As Gary Gensler takes the helm at the Securities and Exchange Commission (SEC), he’ll face decisions on a raft of high-profile issues—including cryptocurrency, the Archegos meltdown, and the GameStop short squeeze. But he may have to put them aside a bit to address environmental, social, and governance (ESG) activism. The feel-good era of ESG investing may be yielding to a more strident era of government-pressured disclosure and validation concerning ESG claims.
To date, many of those claims have received little scrutiny from regulators. Asset management firms already have a responsibility to make disclosures in line with the SEC’s climate change rules adopted in 2010. But more recently, interim agency head Allison Herren Lee set the SEC on a collision course with the ESG movement, just as Gensler’s nomination moved forward. In March the agency announced the formation of a Climate and ESG Task Force within the Division of Enforcement to “proactively identify ESG-related misconduct.” That’s a big deal, because when regulators identify “misconduct,” fines and other punishments often follow.
The most prominent topic under the ESG umbrella is climate change. The SEC’s existing rules on climate-related disclosures for public companies initially had the agency taking no position on climate science. As stated in a January 2010 press release: “We are not opining on whether the world’s climate is changing, at what pace it might be changing, or due to what causes. Nothing that the Commission does today should be construed as weighing in on those topics.”
Today, the SEC appears to have left that cautious approach behind. In a speech to a prominent progressive think tank in March, Commissioner Lee told her audience that “climate and ESG are front and center for the SEC” and that that climate policy should be an issue not just for the Environmental Protection Agency but for the Treasury Department, the SEC, and other agencies, as well.
Ironically, this new emphasis may pose a problem for those working in ESG investing. One of the most common refrains about ESG—besides a confident agreement that it’s growing in popularity—is the confusion arising from disagreements over how environmental commitments, much less all other aspects of ESG, should be measured and verified.
Even the finance and research firms being paid significant fees for ratings and analytics by even larger asset management firms have not arrived at a clear, consistent way to produce data to evaluate ESG policies and investment strategies.
For instance, a 2019 study from three professors affiliated with MIT’s Sloan School of Management found widespread lack of agreement among rating firms when it came to ESG criteria. Not only could they not agree on how to score a company’s environmental or labor rights records—an inherently subjective enterprise requiring value judgments—they frequently couldn’t even agree on factual questions like whether a firm had the same person acting as both CEO and chairman of the board.
Another study from January 2020, from the consulting firm Research Affiliates, found that “ESG ratings vary markedly by ESG ratings provider,” so “the differences in how ratings providers calculate ESG scores can result in the same company being ranked quite highly by one provider and quite poorly by another.”
Stepping into all this is a newly energized SEC that, in Lee’s words, wants to create and enforce “a comprehensive ESG disclosure framework.” This will require the commission to make determinations among the competing strategies of various firms, inevitably invalidating some—if not all—of them. That means significant risk exposure to government enforcement actions and private litigation over whether firms have been using the “right” definition of ESG, and whether their public claims to investing in virtue pass the new government-mandated tests.
It’s not just progressive-minded regulators like Lee who are open to stricter adjudication of ESG topics. Besides requiring disclosure of factors like climate-related investment risks, the agency also makes determinations about how financial products are named, launched, and marketed. Even Commissioner Elad Roisman, who has expressed skepticism about some aspects of ESG theory, suggested last year that he would support greater scrutiny of marketing claims by financial firms: “It would make sense to me that asset managers who want to use these terms [such as ‘ESG,’ ‘green,’ and ‘sustainable’] to name their funds or advertise their products should be required to explain to investors what they mean.”
The SEC pivoting toward a stricter approach may well cause both investment firms and public companies to become more conservative about ESG claims going forward. Many voices in the investing world have pointed out that if ESG metrics are to be of real use, they need to more universal and verifiable. In the short term, at least, erecting new legal risks for companies who do it the “wrong” way will likely make firms more reluctant to take on these issues at all.
Richard Morrison is a research fellow at the Competitive Enterprise Institute.
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