Jeff Meli: Welcome to the Flip Side. I’m Jeff Meli, the Head of Research at Barclays, and I am joined today by Marie Freier, the Global Head of Cross Asset ESG Research. Thanks for joining me, Marie.

Marie: Thanks for having me, Jeff.

Jeff: Now today we are going to talk about the state of ESG investing, particularly here in the US. Because of recent market and political volatility, I think this is a great time to raise this topic.

Marie: I agree, and I have actually been quite encouraged by recent political and regulatory developments, especially those that have incorporated ESG themes and concerns, with regards to climate. I think that these developments show that the ESG movement is gaining momentum, and is actually starting to have an effect also on companies, in part through integration into the formal frameworks – our systems of rules, that determine their operating environment.

Jeff: Well Marie, I also see resistance building to this movement, as you call it; and I’m not sure what the net effect will be, but I do think that this resistance will become more entrenched as the trade offs associated with ESG become more apparent, and I suspect that much of the momentum will prove to be short-lived.

Marie: Well, it’s probably worth level setting a bit up front. So as we know ESG is a framework that is designed to consider environmental, social and governance issues as part of investment analysis, to gain a fuller understanding of a company. Risks associated with these themes are often consolidated into ESG scores or ratings, and there are third party providers of these, and many investors create their own as well. These ESG ratings measure financially relevant sector-specific ESG risks a company is exposed to and, in tandem, ESG investors are increasingly also considering the environmental or societal impact a company is in turn, having through its economic activity – what we call dual materiality.

Jeff: The idea of ESG investing is that you consider these issues when structuring a portfolio. And I think an important question is: to what end should do you consider these issues? I would summarize the goal as trying to influence companies to change their business practices: if investment dollars flow more easily to companies that better manage risks the ESG risks, particularly those that are relevant to society, such as reducing their carbon footprint, then companies will make changes to better attract those investment dollars.

Marie: You know Jeff, interestingly in Europe this is not a controversial concept or topic: virtually any asset manager needs to have an approach to ESG in order to attract or retain AUM – it’s really a commercial necessity now. This reflects a fundamental shift in the expectations from many end-investors – so they want their funds invested in a way that takes into consideration these factors, not least because they believe it will lead to higher returns.

Jeff: This has been slower to catch on in the US Marie, and in part because of scepticism about that last point that you just made – that this framework will lead to higher returns rather than lower returns. I’m sceptical about this myself: I don’t think investors need a new framework to take seriously issues that are truly financially relevant and lead to better returns. That’s what they do already. If you actually convince companies to incur costs or limit revenues in order to improve their ESG score, doesn’t that almost by definition actually reduce returns?

Marie: We can probably debate the benefits or motivations to improve ESG scores, presumably not as an end in itself, but investors and companies have a pro-active role to play in considering changing information and anticipating resulting changes in their operating environment.

Jeff: Well I agree with that sentiment Marie, however I think that considering changing information or anticipating changes to an operating environment, is really just another way of saying ‘running a business’, I’m not sure what’s different here?

Marie: Yeah, or maybe even ‘running a business well’ right? Well let me try to put it another way… I think there’s a new awareness of important costs that’s rising, call it an “ESG cost-consciousness”. And I don’t think that it’s inflating a company’s core responsibilities if they are considering potential business risks or opportunities in this context. And hopefully evolving and innovating around this too. Perhaps we should consider it the latest iteration of Schumpeter’s creative destruction! To me that isn’t “woke”, that is about understanding changing parameters and a clear case of change management. For instance, consider the latest scientific knowledge about the potentially irreversible damage caused by microplastics to our food supply chain or of burning fossil fuels to our climate - and hence undisputable costs that certain business activities are giving rise to and costs that are increasingly being quantified – pecuniary costs.

Jeff: Well Marie, I agree that considering the changing business and regulatory environment is important, although again I think companies were already doing that. For example, a US company that operated for the last 50 years by ignoring the impact of carbon emissions on climate were considered to have quite accurately foreseen the inability of the US to address carbon pollution, such as through a carbon tax. I think in the ESG framework, you would hold companies to a higher account than that, and actually ask the company to take responsibility for its carbon footprint for example, and impose a cost by requiring them to do more than what is strictly necessary to maximize shareholder value given a realistic assessment of how the business landscape is going to evolve.

