors.pdf

[4]https://www.ussif.org/files/SIF_Trends_16_Executive_Summary(1).pdf

[5]https://www.schroders.com/en/insights/global-investor-study/a-short-history-of-responsible-investing-300-0001/, https://www.investopedia.com/articles/07/islamic_investing.asp

[6]https://www.investopedia.com/terms/i/islamicbanking.asp, https://sourcebooks.fordham.edu/source/aquinas-usury.asp

[7]Kant, Immanuel. Groundwork of the Metaphysics of Morals. Revised Edition. Ed. Mary Gregor et al. Cambridge University Press. Cambridge, UK. 2012. Print.

[8]https://www.goldmansachs.com/citizenship/esg-reporting/historical-reports/

[9]https://www.gsam.com/content/gsam/us/en/institutions/strategies/explore-by-solution/esg-and-impact-investing.html#tabpanel_f9a0=dGFicGFuZWxfZjlhMF8xL3B1YmxpYy8x

[10]https://www.oecd.org/finance/Investment-Governance-Integration-ESG-Factors.pdfp 17

[11]https://www.oecd.org/finance/Investment-Governance-Integration-ESG-Factors.pdfp 14

[12]https://www.oecd.org/finance/Investment-Governance-Integration-ESG-Factors.pdfp 35

[13]http://www.robecosam.com/en/sustainability-insights/about-sustainability/smart-esg.jsp

[14]http://europa.eu/rapid/press-release_MEMO-18-3730_en.htm

[15]https://epub.uni-regensburg.de/28511/4/postprint.pdf

[16]https://www.ams.usda.gov/about-ams/programs-offices/national-organic-program

[17]http://europa.eu/rapid/press-release_MEMO-18-3730_en.htm

[18]https://www.oecd.org/finance/Investment-Governance-Integration-ESG-Factors.pdfp 30-1

[19]https://money.usnews.com/investing/investing-101/articles/2018-06-28/how-esg-investing-increases-risk-adjusted-returns