Two-term SEC Commissioner Paul Atkins is the chief executive of Patomak Global Partners – a New York and DC-based financial services consultancy. Paul served as a member of the congressional oversight panel for TARP (remember that?), was a partner at PricewaterhouseCoopers, and an attorney with Davis Polk.
Today's topic we can subtitle as “Financial markets meet Environmental Social Governance (ESG),” which sounds rather benign, but it's far from it. Imagine you're seeking the best physician to cure a serious medical condition. What's the likelihood you'll ask the prospective physician her opinion on immigration, cash bail, or criminal justice reform?
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As Paul will explain, financial regulation is forcing the politics of ESG into our financial markets, resulting in lower yields for all of us and the misallocation of capital.
Links & Resources:
ESG trends and impacts on public pensions, Reason Foundation Webinar, September 23, 2022
A Friedman doctrine: The Social Responsibility Of Business Is to Increase Its Profits, Sept. 13, 1970 - New York Times
Bob Zadek: Tell us the statutory historical purpose of the SEC, so we can understand the context for ESG investing.
Paul Atkins: The SEC is a government agency that was created back in 1934, in the wake of the 1929 stock market crash. Congress, in the new FDR administration, enacted a series of statutes trying to govern the securities markets and bring disclosure to them for transparency. The SEC was created as a specialized agency to be a regulator of the public financial markets, and also as an enforcement agency. It has a whole big regulatory rulebook that governs brokers, asset managers, and other parts of the infrastructure of trading securities here in the United States.
So, the SEC does not do quality control on how good and investment is, but rather makes sure that when decisions are made by the investing public, they have the best information available. Is that a fair summary?
Yes, sometimes SEC is a bit schizophrenic as to how it approaches these things. But Congress wanted to try to make sure that the information in the marketplace is accurate, and that public companies provide material information to investors, so that they can make their investment decisions. It’s not to require companies to disclose every possible thing, because that's impossible, but to disclose material information that is accurate.
What is the relevance of those three words to investment: Environmental, Social, and Governance? Why are we talking about this current buzz phrase?
This is an amalgam of a lot of different ideas that have been percolating in investment circles for a few decades.
It’s odd that these three things are thrown together, because environmental obviously has to do with the disclosure and investment, and what we now call “sustainable companies” or “sustainable products,” and that itself has a very squishy meaning.
The social aspect is what we've seen over the last few years when people talk about equality, or equity, or anti-discrimination issues.
And finally, governance has to do with how a company is run – the roles and interactions between the shareholders, the board, and management. There's a long history of how public companies are governed, the rights of shareholders, the duties of directors, and then how management interacts with that. Basically, the investors invest money in the company. They have their representatives – the board of directors – who are meant to oversee management and the company. Then management is, of course, the hired help. So that's the governance aspect.
More and more institutional investors are using some or all of these various criteria as filters for their investment decision making.
You can trace this back in the ‘70s, when several states directed their pension plans to screen out so called “sin stocks,” like no tobacco, no alcohol, no gambling, etc. A lot of religious-oriented groups did the same thing. Then in the ‘80s, there was the issue about South Africa divestment. In the 2000s, there was a movement by states, again, to screen out their Iranian investments, or even fossil fuels, depending on the state. But ultimately, it didn't have much of a real effect in the financial markets.
Now, especially after COVID, and during that time with the George Floyd issues, this ESG investing by the private sector has grown to where investors are putting pressure on public companies to change their business models to deal differently with workers and so on. These institutions are looking to invest in “good companies” rather than the undesirable ones.
ESG, so far, sounds a little bit vague. Show us how politicized investment through the large institutional investors profoundly and negatively affects each and every listener to our show.
If you think the government is bad at spending ‘other people's money,’ that's what we're talking about here.
Back in the ‘80s and ‘90s, public markets looked different than they do now. More than half of all the money that was invested in the US stock market was held by individual investors – normal folks who putting money into the stock market through their brokers.
Today more like 78% of the total amount of money held in the US markets is held by institutions.
When annual shareholder meetings come up for the stocks held by these various funds, somebody has to vote the proxies. You're not doing that, because it's not you who own that share of stock of the company, but it's the fund that you've put money into. So it’s Vanguard or Fidelity – there's a portfolio manager, or a committee, or somebody who is deciding how those proxies are voted.
Over time, there are people who are much more politically inclined – these politicized shareholder activists, I'll call them – putting pressure on public companies through these shareholder proposals to try to sway the company policy with respect to either businesses that they go into, or products that they issue, how they treat their workers, etc., and they are pressuring other investment managers to vote their way as well.
For example, there are these groups out there who are trying to pressure oil and gas companies to get out of the oil and gas business.
Saul Alinsky, back in the ‘70s, was the first one who recognized the power of swaying corporate management through the use of shareholder proxy process. That has had some very serious and long-range effects.
