May 13, 2024

Is ESG a “must have” only in boom-times?

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Not so long ago, zeal for corporate action on ESG was skyrocketing. Now? Not so much. What happened? Many have attributed the decline in appetite for ESG to the politicization of ESG and particularly to ESG backlash. This paper from the Rock Center for Corporate governance at Stanford has another idea. Has “ESG enthusiasm” reached its expiration date or, as the paper posits, is it like an alligator Birkin bag, just a luxury—something to pursue only when you’re “feeling flush”? In economics, the authors explain, demand for most items declines as prices increase. Not so with luxury goods, where “a high price tag stimulates demand in part because of the social benefits the purchaser receives by signaling to others their ability to afford it.” Demand for luxury goods often rises and falls with the economy; when times are prosperous, demand for luxury goods increases and when money is tight, demand falls. In that light, a “case can be made,” the authors contend, “that ESG is a luxury good.”

The authors first observe that “enthusiasm for ESG has waned.” They base their observation on data such as net outflows from U.S.-based sustainability funds and declines in support for environmental- and social-related shareholder proposals.

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In consultant Semler Brossy’s report analyzing proxy results for 2023 among the S&P 500 and the Russell 3000, SB indicated that last year saw a decline in approval rates for E&S shareholder proposals. According to SB, in 2023, there were 258 social proposals and 106 environmental proposals submitted to shareholders for votes, but only five social proposals (2%) and two environmental proposals (2%) won majority support. Although the number of E&S proposals increased significantly in 2023, median support declined substantially from the prior year to 15% favorable vote for social proposals and 18% favorable vote for environmental proposals. By comparison, in 2022, there were 187 social proposals that received a 22% median favorable vote and 65 environmental proposals that received a 27% favorable vote. SB observed that the “vote outcomes continued the downward trend first observed in 2022.” (See this PubCo post.)

In 2022, BlackRock Investment Stewardship, reportedly the largest asset manager worldwide, also reported a decline in its support for E&S shareholder proposals, but attributed the decline to the nature of the proposals, not backlash or the economy. In this paper, BIS reported that, in 2021, it “supported 47% of environmental and social shareholder proposals,” but would support fewer proposals in 2022. According to BIS, climate-related shareholder proposals submitted in 2021 focused on “material business risks” or requested reports providing information that would be useful to investors to help them assess a company’s “ability to generate durable long-term value.” BIS considered these proposals “to be consistent with long-term value creation” and not undue constraints on management’s strategic efforts to create shareholder value. In the view of BIS, however, many of the proposals in 2022 were “unduly constraining on management or were overly prescriptive as to information sought or timeframes. Others failed to recognize the progress made such that companies had largely met the ask of the proposal.” In voting on behalf of its clients, BIS said that it “supported 24% of E&S shareholder proposals in the U.S. [in 2022], down from 43% [in 2021], reflecting how these factors made these proposals less supportable in the 2021-22 proxy year.” (See this PubCo post.)

The authors also point to a 60% decrease in the number of companies discussing ESG initiatives on earnings calls.

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As discussed in this article from the WSJ, The Latest Dirty Word in Corporate America: ESG, ESG backlash is driving many company executives to drop any reference to “ESG” and instead use terms like “sustainability” or “responsible business,” or opt for “green hushing” altogether. Citing an analysis from FactSet, the WSJ reported that, on “earnings calls, mentions of ESG rose steadily until 2021 and have declined since…. In the fourth quarter of 2021, 155 companies in the S&P 500 mentioned ESG initiatives; by the second quarter of 2023, that had fallen to 61 mentions.”

But are companies just turning down the volume while still pursuing the same aspirations or have they trimmed their objectives too? Is this just about soft-pedaling of terminology or is there some back-pedaling on programs too? According to a recent report by the advisory firm Teneo, the “recent politicization of ESG” is having an effect: in a survey of 260 global CEOs representing $3.4 trillion of combined company and portfolio value, results showed that “72% of CEOs polled are making one or more changes in how they operate in response to the shifting environment.” In the survey, 8% responded that they have ramped down some of their ESG-related programs; 28% said that they had become “more cautious” in their selection of ESG topics for engagement; another 28% reported that they were allocating more time and attention to ascertain which ESG topics were important to employees and customers; and 45% said that they were continuing to do what was right according to their beliefs, but discussing it less outside of the business. (See this PubCo post.) However, a January 2023 survey by The Conference Board of over 1,100 C-suite executives found that “most CEOs globally and in the US are not curtailing their sustainability-related investments due to ESG backlash.” Only about 17% in the U.S. were “proactively refining their priorities or realigning their focus to ensure their sustainability efforts remain effective and impactful.”