Marie: Perhaps there is a question of time horizons there as well, but there is this tension of course around ESG in the US in particular. And - in a market that is philosophically deeply committed to shareholder primacy - leads to some resistance, if positioned that way right – that juxtaposing between ESG and returns.

Jeff: I agree and I think it might be easy to scoff at this resistance, but the notion that corporations should maximize shareholder value has a lot going for it, which I discussed in Episode 44 of The Flip Side. To be clear, this doesn’t mean that corporations should ignore the environment; it means instead that society should set the rules by which companies operate, to ensure a level playing field so we don’t leave it up to individual CEOs to tell us what levels of pollution are acceptable: The government, regulators should step in and set uniform standards, and then corporations have to follow those rules but otherwise maximize profits.

Marie: I agree, of course we do need policy makers and regulators to ultimately play the role of arbitrator and adapt formal frameworks governing businesses. Not least because we need those costs to be considered consistently and overcome the hurdles like misaligned time-horizons. Take one recent regulatory development: the new SEC proposal on climate related disclosures.

Jeff: Yeah, that proposal was released earlier this year; it would require companies to disclose various aspects of their carbon footprint. I think that aspects of this proposal is almost surely going to a challenged – it’s in comment period now. The question will be if the SEC has the statutory authority to take such a step.

Marie: Yes that’s fair, and I’m sure that will be debated, but I would argue that forcing or formalizing climate disclosures is itself a win for ESG investing. Better information and transparency itself changes nothing, but can help inform and enable different outcomes including corporate behavior. Quantifying things always helps and providing investors with comparable information in particular will be so powerful.

Also interesting to me about the proposal were the disclosure rules around net-zero commitments. The proposal says that, if a company makes a net-zero commitment, meaning that it is committing to have a net-zero carbon footprint in a pre-determined time in the future, often many years out, then the company must also disclose the steps it is taking to meet that commitment. That’s really key to me – that is where I think the hard work needs to be done. Developing ambitious but realistic transition plans. Not least, as a bulkhead against ideological approaches - instead enabling well-considered, practical ways forward.

Jeff: You know Marie, these commitments, at least some of them anyway, seem quite cynical to me: companies I think at times, make them to mollify activists – which can include activist shareholders but also NGOs or other types of activists, I think many of these commitments are vague and difficult to enforce or monitor. They are also at times extremely long-dated even out 30 years into the future.

Marie: Exactly: but that’s why this rule is so interesting. If a company voluntarily makes a net-zero commitment, which will surely have financial implications for it, then I think it is reasonable that investors and other stakeholders will want and need to monitor it. Then the regulators step in and say, hold on – if you are going to make important commitments, then you will need to disclose progress, related initiatives, etc.

Jeff: I do see the point: and now you are basically determining the guardrails. You’re setting a level playing field around net-zero, so to speak. Of course, it still remains to be determined if the SEC can make these rules, but I am sympathetic to the notion that a company is not forced to make a net-zero commitment, but once it does, it should have to be transparent about it.

Marie: Yeah, like a nice way to retain the basic structure and understanding of corporate responsibilities, but adapt the guardrails as you say.

Jeff: It could be that, or it could be a lesson for companies: don’t make these commitments in the first place. I mentioned earlier that there is some resistance building to ESG and that resistance is based on the very notion that companies should be taking positions on these types of issues in the first place. So some recent examples: Florida recently required that its pension assets be invested in a manner designed to maximize returns, without any consideration of ESG – that is explicit prohibiting the use of ESG scores in their investment process.

Marie: Indeed, I’m sure you would appreciate I’ve been following that very closely. To me this ignores the very real societal and environmental issues that ESG investing can help to address, but also doesn’t attempt to be part of the solution to create a more balanced framework either.

