Socially Responsible Investing in the United States: The Need for Government Standards — COLUMBIA POLITICAL REVIEW (2024)

Sustainability is the hottest buzzword on Wall Street. So hot that BlackRock CEO and Chairman Larry Fink repeated it 15 times in his 2021 letter to business leaders. At first glance, it's refreshing, even hopeful to see such a momentous push in finance to value sustainable practices that consider a firm’s impact on their social and environmental circ*mstances. In a time when existential issues such as climate change, race and gender discrimination, and human rights, among many others, seem only to be escalating, an all-hands-on-deck approach with sustainable finance as a key component is a necessity.

From a marketing standpoint, attaching the term ‘sustainability’ to any product is a no-brainer in order to capitalize on the trend toward social responsibility. A 2016 Morgan Stanley report found that 94% of US investors, and 84% of millennials, the incoming generation of investors, have expressed interest in sustainable investing.

However, much like the unregulated use of ‘organic’ and ‘natural’ food labeling in the 70s and 80s before the FDA wrangled in the food industry with labeling standard criteria, sustainability in the finance sector is experiencing a crisis of integrity. Armed with a relatively novel and nebulous claim, American firms get away with calling their financial products ‘sustainable’ or ‘socially responsible’ without having to substantiate their claim. Asset managers label funds and portfolios as ‘ESG’ to signal a consideration for environmental, social, and governance factors in their investment decisions and strategies. ESG metrics form a framework for analyzing companies on how they impact the broader society, balance sheets aside. Attempting to measure the rather intangible concept of sustainability, ESG metrics in the US can consider a wide range of factors such as accountability in company management, carbon emissions, or diversity of board composition – virtually any signal of a firm’s internal or external environmental or social impact.

You may be more familiar with the terms social-impact, socially responsible, or impact investing – all expressions gesturing to the same notion of sustainability in investing. But if you’re still confused about what ESG really means, you’re not alone: both investors and firms have made it clear that sustainable investing is experiencing a crisis of definition in the US. The startling lack of government regulation has left companies to their own devices to report and define what sustainability means with little-to-no accountability or public input.

How ESG frameworks Have Evolved in the United States

ESG frameworks are used by investors and asset managers to signal a commitment to a sustainable business approach. Most commonly, asset managers such as BlackRock who package and sell financial products like funds and portfolios, market certain funds as ESG funds, citing a myriad of metrics considered in the investment composition. Asset managers and other ESG rating companies take a range of approaches when creating these products. Three prominent techniques are (1) exclusionary, where firms exclude certain so-called ‘sinful’ investments such as weapons manufacturers, tobacco, etc., (2) single-theme, which focuses on a single metric such as gender diversity or carbon footprint, and (3) best in class, which considers how a firm compares to its competitors.

To fill the void left by the lack of government oversight, NGOs have formed to work at setting independent standards for ESG reporting and labeling. The Global Reporting Initiative, the Sustainability Accounting Standards Board (SASB), and the Task Force on Climate-Related Financial Disclosures (TCFD) are among the many groups attempting to establish common frameworks and language for firms to disclose against and prove some level of external accountability. The extent of this multifarious NGO endeavor is limited by its voluntary nature, and has resulted in a confusing, ineffective, and overlapping patchwork of acronyms.

Correlating ESG Compliance and Business Success

First coined in a 2005 study, “Who Cares Wins,” the term ESG marked a change from seeing socially responsible investing as solely ethical to having financial significance. Although studies have been fairly inconclusive as to the merits of the correlation of ESG integration into business practice with financial returns, Harvard Business School professor George Serafeim found that such considerations can create value and long-term resilience. This notion has been echoed by BlackRock, who claims that “ESG-friendly portfolios could be more resilient in downturns” and that “climate risk is investment risk.” The possibility for the alignment of financial and societal benefit via ESG investment is certainly tantalizing.

A 2017 report by ESG rating group MSCI, a financial group that provides ESG analytics, found that companies in the bottom 10% of ESG ratings were much more prone to a significant crash in share price from an incident affecting their business. Several case studies also support the use of ESG factors as a measure of quality. In one instance, Equifax’s ESG score was downgraded by Morgan Stanley Capital International (MSCI) 18 months before their data breach, which crashed stock value. In a similar case, BP was downgraded over maintenance concerns before the Deepwater Horizon Oil Spill in 2010. Tying ESG factors to financial resilience and returns is an important step to incorporating ESGs into an economic structure governed by fiduciary duty and risk-return analysis.

ESG funds have been wildly successful in the past year. In 2020 alone, $51 billion of new money flowed into ESG funds – double the influx seen in 2019, according to Morningstar. Supported by a growing number of investors citing ESG impact as a central goal of their investment strategy, 75% of ESG funds outpaced the average return of a fund’s broader category, and funds such as iShares Global Clean Energy and KraneShares MSCI China Environment Index doubled in 2020. As ESGs grow in popularity, the need for oversight and consideration of public interest becomes increasingly pressing.

Problems with ESG Integrity

Not to anyone’s surprise, letting corporate interests decide what sustainability means has led some to question the integrity of ESG claims. The US government’s laissez-faire approach to ESG markets has created the rise in ‘greenwashing,’ a phenomenon where firms market financial products as having ESG components when in reality, such metrics are not substantively considered. Greenwashing allows firms to profit off of the idea of sustainability, while only committing themselves to superficial indicators of social responsibility.

