Despite the ubiquity of the acronym, it is not always clear what fits under the umbrella term of ESG. Often used interchangeably with ‘green’ investing, environmental, social, and governance (ESG) covers everything from lobbying disclosures to affirmative action policies for firms.
While these ESG policies are often subjective and political, proponents tend to claim that they are an objective lens to value firms and allocate investments. The evidence for this claim is weak, however.
For many activist investors and politically-motivated institutional investors, investment performance may not be the main priority. ESG can be used to provide activist investors a framework to reshape how finance and investing relate to business into something that better conforms with their visions of the world. There are generally two approaches for these groups: divestment and/or engagement.
The theory behind divestment is that by selling or avoiding the purchase of so-called ‘bad’ companies and industries, these firms and industries will be punished with a higher cost of capital. The cost of capital is the required rate of return or profit a firm must earn on capital investments to satisfy its owners and creditors. Companies can raise capital from equity by selling ownership or debt by taking a loan from a creditor. A higher cost of capital reduces the number of new investment opportunities available to a business.
The latest Global Sustainable Investment Alliance report put ESG investments at 36% of all managed assets. According to the Global Fossil Fuel Divestment Commitments Database, 1,556 institutions have now divested from fossil fuels. These institutions include Harvard and Oxford Universities, several New York City pension funds, and the Norwegian Sovereign Wealth Fund.
The actual impact of these divestment strategies is not clear. The cost of capital in the oil and gas industry has declined over the past decade, which is in line with the general decline in the total market. Conversely, the cost of capital did jump considerably in the green and renewable energy industry in 2021, but there is a fair amount of volatility across all sectors year-to-year.
Examining the impact of divestment, Jonathan Berk and Jules H. van Binsbergen, professors from Stanford's Graduate School of Business and the University of Pennsylvania's Wharton School, respectively, were not able to find a meaningful impact of ESG investing on capital costs within the energy markets. "When calibrated to current data, we demonstrate that the impact on the cost of capital is too small to meaningfully affect real investment decisions," Berk and Binsbergen write. Instead, the authors suggest socially conscious investors should focus on changing corporate policy.
Changing corporate policy through shareholder influence and proposals is the engagement side of environmental, social, and governance strategies. Publicly traded companies hold annual shareholder meetings in which shareholders can vote on various proposals in proxy voting. ESG proposals in proxy votes are increasingly common and supported by large asset managers.
One of the better-known examples of engagement occurred in 2021 in association with the oil company Exxon Mobil. A green activist hedge fund, Engine No. 1, which says it seeks "to create value by helping companies transform their businesses to be sustainable," gained support from asset managers, including BlackRock, Vanguard, and State Street, and elected three supported directors to Exxon's board. Four directors were nominated by Engine No. 1.
However, this election was not an isolated occurrence. According to Morningstar, an investment research and management services firm, there were 273 ESG shareholder proposals in 2022. Notably, the number of proposals that pass has steadily increased over the last three years. Twenty resolutions passed in 2020, 36 passed in 2021, and 40 passed in 2022.
The support for these resolutions is highest with institutional investors, particularly public pension funds. While general shareholders supported 63% of ESG resolutions, according to Morningstar, public pension funds supported 90%—which was even higher than the rate of ESG-focused funds. The Teachers Insurance and Annuity Association of America (TIAA) supported 92%, BlackRock supported 74%, and State Street supported 66%. Vanguard was the only asset manager of the "big three" to support ESG shareholder resolutions less than the general shareholder, voting in favor of 51% of proposals, Morningstar found.
Unfortunately, there are no standardized disclosures or reporting for public pension proxy votes. Morningstar looked at 65 public pensions but could only locate records for 34 (29 were included in its analysis). Only one-third of these public pension plans had their records available online. Six percent charged a fee to provide their proxy-voting records, and five percent declined to give them. The lack of reporting on proxy votes among public pension systems should be viewed as a red flag suggesting these funds may be avoiding transparency and accountability.
While the actual impact of divestment strategies appears tenuous, there are an increasing number of ESG shareholder resolutions with considerable support from institutional investors, particularly public pension funds.
It is inappropriate for public entities to engage in political, non-pecuniary investment activities, regardless of whether it occurs through divestment or shareholder proposals. Public pension plans have a duty to base their investment decisions on pecuniary factors, such as investment performance and financial risk. Reason Foundation's Pension Integrity Project recommends that policymakers help prevent politically-driven investing and proxy voting by public pension systems by allowing the public to view all of the system's proxy votes well in advance of them being cast, as well as by requiring an annual report showing all of a public pension plan's proxy votes.
To serve the public workers relying on public pensions and to protect taxpayers, who are ultimately liable for paying for them, there must be complete transparency and appropriate rationales for proxy votes and divestment decisions made by public pension systems.
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