As we continue here at the CMFA to span the globe to cover the ever increasing growth of ESG (Environmental, Social, and Governance)-related financial regulatory issues, I’m reminded of my favorite part of watching live sports: being part of a crowd. The energy inside the stadium is never more electric than when something great happens for your team. At times like those—a walk-off home run or a last-second field goal—announcers often fall back on the tried-and-true statement: “And the crowd goes wild!”
It’s a little less dramatic than sports competition, but ESG—the acronym for “environmental, social, and governance” that captures a host of often undefined concepts—is having a bit of a “and the crowd goes wild” moment. ESG funds received about $51 billion from investors in 2020, more than double the amount invested in 2019 and representing about a quarter of the money flowing into all U.S. funds. Whether this is a short-term trend or a lasting shift in investment behavior remains to be seen, but there’s no denying the current interest in ESG.
Those who want public companies to be required to disclose ESG information point to this investment behavior as a sign that the “crowd” agrees. During his confirmation hearing, SEC Chairman Gary Gensler cited the “tens of trillions of dollars in assets” as proof that investors “really want to see” climate risk disclosure, which is part of the “E” in “ESG.” SEC Commissioners Lee and Crenshaw also have both pointed to investor demand as supporting SEC efforts to mandate ESG-related disclosure. But do we understand this “investor demand?”
Even if we assume that investor demand by itself justifies mandated disclosure—putting aside legitimate questions about the SEC’s authority to require ESG-related disclosures and whether requiring such disclosures is a good policy—it’s clear that we know far less about “investor demand” than the headlines, or some SEC Commissioners, might suggest. In fact, we seem to understand little about both “investors” and what they are “demanding.”
First, the common refrain that “investors are demanding ESG disclosures” fails to address who those investors are. Investors, of course, are not a monolith, but the conclusions drawn from empirical research in the space often treat them as such. That research tends to ignore individual investors and focuses on professional investors, including many who themselves offer ESG-related products. That research also has largely been conducted by organizations, such as Blackrock, Ernst & Young, and Natixis, that themselves have an interest in the promotion of ESG.
The emphasis on investment professionals is certainly warranted as they are an important constituency to understand. Many of these professionals are making decisions that affect individual investors through mutual funds, ETFs, or the direct management of retirement assets. But even where fiduciary duties are supposed to ensure that these professionals are acting in their clients’ interests, Wall Street and Main Street may not necessarily see eye to eye. While surveys generally show professional investor interest in ESG, few have asked about individual investors. Those that have found that individual investors show only some interest in ESG investing, which largely disappears during economic stress, and individual investors broadly view ESG disclosures as irrelevant when making investment decisions. It's a stretch, then, to say that investor interest in ESG issues applies uniformly to different investor types.
Proponents of mandatory disclosure point to the money flowing to ESG funds as evidence that disclosures are widely demanded. But one does not follow from the other. These inflows say more about professional investor behavior than individual behavior, shedding little light on the issue described above. But, moreover, inflows say little about whether investors view the information provided through voluntary disclosures to be inadequate. In fact, an increase in ESG fund investment may suggest investor confidence in the status quo.
Inflows themselves are also likely the result of more than just financial considerations. In other words, putting money into an ESG fund may be more than just an investment decision. Some research suggests that people derive utility from investing “responsibly,” separate and apart from any financial reward. This is not particularly surprising, given the nature of many of the issues wrapped up in the ESG moniker. It is likely that the utility gained varies considerably by age, occupation, political leaning, and other factors, but survey data exploring such non-financial preferences does not exist. The fact that there is an ongoing debate about whether ESG-friendly investments financially outperform investments where ESG factors are not a consideration supports a theory that those putting money into ESG funds are motivated by something other than returns. Indeed, some researchers have found that “E and S are compatible with noise” when assessing their relevance to investment portfolios, meaning investors are likely exhibiting non-financial preferences when assessing E and S factors.
Calls for ESG data and ESG action have come from many corners, including activists, employees, suppliers, and state governments, and those putting money into ESG funds may be motivated in part by their views and goals as members of society separate and apart from seeking a return on capital. These non-financial motivations weaken the case for the SEC’s involvement, as the agency’s mission is to protect investors and facilitate capital formation.
