The Hitchhiker’s Guide to ESG: Remarks at Annual US-Central and Eastern European Connection Weekend

Thank you, Lukasz [Chyla],for that introduction. And thank you to the Jagiellonian University and to Catholic University for hosting this conference. Let me begin by stating that my views are my own as a Commissioner and not necessarily those of the U.S. Securities and Exchange Commission or my fellow Commissioners.

The last time I was in Poland was approximately three decades ago. It was a brief but memorable stop on an unfocused American student's hop across Europe. Among other things, Poland provided me my only hitchhiking experience. Some kind soldiers in a military jeep driving through the richly beautiful, deeply wooded Polish countryside picked my traveling companions and me up in the early morning hours. They were ferrying, in addition to us weary travelers, freshly baked bread, the smell of which still lingers in my memories. On that trip I did not get any of that bread and I did not make it to Krakow, despite the allure of both. All those years ago, I never would have guessed that a conversation about environmental, social, and governance ("ESG") issues would allow me to visit Poland again. I certainly never would have imagined that I would be a securities regulator spending much time thinking about these issues.

A hitchhiker, as I was that one time in Poland, is someone who "travel[s] by standing on the side of the road and soliciting rides from passing vehicles."[1] Today, we are seeing a lot of ESG hitchhikers-people hopping into one of many passing ESG vehicles without much thought for where they are going. As some of these hitchhikers have discovered, however, they are in for a wild, expensive, unpredictable, and unending ride. Asset managers, companies, and governments are embracing ESG without considering the long-term consequences to, respectively, their clients, shareholders, and citizens. So today I step out on the side of the road, not to hitch a ride, but to wave a cautionary flag.

1. ESG is a hopeless muddle.

The divisiveness of the ESG conversation in today's capital markets stems in part from fuzziness around what ESG means. Greater precision might narrow the differences or at least focus discussions on the issues where views really do differ. In the meantime, some bad behavior hides behind that ambiguity.

ESG encompasses everything that sounds good in the moment: climate, biodiversity, clean water, oceans, employee well-being, labor rights, community engagement, the circular economy, the list goes on. No firm could identify-let alone evaluate-every issue that might fall under the elastic definition of ESG. The fluctuating views on whether something garners ESG cheers or derision further complicates any analysis. What is ESG-friendly one year may not be the next. After Russia invaded Ukraine, for example, assessments of whether weapons manufacturers were consistent with an ESG investment strategy changed.[2] Whether natural gas or nuclear ranks well on ESG scales differs over time as well.[3]

Some of the issues on today's ESG list historically factored into assessments of the long-term financial value of companies without a special label or a special set of regulatory mandates to spur their inclusion. Companies, striving to be profitable by pleasing customers, employees, and communities, considered a wide range of environmental and social factors. Investors, trying to maximize their returns, looked at how companies in which they were investing approached these issues. Whether and to what degree an issue mattered was company-specific, so government needed only to provide the broad framework within which companies could share the factors they considered material to their long-term financial value.

ESG debates would be fewer if each ESG item once again could rise or fall on individual market participants' assessments of its link to long-term financial value at a particular company, not on its prominence in societal debates of the day and its consequent ESG label. ESG becomes most divisive when it mutates into short-hand for forcing companies to ditch long-term value maximization and cater to the current, loud demands of so-called "stakeholders"-that amorphous collection of non-investors clamoring for a say in how all public companies operate and how their resources are spent. This version of ESG is political, not financial. Samuel Gregg explains that today's ESG's "goals and methods are characterized by an incoherence sufficient to call into question not just specific features of ESG but the conceptual integrity of the entire ESG endeavor."[4]

Lumping disparate items into a single ESG bucket creates an analytical muddle. Claims about the efficacy of corporate sustainability programs or the success of ESG investment strategies are suspect because something as imprecise as ESG cannot be studied with precision. Running a test to demonstrate a linkage (or sometimes simply identify a correlation) between one or several ESG factors and a company's profitability does not support a conclusion that ESG broadly or other unrelated ESG factors specifically will have the same effect. Nor does the fact that one set of ESG managers performs well mean that we can extrapolate their results to any other manager that claims to use an ESG methodology, which may be entirely different even though it shares the ESG label. The difficulty of determining whether and how ESG links to financial value makes it easier for people to make sweeping claims that it does. Moreover, a convenient invocation of reputational risk sometimes stands in when a linkage proves elusive.