In addition, the authors point out, there has been a movement at the state level—sometimes referred to as “ESG backlash”—to limit the use of ESG criteria in pension-fund investing.

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As noted in the paper, state and local governments—wielding the levers of government—have begun to enact legislation or take executive action that targets companies that express public positions on sociopolitical issues or conduct their businesses in a manner disfavored by the government in power. As described by Bloomberg, while “companies usually faced mainly reputational damage for their social actions, politicians are increasingly eager to craft legislation that can be used as a cudgel against businesses that don’t share their social views.” And many of these actions are aimed, not just at expressed political positions, but rather at environmental and social measures that companies may view as strictly responsive to investor or employee concerns, shareholder proposals, current or anticipated governmental regulation, identified business risks or even business opportunities. According to Reuters, some “states have unleashed a policy push to punish Wall Street for taking stances on gun control, climate change, diversity and other social issues, in a warning for companies that have waded in to fractious social debates.” Some state officials accuse the targeted companies of “using the power of their capital to push their ideas and ideology down onto the rest of us.” These new prohibitions can create serious impediments to companies’ ability to conduct state business, implicating billions of dollars.

In May 2023, Reuters reported that, at that point, legislators had filed about 99 so-called “ESG backlash” bills compared with only 39 in 2022; as of April 3, they reported, “seven of the bills had been enacted into law, 20 were effectively dead, and 72 were still pending.” What were they about? A number of them were designed to protect fossil fuel companies from climate-related demands of various investment funds, while others related to “hot-button environmental, social and governance (ESG) topics like abortion rights and firearms.” (See this PubCo post.)

Some of these bills may meet resistance. As discussed in a business journal article from the Wharton School, academic research looked at the financial impact in one state of legislation aimed at prohibiting local jurisdictions from contracting with banks that had adopted policies against guns and fossil fuels. It turned out that the legislation may not necessarily have worked in the state’s economic best interest. As a result of the legislation, a number of major underwriters exited the state. By decreasing competition, the legislation increased the costs of borrowing, the research found. The research estimated that, for the “first eight months following effectiveness of the legislation, the cities in that state will pay an additional $303 million to $532 million in interest on $32 billion in bonds.” In this case, as it turned out, the law had “so many loopholes and exceptions” that, when the state began to ask financial institutions to describe their climate policies, several banks attempting to re-enter the market were able to say that their policies were in compliance. For example, one loophole noted by NPR allowed companies that wanted to continue to work in that state to “still avoid investing in fossil fuels as long as they are doing so for strictly financial, rather than ethical or environmental, reasons.” (See also this PubCo post.)

The authors acknowledge that it’s not known “[w]hether ESG has hit a cyclical peak or is in permanent decline.” They attribute this uncertainty in part to the absence of sophisticated independent empirical research regarding the economic consequences of ESG and to the “difficulties of measurement and establishing causality” in this context. Can observers determine if ESG investments “make companies more profitable, or are more profitable companies better positioned to invest in stakeholders”? Do ESG initiatives result in “higher and more sustainable long-term profits” or will a strict focus on increasing shareholder value—“to the extent it generates long- or short-term economic benefit”—be enough incentive, by itself, to invest in ESG ? Is ESG a ‘nice to have’ or a ‘must have’”? On balance, “is ESG a net contributor to financial performance, or a net cost? These are questions, the authors suggest, that are important for corporate directors deciding whether to give ESG initiatives the go-ahead. When pressure to undertake ESG initiatives was intense, the authors show that boards acted to support those initiatives. But now that demand is “in reverse, boards are left to consider what changes, if any, to make to these initiatives.”