Americans hold the right to vote as being quite important. When we vote for members of the House of Representatives, we are voting for people to represent our best interest. It’s the same thing in corporate governance: we don't get a vote in controlling officers and employees of the corporation, but we vote for the people who will represent us in those elections.
These representatives are not voting in our best interest, and may not reflect our views. Do I overstate my case?
People who are putting their money into large ETFs or mutual funds are unwittingly powering an ideological strategy by folks who maybe don't share your outlook or your goal of having financial returns to fund your retirement, your college fund for your kids, your health needs, etc.
They are more interested in doing “good” with the money.
The telling part is the behind-the-scenes strong-arming – almost mafia-type tactics – where people representing these big investment managers meet with corporate management, and say, “We're going to vote against you at the upcoming shareholder meeting if you don't do X, Y, and Z.”
It's a growing type of pressure being put on these various companies to try to have them follow these various type of ideological standards. Ultimately, it cuts down on the returns that investors get. If you're saving for retirement or just saving in a mutual fund, you will have less money in the future, because all of this stuff costs money, and of course a lot of the sustainability investment is riskier than others sorts of investments.
Tell us what happened with Exxon, when activists – who were not concerned about maximizing profits but other goals – actually got to be on the Board.
A couple years ago, Exxon's returns were not doing that well.
Energy prices were very low, and so Exxon was facing pressure from these institutional investors saying they should get out of oil and gas because it's bad for the environment. They wanted Exxon to go down to alternative sorts of energy paths.
This one single-purpose hedge fund was put together called Engine No. 1. They ran what we call a short slate of directors against the other directors that were being put up by the nominating committee. Some of the large investment management funds – in particular BlackRock, State Street, and Vanguard – switched their normal voting. They usually voted with management, but this time they voted for the short slate of insurgent directors who actually won.
That was quite a big boost in investment management circles and it got the whole discussion going about ESG.
Exxon obviously has been around a long time. It prides itself on always paying a dividend. Unlike some other companies, it has a lot of individual investors still holding its stock. Some 90% of the individual investor group voted with management, whereas the institutional investors – voting with other people's money – appointed that insurgent slate of directors.
So whose interests are being represented here? Ultimately, it's the investors who are putting money into it, who will either get the benefit or pay the price of those decisions.
People who are usually on the left have figured out that they can actually do things through the private sector – through these investment managers – to put pressure on companies to achieve “net zero” by whatever arbitrary dates people are now talking about – 2030 or 2050.
Isn't there a market for an investment fund that says, “We pledge to make our investment decisions on a purely economic basis, and we have no interest in doing anything other than increasing the return”?
There are some that are emphasizing that right now, and making a point that they’re not going to engage in that sort of ideological screening of investments or twist companies’ arms behind closed doors to advance their ideology.
However, it's in the interests of these investment managers to push the whole ESG investment process because they can charge higher fees. There was a PwC survey that said 78% of investors are willing to pay a 3-5% premium to invest in ESG.
If you want to do that there should be full transparency and proper disclosure about all this. The fiduciary duty of these pension managers and other financial managers to their investors, should be in violet there.
“People who are usually on the left have figured out that they can actually do things through the private sector – through these investment managers – to put pressure on companies to achieve ‘net zero’ by whatever arbitrary dates people are now talking about – 2030 or 2050.”
That's where the controversy is coming from now with state financial officers, for example, in the red states. 26 of them have been putting contrary pressure on some of these investment management firms [to stop ESG investments].
Florida, for example, has taken money away from management by BlackRock for just this reason.
People need to be aware of how your money could be used, and to ask questions of your investment manager, where you're looking to see how your money's being used by your various funds.
Nothing in this show is expressing an opinion about ESG as goals. I’m agnostic on that. The point of this show is about who gets to decide how your money is used. This is about financial democracy. It's your money, and a stranger should not be permitted to further their social goals with your money.
I agree. First of all, ESG investing, like you say, may be fine. If you like that, God bless you – put your money into that. But be aware that your money could be used in ways that you don't necessarily want it to be. So ask questions.
ESG investing is dangerous because it uses made-up metrics. It's ideologically driven, and could be against your own interests. It distorts markets by denying capital to legitimate types of productivity, and it could cut down on innovation competition – again, to your detriment, because investing into solid products that have a market need is the essence of investing in the marketplace.
Ultimately, ESG is about pushing social and environmental policies through means other than our Constitutional political process. This is all about power, and all about trying to get to ulterior motives down there. So if you're not on board with that, please be aware that you have a lot of power through where you place your money. Just ask your advisors or look at the statements behind the investment manager that is running your fund to see if they're talking about ESG principles.
People talk about ideology 24/7 nowadays. It’s unfortunate that it's invaded the investment management industry. Ultimately, it’s detrimental to investors, and people could be hurt long term – whether you're spending money more on higher fees for the ESG funds, or through compounding of interest. That really hurts after 20, 30, 40 years of saving and investment.