ESG targets are also ambiguous. Obtaining accurate and comparable data to assess whether an ESG objective has been met is difficult. Greenhouse gas emissions are one example, but methodological ambiguity around other more esoteric or newly popular ESG metrics is even more pronounced. Even if the relevant data are available, people may come to different conclusions about whether meeting a particular target is positive. For example, a company's decision to move a factory to a location with abundant hydro-power may lower carbon emissions from production but increase them from transportation.

The ambiguity surrounding ESG serves people trying to use corporate or investor assets for their own ends. Asset managers, companies, and governments, often at the prompting of interest groups with a clear stake in a particular issue, do things in the name of ESG that they otherwise could not get away with doing.

1. Asset managers sometimes hide behind ESG ambiguity to evade their obligation to investors.

Asset managers sometimes have hidden behind ESG's ambiguity to justify behavior that may not align with their fiduciary duty. Investors care about many things aside from financial returns, but the objective that unites investors is maximizing risk-adjusted financial returns. Absent a directive from or assent by its client to consider other factors, an asset manager should focus on financial returns. ESG commitments can interfere with this singular focus.

In seeking maximum financial returns, asset managers serving investors routinely consider ESG factors that they believe affect financial returns. Asset managers are not serving investors well, however, when they make an unsupported claim of a causal connection to financial returns so they can consider an ESG factor that they want to consider for other reasons. Sometimes an asset manager does so to fulfill a promise to a third party to manage money consistent with ESG objectives.[5] Or sometimes a large asset manager has multiple clients, some of whom care a lot about non-financial objectives, and these clients end up driving how the asset manager serves all clients. A large asset manager, for example, might centralize voting and engagement decisions rather than entrusting these decisions to its many funds' portfolio managers. Such a centralized voting and engagement model may serve some funds well, but run roughshod over other funds' objectives. Consider an asset manager that advises both a massive passive index fund and a tiny renewable energy fund. If the asset manager's centralized sustainability team visits a portfolio company that is considering a foray into the oil business, advocating against oil may be consistent with the renewable fund's objectives, but not with the passive fund's simple objective of tracking the index. Ironically, the company is likely to listen to the asset manager precisely because it manages such a large passive fund, not because it manages a small renewable energy fund. The passive index fund, likely unbeknownst to its shareholders, is used to give voice to the renewable energy fund.

Asset managers of course do cater to investors who have objectives other than or in addition to maximizing financial returns. An investor might want, for example, to minimize the carbon footprint of her investment portfolio or invest only in companies with a unionized workforce. She should be able to try to invest in a way that is consistent with those goals and find professional financial advice to facilitate her chosen investment approach. Asset managers should be able to serve this kind of investor as she wishes without dragging other investors unwittingly into supporting her non-financial causes.

Asset managers need to state clearly whether and how they will invest in, vote in, and engage with portfolio companies on behalf of their individual and fund clients. Then investors can select an adviser or fund that accords with their objectives. For example, if an asset manager claims that prioritizing particular ESG factors is consistent with or conducive to long-term value maximization, it should have a basis for that claim. Alternatively, if investors might be sacrificing financial returns to meet an ESG target, the asset manager should make that clear. On voting, a manager of a passive index fund could pledge to vote the fund's shares with management, not to vote, to delegate voting authority to fund shareholders, to follow a third-party's voting directions, or to vote consistent with a set of non-financial ESG objectives.[6] If an asset manager will use a passive fund's votes to add heft to a sister fund's efforts to change a company's behavior, it must tell the passive fund investors of the fund's activist plans.[7] Many fund managers are making helpful disclosures already, but ambiguity regarding investment, voting, and engagement processes remains. Having different options available-some of which focus only on financial returns and others that also or instead concentrate on ESG targets-is fine, but asset managers should explain their plan clearly and stick to it.

