ESG At A Crossroads For 2023
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There is no longer a debate about whether or not ESG is a viable investment and risk management principle. ESG has permeated into policy making and institutional investment frameworks throughout Europe, Asia and North America. Before, ESG was thought to be a fad by some, but given the continued impacts of climate change throughout the world and an evolving public awareness of the ills from inequity and legacy oppression, ESG has moved to the forefront.

But the year 2023 could be a crossroads for ESG in the United States. On one hand we have the regulatory changes from the SEC. The new rule, which is currently set to go in effect April 2023, incorporates ESG concepts into required climate disclosures for publicly traded companies. For example, the rule mentions that the Investor visory Committee – a part of the SEC – recommended, “that the Commission take action to ensure investors have the material, comparable, consistent information about climate and other ESG matters that they need to make investment and voting decisions.” This rule marks one of the first major steps by a US regulatory agency to enforce disclosure of climate-related risks and standardize such disclosures. Given that the US House of Representatives is currently under a Republican majority, the logical conclusion is that the power of majority-rule fueled Congressional hearings will result in numerous House oversight requests to challenge the SEC’s authority to enforce a “woke” regulation. As evidence, consider the letter penned by certain Republican members of the House back in 2021 when the SEC first signaled it planned to draft such a rule. The trend of Republican resistance to climate-related oversight and ESG-focused investment is poised to trickle to the state level as well. As Bloomberg points out, there are several state legislatures that are considering bans on any ESG-based investment criteria for public funds, similar to a ban placed in Florida by Governor DeSantis. ditionally, several US states have already crafted laws or other regulations restricting or banning ESG-based investment policies for state and local investments.

The politics of the day will help determine if the SEC rule comes into fruition. Consider that a Presidential election stands between full implementation and when all impacted organizations need to report (between 2023 and 2025). But 2023 may give ESG another headwind that has escaped the headlines so far.

Tim Quinson at Bloomberg noted as 2022 wound down that “The 10 largest ESG funds by assets have all posted double-digit losses, with eight of them falling even more than the S&P 500’s 14.8% decline.” The article concludes by alluding to the “patience” of ESG investors.

This brings philosophical questions to the forefront. Does ESG identify risk that degrades financial value in the long run? Or does ESG represent what investors are willing to pay for – in sacrificed earnings – as a trade-off for value in societal and environmental benefits? Research alluded to by the Quinson piece from the National Bureau of Economic Research reviews this conundrum. The research reveals a premium that ESG investors are willing to pay and a reduction in value that ESG investors have undertaken, although the authors admit to a small sample size. Meanwhile, the research also alludes to an alternative theory, represented by Blackrock, that ESG investors are at the forefront of a shift in what society deems valuable; therefore, ESG investments will receive the benefit of such “tailwinds” in time.

The research is a microcosm into this question around what is valuable, the importance of ESG in measuring a wider variety of risks and rewarding organizations – via returns in investments in those firms – who do a good job of managing those risks. The key question is when are those risks going to come to fruition and when do we see evidence of addressing those risks proactively.

From an investor standpoint, with an impending recession in the United States and, possibly, across the globe, there is usually a “flight to safety” into investments that are low risk for returns. Note that significant inflows into ESG based investments continue. In Europe, for example, ESG accounts for 65% of all flows into European ETFs in 2022. But in the US, the hill is a lot tougher to climb. Bloomberg Intelligence notes that as of August 2022, after two years in which more than $32 billion flowed into US exchange-traded funds with an ESG focus, investors had put only about $4.5 billion into such ETFs as of that date. Europe’s resilient interest in ESG does not seem to translate west across the Atlantic, as value investors weigh issue-based investing against the need to address a potential recession.

And we cannot forget the politics when it comes to regulation and policy. There is a conflict between representing the need of investors to get quality disclosures from public companies versus the perception that ESG is frivolous and represents issues that are outside of what the financial industry should oversee. The SEC serves to protect investors, and a growing division of the investor community is demanding to understand the social and environmental impacts of their investments. Moreover, as Blackrock CEO Larry Fink points out, the firm has seen 100x more inflows for ESG-based investments versus ESG-related outflows due to anti-ESG state-level regulations.

But it is not a stretch to say the philosophical debate will reach a crescendo once the impactful SEC rule reaches finality.

So in the theaters of regulation and finance, the year 2023 is set to be a crossroads for ESG.

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