In the past year, ESG investing has become caught up in America’s culture wars, as prominent GOP politicians claim that it is a mechanism investors are using to impose a “woke” ideology on companies. Former Vice President Mike Pence has railed against ESG in speeches and in an op-ed. A variety of Republican governors and red-state legislatures are considering executive action and legislation to boycott asset managers that use ESG as a screening tool for their investments. And in Washington, various Congressional committees have pledged to hold hearings in which the Securities and Exchange Commission (SEC) and major asset managers will face public questioning about the legality of ESG investing.
As an attorney who is a lifelong Republican and a business professor who is a lifelong Democrat, we have been dismayed by the politicization of ESG investing, which until recently was a technical (but important) topic that rarely spilled outside of academic and investment communities. The upcoming congressional hearings on ESG present an opportunity to put facts on the record and to begin the process of working toward a bipartisan consensus that will take the political passion out of ESG. Far from enflaming passions, we hope that hearings will make ESG boring again.
The key will be returning ESG to its original and narrow intention — as a means for helping companies identify and communicate to investors the material long-term risks they face from ESG-related issues. Climate change is one such risk for many companies — particularly those with shoreline assets that are vulnerable to rising seas, or those (such as fossil-fuel companies) for whom future revenue would be greatly reduced if governments start taxing carbon. As a result, greenhouse gas emissions are a material issue for an oil and gas exploration company, as are air quality and employee health and safety. But according to the Sustainability Accounting Standards Board (SASB), which helps identify risks by industry, so are human rights and community relations and business-model resilience. Non-material issues include energy management, customer welfare, and systemic risk management.
As we have previously written, for markets to properly allocate capital, investors need companies to disclose material investment risks. To us, ESG is simply about identifying material risk factors that matter to company profitability and shareholder value over time.
Conservatives have been quick to complain that ESG has been stretched beyond this narrow purpose and is being used to promote a progressive political agenda. While some of their arguments may seem overheated, they are reacting to a real phenomenon. Indeed, many prominent liberal voices want to push sustainable investing further than traditional ESG investing allows. For instance, the NGO Fossil Free California is pushing for state legislation to force California pension funds CalPERS and CalSTRS to divest from fossil fuel companies, which both funds opposed last year. (The legislation was not enacted.) Another example is California legislation mandating a certain number of women on the board of directors, a law ultimately quashed by the courts. Investors, not politicians, should decide whether to invest in fossil fuels and whether they want to prioritize board diversity.
On a more technical level, there is debate within the ESG community about whether to extend ESG measurements to include not just the risks a company faces from ESG issues, but also account for the impact the company has on society and the wider world. Adding fuel to the rhetorical fire on both sides are companies and investors who claim too much for ESG with greenwashing claims of various kinds. Our hope is that by questioning ESG experts, the House committees will draw focus back on ESG’s original and important purpose.
Along with the committee hearings, there is legislation that might help clarify the definition of “ESG” investing: the “Mandatory Materiality Requirement Act of 2022,” which was introduced by Senator Mike Rounds (R–South Dakota) and seven other senators in September 2022. Companion legislation, H.R.9408 was introduced by Congressmen Bill Huizenga (R-Michigan) and Andy Barr (R-Kentucky) in December 2022. The purpose of these bills is “[t]o amend the Securities Act of 1933 to require that information required to be disclosed to the Securities and Exchange Commission by issuers be material to investors of those issuers, and for other purposes.” Although the SEC largely follows this materiality focus in connection with other disclosures, providing clarification would be useful.
This emphasis on materiality will also be useful in calming a current irritant in the ESG debate — the SEC’s proposed rule on climate related-risk disclosures for operating companies. In our view, critics of this rule on the left who want even more disclosure are ignoring the central tenet of materiality. Critics of this rule on the right are ignoring the fact that investors with trillions of dollars in assets under management, and which have a fiduciary duty to maximize long-term risk-adjusted returns, regard how a company is managing the effects of climate change to be a material issue.
In fact, many American companies are already making climate-related disclosures. As an example, consider ExxonMobil, which is aggressively investing in solutions to climate change. It reports on its carbon emissions, along with targets for reduction. Currently there are no requirements for it to do either. It also puts a diversity report in the public domain, again without being required to do so. Finally, it publishes a sustainability report—organized in terms of ESG. Chevron and ConocoPhillips are doing all of this as well.
A study by Governance & Accountability Institute, Inc. found that 96% of the S&P 500 and 81% of the Russell 1000 are producing such reports. The problem with these reports is that, in contrast to financial reporting, they are not based on a set of standards. This makes it difficult for investors to assess their validity and compare performance across different companies. However, progress is being made here through the creation of the International Sustainability Standards Board (ISSB). Its work is leveraging that of SASB, which is now part of the ISSB, to develop standards for material information as defined by the SEC and in the proposed legislation.
People ask us what we think the future is for ESG. In the near term, it is important to separate discussions about investors’ need for disclosures about material risk factors from debates about salient political issues. The pending House hearings could simply be political theater with the Republicans attacking Biden administration policy objectives and the Democrats defending them. Or they could be a learning opportunity to clarify what ESG is and what it isn’t. What it can do, what it can’t do, and what it isn’t supposed to do. How can this happen? By framing the hearings in terms of “materiality,” not “wokeness.”
Absent legislation, the role of Congress is to provide oversight of the rulemaking process as the SEC determines which risk factors are material to investors and balances the need for disclosure with the cost to companies of providing the information. The financial-disclosure framework established by Congress nearly nine decades ago has resulted in the greatest capital markets the world has ever seen. We believe that preserving and strengthening that framework should be a priority for policymakers on both sides of the aisle.