1. Companies sometimes hide behind ESG ambiguity to evade their obligations to shareholders.

Companies sometimes have hidden behind ESG ambiguity to avoid accountability to shareholders. Shareholders generally want company boards and managers to focus on maximizing the long-term value of the corporation, a focus that may include issues bearing an ESG label in today's parlance. A value-maximizing company is keenly attuned to meeting a societal need for a product or service effectively, and that objective often requires consideration of issues that fall within the ESG label. Companies, for example, might ask: How can we outcompete our rivals by offering better benefits to attract the best employees? If we can clean up our production processes and drill water wells to serve the local population, will more communities welcome our factories? Would putting better windows in our office buildings and instituting a product return program cut costs? Would expanding job fairs beyond universities as prestigious as this one provide access to a richer talent pipeline?

Companies sometimes target ESG goals that are inconsistent with financial returns. They point to the interests of an expansive set of stakeholders to justify doing things, some of which may conflict with shareholder interests. Catering to non-shareholder interests, which at bottom is what stakeholders represent, if not done to maximize long-term value, weakens board and management accountability and enhances management's discretion. A pliable set of ESG metrics gives corporate managers more latitude than an unyieldingly objective profitability metric.[8] Moving beyond the numbers in favor of malleable ESG metrics dilutes managerial accountability to shareholders. Managers that prioritize ESG metrics garner acclaim from non-shareholder beneficiaries of the ESG priorities, members of the public seduced by high-sounding ESG rhetoric, and a growing sector of ESG specialists who work to elevate the importance of ESG considerations in corporate decision-making. This acclaim can be short-lived, as there is always another ESG target for a company to meet. Companies sometimes acknowledge the ESG objectives to investors, but claim-sometimes without a sound basis-that they are linked to financial returns. And sometimes, in a phenomenon called greenhushing, companies spend time and resources on achieving ESG goals without telling investors that is what they are doing.

Even a decision to collect and report on ESG metrics without an attendant commitment to achieving ESG targets can divert substantial resources from uses that would contribute to corporate value maximization. The direct costs of ESG disclosures include tracking, analyzing, and assuring data. Building the requisite data collection, information technology systems, internal controls, and assurance systems around all the new data elements is more challenging than similar efforts in financial reporting, because ESG data are harder to come by, people have not had centuries of experience thinking about these metrics, and ESG data lack the precision and consistency in measurement that characterizes commonly reported financial data. Companies routinely hire ESG specialists, require other employees to devote some of their time to ESG data collection, and assist suppliers with ESG data collection.[9] Further, emphasizing ESG reporting could harm financial reporting, about which investors care very deeply, by diverting corporate attention or normalizing the weaker standards and looser practices that are accepted by necessity in ESG reporting.[10]

A company that sets up an elaborate ESG data collection infrastructure, whether for regulatory or other reasons, threatens its own dynamism. Integrating ESG data collection efforts into financial reporting, corporate internal controls, audits, firm structure, performance incentives, employee job descriptions, and supply chains not only changes how companies operate day-to-day, but adds inflexibility to corporate decision-making. The ESG processes that companies are integrating into everything they do today will impede their ability to react to changing market conditions. ESG data management and ESG target-setting bureaucracies within companies become one more obstacle to change, sometimes just slowing it down and other times preventing it altogether. Want to build a new factory? Add the internal ESG team to the list of required sign-offs. Want to sign on a new supplier? You will need to add a whole new set of due diligence questions related to the supplier's ability to provide good ESG data. Want to pivot your product line to meet an emerging consumer demand? Not so fast; the ESG department needs to analyze its effect on the company's greenhouse gas, water, and biodiversity metrics. Green tape within companies will become as paralyzing as red tape.

