It’s time to focus on the “G” of ESG

Despite all the debate surrounding the use of ESG for investing, virtually no attention has been paid to a fundamental tension in the ESG policies of major investors and rating agencies – the mismatch between the “G” and the “E”. ” and the “. At shareholder meetings, major investors promoted shareholder primacy by further opening companies to the market for corporate control, imposing policy changes at the request of a momentary majority of shareholders, and aligning compensation of the management of the company on a single constituency – the shareholders – by linking it closely to the total return of the shares. These are not the fundamentals of long-term “sustainable” management. Investors need to address this mismatch by changing their activities at annual shareholder meetings.

The largest traditional institutional investors and the rating agencies that serve them now say they consider high-quality environmental, social and governance (“ESG”) practices by companies to be necessary for long-term sustainable wealth creation. term – a position that has generated academic results. and political controversy. But despite all the debate surrounding the use of ESG for investing, virtually no attention has been paid to a fundamental tension in the ESG policies of major investors and rating agencies – the mismatch between the “G” and the “ E” and the “S.”

In today’s parlance, ESG is shorthand for things like social responsibility, treating stakeholders well, not creating environmental harm. In other words, in the political debate, ESG is mainly about the “E” and the “S”. Until recently, environmental, social and social proposals at corporate meetings got little support from the asset managers of the “big three” (BlackRock, Vanguard and State Street) or others. traditional investors. Unlike the “E” and “S” Propositions, however, the “G” Corporate Propositions have long enjoyed strong support from institutional investors, including the Big Three. However, the impetus for these successful G-proposals has nothing to do with the environment or stakeholders like workers, or issues like gender or racial diversity. On the contrary, they have promoted shareholder primacy by making corporations more open to the market for corporate control, imposing policy changes at the behest of a momentary majority of shareholders, and aligning corporate management pay. business on a single constituency – the shareholders – linking it closely to total equity returns.

In fact, by the time the current focus on ESG emerged, the Big Three had already played a key role in driving a sharp drop in the incidence of classified advice and poison pills, turning the votes forbearance (a decision not to vote for an incumbent board member on management’s proxy) and annual votes on leveraged compensation for use by activist investors, and encouraging CEOs to lobby other stakeholders to generate immediate returns for investors. Suffice it to say that these market-based management arrangements are not what the public conceives of as the ESG agenda, which promotes sustainable wealth creation rather than short-term equity price extraction. Especially in the large-cap sector of the market that affects most investors, these G-moves have made companies more open to leadership changes that could upset long-term strategic plans, as companies lacked the ability to avoid an annual referendum in which company policies could be changed by a momentary majority.

Researchers question whether these types of direct-democratic approaches to corporate governance are beneficial or harmful to diversified and long-term investors. Some scholars have argued that greater market responsiveness for corporate control and activism benefits shareholders without long-term harm to the companies themselves or other stakeholders. Others see the results differently and believe that the gains from activism are fleeting and mainly involve transfers of value from workers, creditors and communities to investors in the short term, and that companies are often harmed in the long term. . As with the general debate on corporate purpose and ESG, we are not engaging in this showdown here.

Instead, we focus on something more indisputable that has been ignored. As the Big Three, other investors and advisors like ESG raters have emphasized sustainable wealth creation and more on E and S, their G policies have not changed. And these are the same G policies that have their origins in the desire of shareholder primacists to have companies focus more on returns for investors and to give investors the ability to act at any time to change the long-term focus of the business in order to pursue a short-term profit opportunity, such as selling the business, leveraging it, and distributing cash, or other strategies that often involve risk to others stakeholders and putting pressure on business costs in terms of regulatory compliance programs.

ESG requires a long-term commitment. Even large companies have years where they struggle, given the dynamics of the market. Persevering through difficult times may be what is needed to seek profits in an ethical and sustainable manner, as there may be situations (e.g., a pandemic) where it is necessary to cut a dividend to continue paying labor. work and comply with high consumer standards. and environmental protection in line with a well-thought-out business plan. As historians have noted, if Abraham Lincoln had faced an annual election, he likely would have been removed from office at the start of the Civil War instead of standing trial on his full record in 1864.

In our view, this disconnect between the stated ESG commitments of investment communities and their approach to corporate governance has two important policy implications. First, it is unclear whether the Big Three, other institutional investors, or ESG raters have reflected on this tension and considered whether their G policies should evolve accordingly. One could imagine a range of measured issues that would bring “G” back into ESG alignment, such as supporting companies that want to transition to the emerging model of a public benefit company that demands respectful treatment of all stakeholders, refusing to support restraint campaigns and demand activists to field real candidates, calling for executive compensation tied to ESG metrics and not just shareholder returns, scheduling quadrennial pay votes aligned with a reasonable timeline for compensation contracts leaders, and even rethinking general opposition to classified councils. For ESG assessors, there is an additional problem. Insofar as companies are credited with simply succeeding in reaching market G, is that clear? And how does that obscure and confuse the rating a company gets on the E and the S?

The second and most important policy implication of investors’ ESG mismatch is that the more companies are subject to constant plebiscites, the more institutional investors themselves must become gatekeepers to companies’ ability to implement sustainable strategies. and respectful of stakeholders to create sustainable wealth. Sustainable wealth creation is not produced by a proposal at an annual meeting; it takes patience, the willingness to overcome adversity during difficult times of change and unexpected headwinds, and to put the long term ahead of tempting, but reckless, short-term action. As we’ve seen in the year since the ESG-activist hedge fund’s success in electing nominees to Exxon Mobil’s board of directors from its own nominees, investor sentiment can be erratic with the pump inflation and other immediate economic disruptions that lead to fewer votes for shareholder proposals. to deal with climate change. And, given the intense pressures all institutional investors are under to generate immediate returns themselves and the collective pressures of short-term Morningstar ratings, a system of corporate governance that subjects companies to the constant threat of a immediate referendum and the use of speak-and-pay and other votes as means of expressing dismay at short-term earnings declines present a considerable consistency challenge for all institutional investors. And the overwhelming number of votes they must cast is particularly burdensome for institutional investors with more limited management resources – a phenomenon that increases the influence of proxy advisory firms – but also for the Big Three whose ability to management is outmatched by the number of votes they have. must launch each year.

A more tempered corporate governance system would still provide strong accountability to investors, while allowing companies reasonable space to balance the needs of all stakeholders and implement a sustainable plan for long-term growth. Such a system would also allow institutional investors to more effectively focus their limited stewardship resources by casting fewer, but more informed votes, guided by their stated intent to support the responsible wealth creation that American worker-investors need. At the very least, if big investors continue to adopt G policies that put market preferences above all else, these big investors must live up to their responsibility to maintain – every vote, every year, even when things are tough – sustainable corporate policies they say they embrace.

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