SEC Commissioner Mark T. Uyeda says standardized ESG measures are doomed to fail

At the California ‘40 Acts Group’, SEC Commissioner Mark T. Uyeda commented on issues related to asset managers’ use of environmental, social, and governance (ESG) investment strategies.

Having taken the asset management industry by storm, ESG investing is expected to exceed $50 trillion by 2025, which would represent more than one-third of total projected global assets. Since, ESG assets only crossed the $35 trillion threshold in 2020, this means an expected 43% growth in five years.

The SEC Commissioner noted that touting a product as being “ESG” is good for business. “ESG products typically charge higher fees than more “plain vanilla” products. Globally, fee revenue from ESG-themed funds grew from $1.1 billion in 2020 to $1.8 billion in 2021.

“The incentive for asset managers to label any product as being “ESG” makes it hard to calculate the true assets under management in ESG funds. Some ESG funds are highly correlated with broad-based indices, like the S&P 500 Index.

“A skeptic might believe that some ESG products are merely offered in order to extract higher management fees. In 2022, one ESG rating firm stripped more than 1,200 funds of their “ESG” designations because the funds did not “integrate [ESG factors] in a determinative way in investment selection.” Collectively, these funds had assets under management of more than $1 trillion”, he continued. “Although ESG investing is wildly popular, it is difficult to ascertain exactly what ESG means, so it is challenging to identify when an ESG investment strategy is properly labeled as such. Fortunately, the federal securities laws are designed to address situations in which an investment adviser is marketing a particular strategy to clients and potential clients.”

SEC Commissioner Mark T. Uyeda reminded that according to the law, the fiduciary duty “means the adviser must, at all times, serve the best interest of its client and not subordinate its client’s interest to its own.”

He also noted that ESG investing is complicated by three factors:

• First, the inability to objectively define “ESG” or any of its components.
• Second, the temptation to place the regulators’ fingers on the scale in favor of specific ESG goals or objectives.
• And third, the desire of certain asset managers to use client assets to pursue ESG-related goals without obtaining a mandate from clients. A deep dive into these factors reveals the difficulty of establishing “ESG”-specific regulatory frameworks.

The Commissioner added that SEC essentially recognizes the fundamental reality that standardized ESG measures are doomed to fail.

“This is particularly true because ESG measures increasingly are put to use to advance social or political causes. Although certain ESG metrics could be used to assess the projected financial returns of a company, the goal of ESG investing often is something other than financial performance. Since stakeholders have different views as to what constitutes a desirable social or political outcome, success in categorizing investments as “good” or “bad” from an ESG perspective can be elusive.

“This point is illustrated by comparing the correlations between ESG ratings and credit ratings issued by various providers. According to one study, the two largest credit rating agencies issue the same letter category rating 78% of the time when evaluating investment-grade issuers, and ratings differ by more than one letter grade less than 1% of the time. In contrast, the same study showed that two large ESG rating firms agreed on their ESG ratings only 18% of the time. The low correlation among ESG rating agencies can be attributable to various factors, including differences as to: (1) scope – meaning what the relevant categories of ESG performance are, (2) weight – meaning how important the categories are relative to one another, and (3) measurement – meaning how well a company performs within a given category.[19] To the extent investment advisers use ESG ratings to make portfolio management decisions, subjective ESG ratings will play an increasing role in how asset managers allocate capital.

“The impracticality of a universal “ESG” definition creates the potential for abuses that can drive assets to particular companies based on social or political agendas. To the extent regulators have concerns about “greenwashing,” the federal securities laws already have standards in place. If an adviser uses third-party ESG ratings as inputs for its ESG strategy, the identity of the rating firm and its methodology would need to be disclosed to investors if material. While the use of the term “ESG” – without more – says very little about an investment strategy, an adviser is required to provide full and fair disclosure about what it means when it uses that term. Given this existing framework, it is not clear why additional rulemaking is needed in this area.

ESG standards could serve particular political or social agenda

Regarding IOSCO’s call for action toward standardizing ESG measures, the SEC Commissioner said he is concerned that the goal of establishing ESG rating standards goes far beyond preventing “greenwashing.”

“Rather, these standards may be intended as a means for asset managers to engage with company management in a broader effort to drive companies to satisfy the criteria of a specific ESG rating service. Because ESG ratings may be divorced from matters of financial materiality, they can reflect a particular political or social agenda.”

“The result – and perhaps the point – is that companies will be forced to further the agenda of the ESG rating firm in order to obtain capital. The emerging system has more in common with a George Orwell novel than what anyone would consider an accepted financial analysis tool.”