1. Governments sometimes hide behind ESG ambiguity to evade their obligations to citizens.

Governments too have figured out how to hide behind ESG ambiguity for their own ends. By mandating increasingly granular ESG disclosures, securities regulators draw boards' and managers' attention away from objectives that would maximize corporate value and toward objectives in line with government objectives. ESG disclosure mandates fill company prospectuses with information regulators want to highlight. Requiring companies to consider ESG factors or even merely to collect and report data on ESG issues encourages boards and managers to devote resources to considering ESG matters and facilitates activist pressure by non-shareholder groups on companies to pursue ESG objectives.[11] The effect here is to provide the government with indirect control of corporate resource allocation decisions. Prescriptive disclosure requirements for companies are sometimes paired with required or encouraged investor consideration of ESG issues in making their investment decisions. In this way, detailed ESG mandates have become a subtle mechanism for conforming corporate behavior to regulatory objectives and shifting capital flows.

Claims that all manner of socially and politically contentious items are linked to financial returns have provided securities regulators the cover to demand more granular disclosures about a growing list of issues. These disclosure mandates often lack a traditional materiality trigger.[12] As ESG metrics multiply and become increasingly attenuated from metrics that a company would otherwise use to manage its business, their effect on capital allocation will intensify. For example, the Corporate Sustainability Reporting Directive ("CSRD") will require almost 50,000 European companies[13] to report approximately 1200 ESG-related data points across twelve broad categories.[14] ESG data challenges with respect to certain mandated elements could cause companies to produce different products and services than they otherwise would, switch to a supplier that can comply with data demands, or slow their product and service innovation. Intense regulatory ESG disclosure demands are altering companies, including by driving decisions and making them more brittle and less able to respond to changing conditions in the marketplace.

Sometimes regulators point to investor demand as a basis for their ESG prescriptions. Yet when I talk to companies, they often cite a decided lack of investor interest in the issues on which regulators seem most focused. Retail investors themselves, as distinct from asset managers, do not seem willing to sacrifice financial returns to achieve non-financial objectives[15] and may care about ESG data primarily if it influences a company's financial returns.[16] In the United States, traditional securities disclosures have focused on supplying investors with financially material information they need to understand companies through the eyes of management. An investor-centric, principles-based disclosure regime rooted in the concept of financial materiality (as opposed to double materiality) provides investors with tailored, relevant information, rather than mechanical responses to a set of items prescribed for all companies. Under a principles-based approach, ESG items that factor meaningfully into value-maximizing decisions are reported in the same way other items are. Public companies, for example, already disclose material risks, which may include rising sea levels, a more fragile supply chain, or shrinking water access, and litigation, which may give investors insight into employee and consumer product safety issues. A principles-based disclosure regime does not need to change with every new issue that captures societal attention and accommodates many types of companies, each facing its own unique set of issues. The goal of principles-based disclosure is to get investors the information they need to make decisions, which can vary by company and over time as a company's circumstances change.

Some ESG advocates argue that externalities-the costs imposed on society by inadequate corporate and investor attention to issues like climate change-justify ESG disclosure mandates. If the market will not force internalization of such externalities on its own or solve the underlying problem with technological advances, government intervention to address them should come by way of direct lawmaking through a transparent political process that targets the particular externality of concern, not indirect attempts to use ESG reporting to shift capital flows away from the offending activity. Legislative bodies have ready access to the expertise helpful to identify and weigh difficult trade-offs and to design tools narrowly tailored to address the externality at issue. More importantly, unlike securities regulators, legislative bodies hold the democratic legitimacy and legal authority to enact legislation designed to address the issues. Legislatures also have a broader perspective than specialized regulators, which enables them to consider how a well-functioning, prosperous economy forms the basis for better schools, a cleaner environment, a more effective social safety net, and stronger civil society institutions.

1. It is time to stop hiding behind the ambiguity and confront the high stakes of the ESG endeavor for global well-being.

