ESG: The Good, The Bad and The Ugly

ESG, or Environmental, Social, and Governance, is in part a new take on sustainable investing. ESG provides investors with the means to use non­financial metrics to value business entities. Like the classic spaghetti western film, “The Good, The Bad and The Ugly,” whose characters were hard to pin down, ESG has good, bad and ugly qualities in the eyes of many. Some companies have accepted ESG concepts and restructured their business models and how they use resources. Others have been less inclined to embrace ESG considerations. This article explores the current landscape and likely future use of ESG in the United States.

ESG appeared in the mid-2010s when the Obama administration issued guidance for public company boards in relation to their fiduciary duties. Prior to that, a board's primary – if not sole responsibility – was to maximize the value of the business and return to its shareholders. While some investors urged public boards to consider the impact of conflict minerals and "sin" products on society, the investment opportunities for those issues were few and far between. ESG expanded the idea of sustainable investing by including additional stakeholders such as employees, customers and community members.

On March 6, the U.S. Securities and Exchange Commission (SEC) adopted final rules in an effort to “enhance and standardize climate-related disclosures by public companies and in public offerings.” These regulations have led to lawsuits from both sides of the political aisle. Liberty Energy, Inc. convinced the Fifth Circuit to block temporarily the implementation of the new disclosure rules. Liberty Energy Inc. claimed that it and other companies subject to the new disclosure rules were already suffering irreparable harm by having to build up compliance programs to meet the new requirements.

Republican state attorneys general and trade groups that have filed suit, such as the U.S. Chamber of Commerce, seek to vacate the rules, arguing the SEC overstepped its authority by writing climate regulations and that complying with the regulations would drive up business costs.

On March 19, the SEC requested consolidation of nine cases filed in six different appellate courts challenging the rule from the U.S. Judicial Panel on Multidistrict Litigation. The Panel conducted a random draw to designate the U.S. Court of Appeals for the Eighth Circuit to review the consolidated cases. Despite the good ESG aims to bring, the inability of all parties involved to identify a neutral framework for developing ESG concepts has consequences that could be characterized as bad and ugly.

THE GOOD

Some companies using ESG principles have seen benefits such as:

• • Improvement of the bottom line
  • Improved relationships with stakeholders, who have better access to information on company activities and
  • Attraction of better talent as employees and partners.

Profitability can increase when a company receives fewer penalties from regulators for discrimination or wage-and-hour claims, environmental and other compliance issues. And better environmental and business practices can yield more revenue from the improved use of materials and more efficient business processes.

When the focus is on ESG metrics, a company will measure factors that it previously did not track and will create additional data from its processes. Better data can lead to better management decisions. A company will also have data that lenders, partners, customers and employees value, which can yield benefits by fostering better relationships with those stakeholders.

Companies that choose to implement ESG principles do not have to do so all at one time. They can begin with a deliberative process that:

• • Considers what ESG factors are most important to them and best align with their business objectives
  • Sets corresponding goals and
  • Establishes internal processes to measure progress towards those goals.

The market may then expect to see incremental improvements in the areas that are most relevant to the company and to its stakeholders. As an ESG measurement process matures, investors will be more sophisticated in their expectations.

Certain issues are, of course, more relevant to specific companies. For example, the reduction of the company's carbon footprint in use of fossil fuels is important to all businesses dependent upon the transportation industry.

THE BAD

ESG’s language, concepts and potential enforcement tools are evolving at an extraordinarily rapid pace in the United States, with some unintended consequences such as:

• • Difficulty keeping pace and tracking market expectations as concepts evolve
  • The possibility of inconsistent state and federal disclosure requirements and
  • The inability to determine costs and impacts of implementing ESG metrics.

Some companies have misread their customers’ concerns and focused on issues more relevant to their non-shareholder constituents.  Companies can face a backlash for the perception they have gone either too far in their pursuit of ESG objectives, or not far enough. It is a challenge to strike the right balance.  Focusing on ESG initiatives that align well with a company’s overall business objectives can address competing concerns.

ESG issues are not created equally for all companies. ESG considerations can be measured across many unequal topics. Some issues are evaluated scientifically or objectively, while others are evaluated subjectively. This can lead to an overall ESG rating score, for example, that by itself may not be meaningful.

THE UGLY

Negative tendencies sometimes associated with ESG include:

• • Litigation over allegations of greenwashing information to promote a more favorable image
  • Political or other pressures to make ESG-related decisions that may not align well with company objectives and
  • Lack of a standardized scoring system of vetted metrics.

Many countries have been working on ESG principles for years. These nations already have policies in place, or they are much further along than the United States in developing them. And the standards other countries use may not reflect the concepts and terminology found in a U.S.-led system.

CONCLUSION

As ESG concepts and scoring become more widespread, ESG metrics may become the norm for nonfinancial measurement and values. But ESG also faces backlash and political scrutiny that could potentially lead to a decrease in some ESG-related investments.

Consider the case of BlackRock, Inc., one of the largest publicly traded investment management firms in the United States. It has been a leader in the ESG movement. But BlackRock shifted its investment strategy from ESG terminology to "Transition Investing," emphasizing investments in clean energy and infrastructure to aid the transition from fossil fuels. BlackRock is betting on tangible climate change mitigation projects, which have attracted significant investment and interest, aligning with a broader trend towards decarbonization investments without the polarizing ESG label.

Companies throughout the supply chain are requiring data necessary to measure and manage various ESG-related metrics – not just large, publicly traded companies that are subject to the SEC’s new rule. This reality suggests that companies, which have not already done so, should start analyzing their activities and partners to anticipate and plan for likely pressures to adopt ESG-driven requirements or to report ESG-related information.

Please contact Mark Beutelschies, Alan Harrell, Asa Toney or any member of the Phelps ESG team if you have questions or need advice or guidance.