by Aegis J. Frumento, Partner, Stern Tannenbaum & Bell
A few weeks ago, SEC Commissioner Hester Peirce bemoaned the labeling of public companies on environmental, social and governance (ESG) issues before a pro-business crowd at the American Enterprise Institute. https://www.sec.gov/news/speech/speech-peirce-061819. She used Nathaniel Hawthorne's classic The Scarlet Letter to make her point, riffing off the name she shares with the novel's heroine, Hester Prynne. Peirce told her audience that uptight social activists are now forcing corporations to wear ESG labels the same way Hester Prynne was forced to wear her scarlet letter. It is, she claims, as unfair for corporations to be subjected to such public "shaming" as it was for Hester Prynne to be forced to wear her "A."
Uhh . . . no.
For starters, let's get the novel right.
First, Peirce said that Hester Prynne's embroidered "A" "was affixed without taking into account the full character of the woman who was forced to wear it." "The community's morality police . . . did not consider whether a measure of mercy might be appropriate." Not quite right. Hester was made to wear the "A" solely because she was an adulteress, which she absolutely, positively was. And Hester did in fact get off easy. "At the very least, they should have put the brand of a hot iron on Hester Prynne's forehead," said one of the bystanders on hearing the judgment. Another upped the stakes: "This woman . . . ought to die. Is there not law for it?" Yes, there was. The Massachusetts Bay Colony's Code of 1647, the country's first set of codified laws, lists adultery as the 9th "Capital Lawe": "If any person commit ADULTERIE with a married or espoused wife; the Adulterer & Adulteresse shall surely be put to death." See https://oll.libertyfund.org/pages/1647-laws-and-liberties-of-massachusetts.
Second, Peirce said that the scarlet letter was not appropriate because Hester was misunderstood, as her later acts of charity proved. That's not right either. The scarlet letter was supposed to subdue Hester into contrite conformity to the community's Puritan norms, but it didn't work. Hester, in her ostracism, came to realize that her moralistic society was built on paternalism and the subjugation of women (reread Chapter 13, if you don't believe me). The Scarlet Letter may well be the first in the line of feminist literature that leads directly to The Handmaid's Tale. "The scarlet letter had not done its office," wrote Hawthorne. Instead of piety, Hester's introspection spurred her to become the empathetic consoler of her neighbors who came under public approbation for falling from grace, and especially women. They eventually forgot the letter's original meaning. "They said it meant Able; so strong was Hester Prynne, with a woman's strength."
So, The Scarlet Letter is not about unfair shaming. It is about insight and transformation. Hester Prynne redefined the scarlet letter into a symbol of resistance. She wore it as a badge of honor long after any officials would have required her to, and when she died it was emblazoned on her tombstone.
It is not likely that ESG labels will perform anything like Hester's scarlet letter. As Peirce pointed out, ESG labels are so variable in their messages that they are essentially meaningless. See also https://www.wsj.com/articles/why-its-so-hard-to-be-an-ethical-investor-1535799601. That rather disqualifies them from being a universal brand of shame. It also renders them quite impotent as instruments of corporate cultural change.
Let's first draw a distinction between ESG grades and so-called "impact investing." The latter just means preferring to invest in companies that are active in certain businesses deemed socially "better" than others, like alternative energy or microfinance -- or cannabis. That, to me, is just a species of sector investing. It is important in its own right. Recently, a billion-dollar Verizon "green bond" was 8 times oversubscribed. https://www.ft.com/content/7d64d1d8-91a6-11e9-b7ea-60e35ef678d2. But that's not really part of the ESG discussion.
ESG investing is the steering of capital to support companies, in any industry, that exhibit, by some definition or another, good corporate citizenship. And as Peirce acknowledged, that has become very relevant. According to a recent Morningstar report, a full 72% of investors say ESG issues are important to their decisions. https://www.cnbc.com/2019/04/22/socially-responsible-investing-is-not-exclusive-domain-of-millennials.html. Peirce admits that a bad ESG score will cause a stock to fall, which automatically tells you that ESG is "material" to investment decisions. From all indications, ESG will become even more material when men's wealth passes on to women and millennials, as it inevitably will.
But the fundamental problem is that we don't really know what it means to be a good corporate citizen in the 21st Century. It is not radical to say that large corporations have community responsibilities like the rest of us. Because of their power and influence, they have even greater responsibilities. Nor is it radical to accuse corporations of not taking those responsibilities seriously when they only focus on quarterly earnings and share prices. Yet, we are still evolving a common understanding of how a corporation should otherwise behave. Indeed, we may never have a fully common understanding; hell, we don't even have a common understanding of good citizenship in real people. Too much subjectivity goes into the calculus.
Investment advisers and investors, unable (or unwilling) to figure out what good corporate citizenship means to them, have outsourced to task to a half-dozen rating services. They operate under an illusion those raters can grade companies on ESG issues the same way S&P or Moody's can rate creditworthiness. They assume that by relying on ratings, their job is done. But, as one commentator put it, ESG ratings "are no more than a series of judgments by the scoring companies about what matters -- and investors who blindly follow their scores are buying into those opinions, mostly without even knowing what they are." https://www.wsj.com/articles/is-tesla-or-exxon-more-sustainable-it-depends-whom-you-ask-1537199931. For example, ESG scorers would generally rate a company's carbon footprint by looking at its manufacturing plants. By that measure Tesla would have a mediocre rating; it only improves when you include the carbon footprint of its cars. But you'd have to know something about both Tesla and the scoring criteria to understand that. If you don't, even an Exxon may score higher.
Nor is there much clarity whether an ESG focus makes for better or worse investment results (that is, profits). A leading ESG scoring firm asserts the companies it scores high on ESG criteria outperform. https://www.msci.com/esg-ratings. Another analysis says this is an illusion, that stocks hammered by poor ESG ratings actually perform better (coal companies are supposedly up 20%), simply because they've been brought down so low everything looks up. https://www.wsj.com/articles/if-you-want-to-do-good-expect-to-do-badly-1530185698?mod=article_inline. To suppose that ESG concerns are material is not to say that they trump profitability.
I personally think this is a tempest in a teapot, and that Peirce was merely throwing red meat to a pro-business crowd. After all, it's not like she provided any suggestions for solving anything. When all is said, her speech amounted to one long woe-is-me.
Which is maybe all ESG labels deserve. They only provide one datapoint in the investment decision. It's up to investors to understand what they mean, just as they should understand a company's products, its sources of revenues and the quality of its earnings. Investors -- be they individuals or institutions -- who overly credit facile scores when they choose investments are as misguided -- and lazy -- as they who think they can choose a college based only on U.S. News rankings. The ingredients of good citizenship, corporate and otherwise, are too varied, too complex, and ultimately too subjective to be captured in a simple score.
ESG labels shame no one. Nor are they likely to force a change in the corporate culture. Should that ever come, it will have been because we, as investors, consumers, venders, employees, regulators, activists, and otherwise denizens of the corporate milieu, demand it. Until then, ESG labels are just colorful ornaments -- more scarlet begonias than scarlet letters, but still with a touch of the blues.
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