Greenwashing – The Problem with ESG

Last week I had the good fortune to be invited to an event at the Burridge Center for Finance at the Leeds School of Business on the subject of sustainable investing. Presenters included Professors Asaf Bernstein & Simona Abis, and Angela Bricmont the Chief of Finance for Denver Water, which provides service to 1 in 4 people in Colorado. They all give separate talks, two reflecting research on the domain of ESG* disclosure and regulations, one reflecting the basic day-to-day practices in a public utility and how disclosure regulations can increase transparency but at the cost of additional burdens.

*ESG stands for “Environmental, Social, Governance” and typically reflects a somewhat progressive or otherwise liberal focus on investment topics. As we’ll discuss later, however, there are some problems with that assumption.

To me, perhaps the most interesting element of the presentations lay in their overlap. Professor Bernstein served at the SEC recently, working on a model ESG disclosure rule that, with the latest presidential administration, is expected to die either revoked or otherwise unenforced for the time being. The primary focus of the disclosure rule was not to increase reporting burdens on publicly traded companies or securities issuers (whether primary securities or products) but to increase transparency in the companies. I asked during the Q&A portion whether the focus was on creating a normative definition of ESG and what metrics matter to its consideration, and Dr. Asaf stated that the focus was more about requiring issuers and product companies to disclose what they meant when they claimed ESG practices.

I can see the realpolitik in that course of action and answer because, as the late Charlie Munger once put it: “Show me the incentives, and I’ll tell you the outcome.” When rules in the securities regulatory world are written with clear bright-line tests, what often results is compliance to the letter of the regulation, if not, perhaps, the spirit of the regulation. Thus, by leaving it more open-ended in asking issuers to clarify their ESG activities and intentions in their own words, it removes the opportunity for those issuers to simply comply to the minimum standard with normative requirements and instead places the burden on them to substantiate: “Here’s what you said you’re doing, here’s what you’re actually doing. Do those things align?” This has also been a preferred approach by the SEC to regulation over the years, in which it often presents a principles-based guideline or rule, and then engages in aggressive enforcement against firms it feels violate the vague notions of that rule.

But, herein becomes my question of the day: Securities regulation, despite a reputation for being generally vague and principles-based rather than bright-line oriented (for the aforementioned reasons), is generally about protecting the public. Requiring that adequate disclosure and information be made available so that a sufficiently interested and educated party can parse the available data to select investments and investment products that align with their goals, whether that be profit maximization or a hybrid of impact and return. But in a world where there is essentially no regulation of the term ESG, companies will happily engage in “Greenwashing” to attract investors, the same way that many companies engage in Pride-washing during Pride in June or other forms of cultural pandering as a form of marketing.

The need for this type of disclosure transparency was well-highlighted by Dr. Abis’ study, which found that while more and more firms and assets under management are being labeled with ESG language, whether in title or in the prospectus data for investment products, the applied practice of the vast majority of ESG fund managers is not to maximize impact, but simply to include ESG factors in their analysis in the pursuit of increasing returns. Not a bad use of the data, mind you, but perhaps not the intent of those seeking ESG-type investments.

So, other than the impending death of the model ESG rule Professor Bernstein worked so hard on, what’s the big deal? Well, let me present you with a hypothetical.

Think Horses, Not Zebras

Imagine an investment fund family is run with a focus on Evangelical Christian religious views. It establishes an ESG mutual fund and decides to invest in an oil and gas company. You might raise an eyebrow, given the earlier description of ESG. Does this hypothetical oil and gas company really pass muster? Well, let me present an argument that it could.

Let’s say the oil and gas company has invested heavily in developing fossil fuel infrastructure (e.g. delivery systems, pipelines, gas stations, etc.) in a developing African nation. A primary source of energy and heat in many developing countries is the use of waste, animal or human, which are burned as fuel to produce heat. The burning of mammalian waste is not only very toxic to those who do it, but also harmful to the environment. Thus, the ESG fund in question ascertains that the oil and gas company’s investment in this 3^rd world country is not only environmentally preferable to the continued burning of mammalian waste, but also advances the social and economic interests of the locals. Perhaps the company also donates heavily to Christian religious charities and has a board of directors that is largely patriarchal in nature, mirroring the religious and cultural preferences of many conservative Evangelical Christian religious communities.