In the US, for example, eight of the ten largest US ESG funds are invested in oil and gas firms. BlackRock, which has been a leading force in bringing ESG metrics to the mainstream, manages a fund that claims a composition of investments with “positive environmental, social and governance characteristics,” but includes Exxon, a company that is being sued for allegations of misleading investors about how it considered climate change regulations. Another case of greenwashing is Vanguard Group’s fund which claims it excludes firms with “significant controversies regarding environmental pollution or severe damage to ecosystems,” yet includes Occidental Petroleum Corp., which settled a suit for contaminating the Peruvian Amazon in 2015. It’s clear that when corporations get to define sustainability, they do it on their own terms with little regard for the integrity of the labels they employ.

European ESG Regulation

Recognizing the fiduciary impact of ESG factors on investment performance as well as the opportunity for investment alignment with societal goals, the European Union (EU) assembled an independent task force to put together a report in 2018 on legislative proposals addressing the lack of standardization in sustainable finance. What ensued was the EU Action Plan for financing sustainable growth which is set to be fully implemented by 2022. The Action Plan aims to regulate against three goals: (1) reorient the flow of money towards sustainable investments, (2) mainstream sustainability into risk management, and (3) foster transparency and prioritize long-term strategy. According to the UN Principles for Responsible Investing (UNPRI), the EU effort is one of the first serious endeavors to regulate a disclosure requirement against a sustainability target – in this case, the EU’s commitment to reach net-zero carbon emissions by 2050.

Several components of the Action Plan have already been implemented, such as the Non-Financial Reporting Directive (NFRD), which requires public-interest firms that employ more than 500 workers to publish data relevant to ESG factors in their management reports. Companies who deem themselves out of scope must publish a defense of why they do not consider ESG factors. The Plan also includes a taxonomy of standards and labels that provides a common language and classification of ESG criteria aiming to define ‘sustainability’ and ‘good’. The taxonomy enumerates six environmental objectives including a transition to a circular economy and climate change mitigation. Assertions of sustainability must be backed up with proof of a substantial contribution to at least one of these environmental objectives on top of not harming any of the other five. While the taxonomy mainly focuses on the “E” of ESG, it does include a social component with required adherence to minimum safeguards laid out by the Organization for Economic Cooperation and Development guidelines on multinational enterprises and UN guiding principles on business and human rights.

In March 2021, the newest component of the Plan – the Sustainable Finance Disclosure Regulation (SFDR) – went into effect. This disclosure regulation requires the same firms under the NFRD to publish environmental and social harm associated with their investment strategies and decisions on their websites. The UNPRI predicts the SFDR will decarbonize high-carbon sectors and encourage growth in low-carbon sectors. The EU plans to continue expanding the Plan’s regulatory framework with a report in December 2021 on the extension of the taxonomy into social objectives.

The Future of ESG Investing in the US

While the freedom to set the rules has been profitable for American firms, the absence of US regulation has become a burden for investors and companies. Moody’s, one of the biggest American credit rating agencies, has been vocal about the “lack of standardization of definitions and process” that is impeding ESG growth. And in 2020, the US Securities and Exchange Commission (SEC) Investor Advisory Committee recommended that “the SEC ... take control of ESG disclosure for the US capital markets before other jurisdictions impose disclosure regimes on US Issuers and investors alike.” Currently, they noted, investors are forced to “rely on third party ESG data providers, which may not always be reliable.” Without a required standardized reporting framework, a group of academics and financial reform activists petitioned, “voluntary ESG disclosure is episodic, incomplete, incomparable, and inconsistent.”

For example, MSCI gives Tesla a top ESG score in the car manufacturing industry, while FTSE gives them the worst. The inconsistency arises in the different approaches taken by the two ESG rating agencies – MSCI measures carbon emitted by product, and FTSE by carbon emitted by factories. As ESG criteria become increasingly prominent in the US and global economies, the SEC has failed to keep up and respond to any calls for regulation. In fact, under the Trump administration in 2020, the Department of Labor released a rule requiring that retirement fund plans only consider financial, not ESG metrics for stocks and bonds. The Biden administration flagged the rule, prompting many to predict that the president plans to strike it down in the coming months.

We are at a critical stage in the integration of ESG metrics into the global economy where corporations and organizations are generating the common language and frameworks for what social impact means. The fact of the matter is that one in every three dollars of American assets under professional management utilizes environmental, social, and governance criteria. If the government continues to ignore the need for consistent metics and language for quantifying, measuring, disclosing ESG factors, public interest will not be accounted for as the economy shifts in this new direction.

The Biden administration’s SEC staff picks seem to signal a deviation from the laissez-faire precedent. The National Law Review expects SEC Chairman nominee Gary Gensler to take up the issue of ESG reporting. And while Gensler has not been outspoken on the subject, John Coates, senior advisor for climate and ESG matters for the SEC, recently said that the agency “should help lead” the creation of a corporate disclosure system for ESG criteria. If Biden’s SEC approaches ESG regulation like Congress’s response to the organic movement’s self-regulation struggle in the 90s, sustainable investment might just nudge the US economy in a highly unusual direction – aligning Wall Street and the public interest.

Carmen Vintro is a sophom*ore studying English with minors in philosophy and economics at Barnard. She is a self-described library-enthusiast and adores chatting with strangers at coffee shops.