ESG Investing and the Use of ‘Risk’

‘Socially conscious” investors have long claimed that Environmental, Social, and Governance (ESG) investing is an effective means of managing risk. The theory is that companies in compliance with popular views on, say, climate change, are less likely to face legal ramifications or other adverse effects to their businesses. But as regulators and politicians pay closer attention to the wave of ESG investing and the dubious claims that go with it, the case for ESG as a way to reduce risk is unraveling.

The Department of Labor recently proposed a rule that requires pension-fund managers to select investments “based solely on financial considerations,” effectively repudiating the claim that ESG investing maximizes portfolio returns. Elsewhere, Securities and Exchange Commissioner Hester Peirce has been calling for more oversight of ESG-marketed funds. Among the issues one would expect regulators to examine is whether these ESG-friendly funds truly reduce risk in the way that is often claimed. Take the example provided by California utilities company PG&E, once in the vanguard for public advocacy of green causes. Sustainalytics, an ESG rating firm, put PG&E in the top 10 percent of similar companies for environmental factors in November 2018, and at one point PG&E was held by 3.7 percent of ESG funds. Once PG&E went under, the financial media featured numerous postmortems asking some variation of the question, “Wait, I thought this was supposed to avoid risk?”

The problem is that there are risks, and there are risks. The risk that PG&E may have been trying to reduce was that supposedly arising from climate change, but while it was focused on that, it seems to have been negligent (criminally, in fact) about the basics, like not having its equipment starting massive fires. PG&E has spent much of the last decade incessantly pandering to climate activists — supporting legislation mandating emission caps, focusing on renewable resources to generate power, and minimizing their own greenhouse-gas emissions. But those investing in PG&E thinking that this made it a generally less risky company have been badly disappointed.

Having steered the corporate world into alignment on climate change, activist investors are now looking to replicate that success with abortion. Recently, a group of investors managing over $230 billion in assets wrote a letter addressed to major corporations inquiring about their position on “abortion and contraception.” This is part of a broader campaign by left-wing corporate-activist group As You Sow to draft the corporate world into their war against restrictions on abortion. Abortion was not a common topic for shareholder resolutions until quite recently. That seems to be changing, but it is one thing to honestly urge a corporation to oppose restrictions on abortion as a political choice, yet quite another to pretend that this has anything to do with “risk,” even if the nature of this issue means that activists don’t have much choice in the matter. A company may be wary of taking an openly political stance, but if the matter can be sold as a matter of risk avoidance, that is an entirely different question.

After Georgia, Indiana, and Alabama passed laws applying restrictions on abortion, As You Sow shareholder resolutions implicitly alleging that abortion is bad for business. After Alabama passed its abortion ban, corporate managers from 180 companies including Twitter and Bloomberg signed a letter for the “Don’t Ban Equality” campaign stating that restricting abortion “goes against our values and is bad for business.” The modest restrictions on abortion signed into law in Georgia prompted Netflix to threaten a flat-out boycott of the state, while other high-profile entertainment companies “voiced concerns.” The message was clear: Attempts to protect the unborn would be met with financial punishment.

Late in 2019, As You Sow proposed a shareholder resolution requesting that the insurance company Progressive issue a report evaluating the “risks” of pro-life legislation at the state level. In support of the resolution, As You Sow cited two studies. The first “estimated that denying female employees full coverage of contraceptives increases unexpected pregnancies and terminations and increases employer costs associated with employee absenteeism, decreased productivity, employee replacement, maternity leave, and sick leave.”

The second study cited by As You Sow was more revealing. It found that “nearly one in three millennial workers has turned down a job offer due to insufficient health insurance.” The conclusion drawn by As You Sow?  “Progressive may find it difficult to recruit the highest quality employees within states viewed as inhospitable to women’s reproductive rights; this may harm Progressive’s ability to meet diversity and inclusion goals, with negative consequences to brand and reputation.” To make the link from the general (Millennials turning down jobs because of insufficient health care) to a specific point about lack of health care in one area — reproductive rights — is a stretch, but to go on to say that this will allegedly lead to damage to reputation, is to stretch a stretch, and reveals yet again how “risk avoidance” is being used as a cover for the pursuit of an ideological objective.

But when a study is inevitably produced that alleges some risk of investing in a state that protects life, management is now under pressure to demonstrate what it is doing to avoid that “risk.” Managements are, of course, obligated to be faithful stewards of their investors’ money. A few questions might then occur to the reasonable observer: Were the shareholders who wrote that resolution motivated by a genuine desire to keep the company out of a risky situation, or were they just using their vote to advance their ideology rather than the interests of other shareholders or the company as a whole? Was the study conducted in a neutral, non-partisan way? Did the internal research team in charge of that study make any effort to promote the ideological diversity essential to come to a balanced, reasonable conclusion?

The central conceit of ESG investing is that investors who follow its precepts will do well by doing good. ESG is, so the argument runs, a conduit to sustainable investing, and within that word sustainable — a word with many implications — there is an implication of risk reduction. But we have no reason to believe that the definitions of risk used by activist groups are based on any sort of neutral assessment. In fact, we have abundant reason to believe the opposite.

A left-wing agenda is being sold to corporations and to shareholders, in part as a form of risk reduction, of which the claims over abortion are only one example. But in an age when ESG investing is coming under more political scrutiny, these claims of risk will need to stand up, at least if those signing up for them wish to be seen to be above the political fray. And that is before we consider the extent to which companies adopting political agendas could find themselves under legal and regulatory attack for breach of the fiduciary obligation they owe their shareholders. The same can also be true of the duty owed by asset managers that have embraced ESG as a principle in running of all their active funds, as opposed to those sold specifically on the basis of their “social responsibility.”

If there is still a case for ESG as an effective form of risk management, it is weakening by the day.