Jeff: Well, Florida isn’t alone – a number of other states have recently taken steps to limit the way they do business with banks they feel are taking inappropriate positions on social or environmental issues, there’s also Blake Masters, a candidate for the US Senate from Arizona, has suggested banning ESG scores because in part he believes they are quote “un-American”. Now the commentary justifying a lot of these actions really makes a point of saying that these organisations or individuals don’t want corporate America dictating terms to citizens on issues that are really appropriately left to governments to address.

Marie: If I may, let me come back to your first point: that companies shouldn’t be taking positions on these types of issues. I don’t agree. But I do think what really matters what motivates the position. Undue political pressure (without actually changing the legal basis) doesn’t seem right. But neither should it be for ideological reasons or to “do good”. But they may be doing it for practical, completely rational reasons. Because either they anticipate policy makers/regulators taking action, or to avoid reputational damage as they see public opinion changing, maybe anticipating public outrage, or because they are foreseeing and embracing change in a sort of corporate context.

I would push back on this notion that considering ESG issues, or using the scores, necessarily requires some great sacrifice from shareholders. Here’s a fact: there is a lot of pressure on companies, from a large set of stakeholders, to reform their business practices.

Jeff: That is true – even seen some activists take ownership positions in a company’s stock in order to have a voice at things like their annual meetings, where they can try and actually influence policy as an owner.

Marie: Indeed, so whether it’s reputation, demands from suppliers, customers, or employees, scrutiny from activists, all can affect their business activities and the bottom line. It might sound self-fulfilling, but if ESG issues are elevated to the point where they actually affect shareholders, then arguably shareholder value and ESG are not really in tension.

Jeff: It’s a bit circular and self-fulfilling I think, but I think what you’re saying is accurate. So what you’re saying is the pressure from various stakeholders can itself have an influence on operating performance and therefore companies need to take it into account. I think we are hearing from some prominent asset managers who were early advocates of ESG: that these issues are a path towards long term value, so to speak, and not in conflict with shareholders. Of course, what I would say though is the same logic applies to the resistance that’s building to ESG

Marie: How so?

Jeff: Well I think it’ just symmetrical in a sense, if the resistance to ESG rises sufficiently that that affects the bottom line, so for example if certain types of investors will not participate in your share or your bond offerings, or certain customers won’t do business with you because of the types of positions you’re taking on ESG, then that could actually influence companies in the exact opposite direction and get them to be more reluctant to take these sorts of positions or to make these sorts of changes. I’m not really sure that a shouting match over corporate purpose is the greatest thing for our economy at this point.

Marie: That’s a very good point. Navigating the increasingly polarized and politicized debate around many of these issues in the US is proving challenging for large investors and corporates and I suspect they’ll have to keep a much closer eye on state level regulation policy and how much that is bifurcating.
But here’s another fact, at a Federal level, we are seeing new rules and with a lot of tangencies to ESG, and of course a key example is the Inflation Reduction Act, which seeks to achieve 40% emissions reduction by 2030, relative to 2005 levels which implies a reduction of 3% per year from 2021-30. With approximately $370 billion allocated toward climate and energy, the IRA is the US’s largest investment in climate change mitigation and adaptation in history and represents meaningful progress towards making good on the US’s climate commitments. It does of course involve tax credits and grants, but also things like methane fees.

Jeff: Totally agree. Actually, I think that this highlights I think some of the short-sightedness of critique of ESG scores, because regardless of your investment mandate, whether it includes ESG or not, these types of bills – spending proposals, the SEC rules will have an effect on companies’ performance and analysts need to understand those effects, investors need to account for them in their portfolio construction, and I feel like the ESG framework again regardless of your investment mandate, the framework is an extremely convenient tool for analysing these sorts of issues, it’s a great lens if you will, to put into contrast even at times conflict between E, S and G scores which don’t always push in the same direction, but being able to balance those effects and understand how it’s going to affect a company’s bottom line.

Marie: Right – I totally agree and perhaps that’ s the synthesis of our argument that regardless of whether you label it ESG or not, certain topics for certain sectors and certain companies are increasingly important and therefore important to corporates and investors alike.

Jeff: I agree with that and think that’s a good synthesis and a very good mission statement for our overall ESG Research effort. Thanks for joining me Marie.
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