So, has the investment fund violated the “purpose” of ESG? Or are they fully in compliance with the letter, if perhaps not the spirit, of the concept as others might see it? For example, if you surveyed random pedestrians on the Pearl Street Mall as to whether they think investing in a Fossil Fuel company supports ESG goals, they’d probably tell you no. Yet, unless an investor has done an appropriate level of due diligence on an ESG fund, they might accept ESG in the name or in the basic description of the fund as sufficient cause to believe that they are investing in a fund that aligns with their politics, morals, or values. They might think it’s sufficient to think that when you read ESG, you should think of progressive horses, not convoluted zebras. Yet, both regulations on ESG as it stands today and even as proposed likely do not satisfactorily distinguish these issues.

The Convoluted Definition of “Good” and Investing

Another term similar to ESG that has a slightly longer history is “SRI,” or “socially responsible investment.” This idea emerged well back into the 18^th century when religious groups regularly advocated for their adherents not to invest in things ranging from slavery to alcohol. These principles have come and gone and changed group by group, but perhaps it wouldn’t surprise you to learn that, just as with the given ESG example before, SRI has had trouble being well-defined over the years. One group of Orthodox Jews might find SRI to mean avoiding investing in non-Kosher activities or those that contradict their religious worldview, while another group might find that SRI means boycotting, divesting, and sanctioning Israel for its human rights record. Rather contradictory points of view for what is ostensibly supposed to be “the same thing,” no?

So, what do labels like ESG and SRI mean? Fundamentally? Nothing. The problem with either term and terms like them is that they are non-specific and principles-based. A company like State Street can simultaneously release an ETF like SHE, which only invests in women-led companies, and also be sued for pay discrimination against women in its workforce. Any company can create just about any product and come up with a rational argument as to why it adheres to some arbitrary standard of ESG investing. Even those who claim to do so solely for return reasons can establish their own definitions, and those who do invest for impact get to decide what kind of impact they’re looking to make.

What’s a better way to avoid Greenwashing?

I’m far from an expert in this area, but I raised the question I asked Dr. Bernstein as a hint toward what I think would be a better way to avoid greenwashing. Go ahead and create bright-line definitions for ESG, and create a different term for alternative “philosophies.” If investors want ESG investments, they deserve a clear enough disclosure and framework to not need to read to the 195^th page of a 300-page investment report to figure out what the definition of “is” is.

In turn, there’s nothing wrong with creating a term for something like “principles-based investing,” in which the fund can define what principles or variables matter to it and use those to inform exactly how they’ll invest on a going basis. But, the current “confusion in the marketplace” around a term like ESG is exactly what regulation around clear and transparent disclosure is supposed to solve. I perhaps differ in the opinion that it should be sufficient that a fund has to self-disclose what it’s actually doing, and that it should have to adhere to something a bit more clear when it seeks to take advantage of the marketability of something like the term ESG when their endeavors clearly wouldn’t meet the threshold definition that someone with a passion for the subject might seek.

In this regard, perhaps the Certified B Corp provides a good role model. While there are plenty of areas for improvement in the B Corp certification process and how they define eligible companies and their activity, what’s most important from a position of public trust and confidence in the certification is that there is a uniform definition of “the good” the certification represents. Nothing stops someone else from inventing a “Certified A-for-Awesome Corp” designation to mean something else similar but different; but in the marketplace and in a world in which everyone is reliant on signals to ascertain the underlying meaning of something, and where satisficing is a normal behavior for individuals to make decisions with, a deep disclosure approach seems less valuable than a basic “words have to mean something” consumer disclosure approach.