The authors suggest that “[i]t bears considering how investors view the ESG characteristics of firms in their portfolio.” And that’s where the luxury goods analysis comes in. The authors find a correlation between the initial rise in ESG corporate commitments and investment in sustainability funds—when there was “economic prosperity, low inflation, and a strong bull market”—and today’s high inflation, high interest rates and economic pessimism—when the authors find “evidence that investors’ taste for environmental and social advocacy has waned considerably.” During that period of prosperity, the authors contend, “companies that were financially positioned to invest in stakeholder initiatives were rewarded for doing so through public recognition. Investors, too, who financially benefited from a bull market demonstrated their support for ESG by investing in sustainability funds.” But current “economic headwinds have scrambled the equation,” leading to the current decline.

As corroboration, the authors cite a Stanford survey, demonstrating a decline in young investors’ willingness to forfeit some of their investment savings to support ESG issues—from amenability to forego between 6% and 10% of their investment savings in 2022 to giving up only 1% to 5% in 2023. The survey also showed a decline in their serious concern for environmental issues of over 20 percentage points and for social issues of more than 10 percentage points. In the survey, only 52% of investors said they owned an ESG fund compared to 78% the prior year. The authors also report that investors have significantly lower expectations for stock market returns. A different survey demonstrated that institutional investors have receded in their commitment to ESG, with only 20% “explicitly consider[ing] ESG factors as central to an investment thesis,” and the

“vast majority consider[ing] ESG as part of a laundry list of factors. Furthermore, the list of ESG factors they do consider—with the exception of climate change—is dominated by traditional governance factors (such as the structure of the board, ownership structure, board diversity, and the quality of financial reporting) and not the environmental and social issues that more appropriately might be considered stakeholder-oriented….Illustrating just how much ESG has changed, 68 percent of institutional investors say governance is the most important aspect of ESG; only 2 percent say social factors are.”

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But, are ESG initiatives necessarily in decline on the corporate side? Some data from KPMG suggests otherwise. A 2024 global survey conducted by KPMG of 550 company directors and members of management showed that the vast majority of global organizations plan to increase spending on sustainability initiatives over the next three years. Why? KPMG’s US ESG Audit Leader told Bloomberg that the “key reason” at the moment for the increased interest in ESG “‘is really regulatory pressure.’ Regulations are forcing companies to ‘inject the same level of rigor into [their] sustainability reporting that is required of financial reporting….Historically, sustainability reporting has sat with a very small group of under-resourced people,’ [she said]. Now as requirements evolve, ‘the amount of effort and rigor that needs to go into reporting has changed substantially.’” But these expenditures are not designed purely for compliance, KPMG concluded; they are also considered “a valuable tool for enhancing financial performance both now and in the future.” In response to the survey, 90% of respondents reported that they expected to increase their ESG investments over the next three years, with 43% increasing expenditures on dedicated ESG personnel, 40% on ESG-specific software, 38% on employee training and education and 37% on data collection and management tools. About 32% planned to invest in external consulting or advisory services. (See this PubCo post.)

The authors observe that, if their analogy to luxury goods is apt and “demand for ESG follows the economic pattern of a luxury good”—that is, demand correlating to the economic cycle—then “boards will want to rethink how they plan, prioritize, and invest in ESG.” To that end, the authors advise, boards “will want to be more deliberate about the initiatives they support, prioritizing those with a clear link to the company’s business model.” But how do boards “determine what stakeholder initiatives are central to their business model,” the authors ask? The authors suggest that management should “be asked to justify—so that board members, in turn, can communicate to stakeholders—how each initiative contributes to the financial performance or risk reduction of the firm.” Consistent with the luxury goods model, the authors suggest that companies may decide to “increase investment in a broader set of initiatives” during periods of prosperity, but expect to “decrease these investments when times change.” That would include exercising greater selectivity and “prioritizing those with sound economic justification.” Nevertheless, they recommend, “the board will want to maintain investment in its core set of ESG initiatives through the business cycle. When stakeholder pressure is higher, the board will be able to point to the long-term investment it made and explain how these served the dual-purpose that ESG always purported to support, increasing both profits and social welfare.”

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.