For all the debate surrounding the use of ESG for investing, virtually no attention has been paid to a core tension in the ESG policies of major investors and rating agencies — the discordance of the “G” from the “E” and “S.” At shareholder meetings, major investors have promoted stockholder primacy by making companies more open to the market for corporate control, by forcing changes in policy at the instance of a momentary stockholder majority, and by aligning company management’s pay to only one constituency — stockholders — by tying it tightly to total stock return. These are not the fundamentals of long-term “sustainable” management. Investors must address this discordance by amending their activities at shareholder annual meetings.
The largest mainstream institutional investors and the rating agencies that serve them now say they consider high quality Environmental, Social, and Governance (“ESG”) practices by corporations to be necessary for sustainable, long-term wealth creation—a position that has generated academic and political controversy. But for all the debate surrounding the use of ESG for investing, virtually no attention has been paid to a core tension in the ESG policies of major investors and rating agencies — the discordance of the “G” from the “E” and “S.”
In today’s parlance, ESG is short-hand for things like social responsibility, treating stakeholders well, not creating environmental harm. That is, in the policy debate, ESG is mostly about the “E” and the “S.” Until recently, environmental, labor, and other social proposals at company meetings drew little support from the “Big Three” asset managers (BlackRock, Vanguard, and State Street) or other mainstream investors. By contrast to “E” and “S” proposals, however, “G” proposals to companies have long garnished strong support by institutional investors, including the Big Three. However, impetus for these successful G proposals has had nothing to do with the environment or stakeholders like workers, or issues like gender or racial diversity. Rather, they promoted stockholder primacy by making companies more open to the market for corporate control, by forcing changes in policy at the instance of a momentary stockholder majority, and by aligning company management’s pay to only one constituency — stockholders — by tying it tightly to total stock return.
In fact, by the time the current emphasis on ESG emerged, the Big Three had already played a key role in driving a sharp drop in the incidence of classified boards and poison pills, turning withhold votes (a decision not to vote for an incumbent board member on the management proxy) and annual say-on-pay votes into levers for use by activist investors, and encouraging CEOs to squeeze other stakeholders to drive immediate returns to investors. Suffice it to say these manage-to-the-market provisions are not what the public conceives of as the ESG agenda, which favors sustainable wealth creation over the juicing of short-term share prices. Especially at the large cap sector of the market that affects most investors, these G moves made corporations more open to changes in direction that could upend long-term strategic plans, because companies had no ability to avoid an annual referendum at which the company’s policies could be altered by a momentary majority.
Scholars contest whether these sort of direct democracy approaches to corporate governance are beneficial or harmful to diversified, long-term investors. Some academics have argued that greater responsiveness to the market for corporate control and activism benefits stockholders with no long-term harm to companies themselves, or other stakeholders. Others view the results differently, and believe that gains from activism are ephemeral, and mostly involve transfers in value from company workers, creditors, and communities to short-term investors, and that companies often are harmed in the long run. As with the general debate over corporate purpose and ESG, we do not engage here with this tussle.
Rather, we focus on something more indisputable and that has been ignored. As the Big Three, other investors, and advisors like ESG raters have embraced a focus on sustainable wealth creation and more emphasis on the E and the S, their G policies have not changed. And these are the same G policies that have their origin in the desire of stockholder primacists to make corporations focus more on returns to investors and to give investors the ability to take action at any time to change the corporation’s long-term direction in order to pursue some opportunity for a short-term profit, such as selling the company, leveraging it up and distributing cash, or other strategies that often involve risks to other stakeholders, and that put cost pressures on companies in terms of regulatory compliance programs.
ESG requires a commitment to the long-term. Even great companies have years where they struggle, given market dynamics. Persevering through tough times may be what is required to pursue profits in an ethical and sustainable way, because there may be situations (say, a pandemic) when it is necessary to reduce a dividend to keep paying the workforce and comply with high standards of consumer and environmental protection in accord with a well-thought-out business plan. As historians have noted, if Abraham Lincoln had to face an annual election, he would likely have been tossed out of office early in the Civil War instead of being able to be judged on his full record in 1864.
To our minds, there are two important policy implications of this disconnect between the investment communities’ stated ESG commitments and their approach towards corporate governance. First, it is not clear that the Big Three, other institutional investors, or the ESG raters have reflected on this tension and considered whether their G policies should evolve accordingly. One could imagine a range of measured issues that would bring “G” back in alignment with ESG, such as supporting corporations that wish to transition to the emerging public benefit corporation model that requires respectful treatment of all stakeholders, refusing to support withhold campaigns and requiring activists to run actual candidates, calling for executive compensation linked to ESG measures and not just shareholder returns, scheduling quadrennial say-on-pay votes aligned with a sensible time-line for executive pay contracts, and even rethinking blanket opposition to classified boards. For ESG raters, there is an additional issue. To the extent that companies are getting credit for simply having managed-to-the market G, is that made clear? And how does it obscure and confuse the rating a company gets on the E and S?
The second and more important policy implication of investors’ ESG discordance is this: The more corporations are subject to constant plebiscites, the more institutional investors themselves must become the guardians for whether corporations can implement sustainable, stakeholder-respectful strategies to create durable wealth. Sustainable wealth creation is not produced through a proposal at one annual meeting; it requires patience, the willingness to weather adversity during challenging periods of change and unexpected headwinds, and putting the long-term ahead of a tempting, but unwise, short-term action. As we have seen in the year after ESG-activist hedge-fund succeeded in electing candidates to the Exxon Mobil board of its own candidates, investor sentiment can be erratic with inflation at the pump and other immediate economic disruptions driving less voting support for stockholder proposals to confront climate change. And, given the powerful pressures that all institutional investors are under to generate immediate returns themselves and the herd pressures of short-term Morningstar ratings, a corporate governance system that subjects corporations to the constant threat of an immediate referendum and the use of say and pay and other votes as ways to express dismay over dips in short-term profit presents a sizable steadfastness challenge to all institutional investors. And the overwhelming number of votes they must cast is especially burdensome on institutional investors with more limited stewardship resources — a phenomenon that increases the influence of proxy advisory firms — but also to the Big Three whose own stewardship capacity is outmatched by the number of votes they must cast each year.
A more tempered system of corporate governance would still provide robust accountability to investors, while giving corporations some reasonable space to balance the needs of all stakeholders and carry out a sustainable plan of long-term growth. Such a system would also allow institutional investors to concentrate their limited stewardship resources more effectively by casting fewer, but more informed votes guided by their stated intent to support the responsible wealth creation that American worker-investors need. At the very least, if big investors continue to embrace G policies that put the market’s preferences above all then those big investors must own up to their responsibility to sustain — at every vote, every year, even when things are tough — the sustainable corporate policies they say they embrace.
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