Second, even if we understood who the investors are, there is little clarity on what they are “demanding.” While investors shouldn’t be expected to be able to articulate their disclosure needs with precision, there is little consensus about what information should be subject to mandatory disclosure. Studies in this space often ask questions about “ESG” generally—an exceedingly vague categorization—and their results offer little in terms of what information may be useful to investors. A Schroders report notes that “[k]eeping details, definitions and methodologies vague [has] allowed investors to infer their own expectations of what constitutes sustainability.” This vagueness has resulted in an eclectic mix of strategies and products being described as “sustainable,” and it complicates attempts to determine what information may be of interest to investors.
But even in more specific areas of ESG disclosure, like climate change, it is unclear what investors purportedly want to be disclosed. Compared to some ESG categories, climate change is better defined and has a longer history of attention in securities markets. Indeed, the SEC first produced guidance in 2010 about companies’ disclosure obligations relating to climate change. Yet, a look through the comment letters that the SEC received in response to its request for public input on climate change disclosures shows a wide variety of requests, many of which are not compatible with each other. An alphabet soup of competing disclosure frameworks (TCFD, SASB, CDSB, etc.) produce different types of information using different methods, and little research examines which investors prefer.
The myriad of ESG ratings also demonstrates how subjective beliefs factor into the demand for ESG information. ESG rating frameworks are often the result of specific circumstances and backgrounds of the organizations’ founders, and it is not unreasonable to believe that investors similarly have heterogeneous preferences in ESG-related disclosures. These diverse preferences are not themselves problematic; in fact, they represent the complex reality of the issues involved in the ESG discussion. This underscores just how important it is to not paint “demand” with broad brushstrokes.
Rather than pinpointing the information being demanded, we might look at how the information is being used to understand demand. But this also fails to generate clear results. As some researchers have admitted, “[l]ittle is known about how investors use ESG information.” Research in this area falls prey to the same problems identified above–surveys tend to focus on a subset of professional investors—but even among professional investors, ESG data is used in many different ways.
ESG factors are often used to screen investments (i.e., choosing whether to invest or not simply on the basis of some ESG factor). Many ESG screening strategies have little to do with climate risk and most social issues and instead aim to avoid “sin” industries like alcohol, tobacco, and gambling. ESG factors may also be “fully integrated” into investment analysis, which vaguely implies that ESG factors are weighed along with financial considerations in making an investment decision. But how professional investors integrate ESG into their analysis varies widely. One study of mainstream investment professionals found that only 11 percent of investors use ESG data for risk analysis. Yet, the same study found that 42 percent of investors claim to take ESG factors into account to improve portfolio performance. And some surveys have found that governance, rather than “E” or “S” factors, are the most impactful for investment decisions. The uses for, or interest in, ESG data may also vary depending on industry-specific circumstances. And for investors who look to ESG disclosures and initiatives as a signal of a firm’s good health, mandatory disclosures may be contrary to an investor’s demand for information. It’s difficult to make heads or tails out of a lot of this research other than to say, broadly, that people are interested in ESG-related issues, but there isn’t a clear use to guide demand for disclosure.
More generally, research attempting to gauge investor demand is also complicated by investor views on financial materiality. One study suggests that 82 percent of investors that incorporate ESG data believe it to be financial material. But given the existing requirements to disclose financially material information, including the SEC’s 2010 climate guidance, it is not clear that investors are demanding something more. If investors are demanding something more, it may be because they have a conception of materiality that is different from the traditional one employed in U.S. securities laws. Some investors point to growing client and stakeholder demand as reasons for using ESG data, but this conception is more in line with the European “double materiality” standard, which takes into account a company’s environmental and social impact. Rather than pushing what may be substantial and costly changes to the U.S. securities disclosure regime, the SEC must first understand more about what information investors may find useful.
If proponents of mandatory ESG disclosures want to rely on “investor demand” to justify new regulation, the SEC first should understand more about that demand. The SEC’s request for public input on climate change disclosures may have been an attempt to do just that; but turning to comment letters will provide little clarity about the views of the crowd on mandatory disclosures. Professional investor views will be disproportionately represented, and even among them, there’s little consensus in the responses on a desired outcome. The SEC expects to propose a climate change disclosure rule in October 2021, but it should not do so when little is understood about what it is that investors are purportedly demanding. Failing to understand demand will compound the problems faced by the SEC when considering less easily quantified social factors, which loom on its agenda.
Here, where members of the crowd may be cheering for different teams or not even watching the same sport, the market is well equipped to respond when the crowd goes wild. Crowdsourcing demand from diverse market participants is a market specialty, and the proliferation and ubiquity of voluntary ESG disclosures shows that public companies are being responsive to the interests and demands of their constituencies. Mandating ESG disclosures, where there is little to guide the precision necessary for an effective and useful disclosure regime, is not the answer.