The global embrace of corporate ESG reporting and target-setting comes at a price: reduced economic growth, which in turn makes it harder to improve society. As the world unites in a mandatory ESG regime of unparalleled intricacy, global economic prosperity will suffer.

Driving my concern is the role that even a mere reporting framework, divorced from what matters to a company's long-term economic value, can have in changing the responsiveness of the economy to real people's needs. Mandated ESG metrics reflect the regulator's view of what should be important to decision-making. But the regulator sees only a small sliver of what markets observe. Markets composed of countless people making independent decisions based on their daily experiences are better than regulators at identifying important information and, thus, directing money toward its best use. They also adapt more quickly to changing market conditions. People, whether acting individually or jointly through companies, respond to what they and others value.[17] For example, I love honey, but, having recently donned a beekeeping suit for the first time, I realize that I have to rely on others to satisfy my sweet tooth. If, however, someone discovers a new use for honey that drives its price up, I might cut my consumption and intensify my effort to join the ranks of producers to help meet the increased demand. That sweet example is but one of the countless decisions that undergird our economy. The beauty is that nobody needs to plan anything other than her own activities for this free economy to work. An economy that draws on everyone's knowledge and experience can do much more important things than supply me with honey; it can solve hard technological problems and generate the prosperity that improves people's everyday lives and then creates the demand for an even better world for everyone.[18] When regulatory codes, instead of popular demand, drive corporate behavior, we lose the dynamism of the unplanned economy.

Because of the direct and indirect costs, jurisdictions that have adopted stringent ESG mandates will find themselves competitively disadvantaged. To blunt these adverse competitive effects, an effort is underway to standardize ESG reporting and ESG practices so that companies everywhere bear the same reporting burden. We see that in the United States where California has adopted stringent ESG reporting rules, which it plans to impose on companies outside California too. Most notably, Europe is trying to impose the costs of its particularly draconian regime on foreign companies so that European companies do not suffer alone. I care about these developments because they affect many American companies, but I also care because increasing the rules' reach will make it easier to fool people about the costs of an intense ESG regime on economic growth. Consider:

• The previously mentioned CSRD will require companies to report across their value chain-which includes suppliers and buyers-on ESG issues ranging from climate-related disclosures, like Scope 3 emissions levels and recycling practices, to workforce disclosures such as those relating to demographics, collective bargaining, and "adequate wages."[19] Companies must report on a double-materiality basis, meaning in assessing materiality they must think about how their activities influence the community and environment around them.[20] Approximately 3,000 American companies must eventually comply.[21]
• The European Taxonomy Regulation will require companies to classify environmentally sustainable economic activities with an explicit goal of "reorient[ing] capital flows towards sustainable investment in order to achieve sustainable and inclusive growth."[22] The 3,000 American CSRD-reporting companies arguably must eventually comply.[23] The European Commission also invites other non-EU companies to comply to satisfy alleged eventual demands from "financial institutions," "EU companies," and "EU investors."[24]
• The Corporate Sustainability Due Diligence Directive ("CSDDD") "establishes a corporate due diligence duty" for companies to "identify[] and address[] potential and actual adverse human rights and environmental impacts in the company's own operations, [its] subsidiaries and, where related to [its] value chain(s), those of [its] business partners."[25] CSDDD companies must "integrate due diligence into their policies and risk management systems,"[26] end or minimize "actual adverse human rights and environmental impacts" in "its own operations and those of its subsidiaries,"[27] and "periodically" assess their due diligence measures.[28] Other requirements include that firms seek contractual assurances from direct business partners,[29] consult with "relevant stakeholders,"[30] and provide "remediation" to those harmed by the firm's adverse human rights or environmental actions.[31] Generally, any American firm with more than 450 million Euros in net turnover must eventually comply.[32]

Similarly, the International Sustainability Standards Board ("ISSB") was formed in 2021, among other things, "to develop standards for a global baseline of sustainability disclosures."[33] The ISSB issued its first two sustainability standards last summer and then embarked on a global public marketing tour to encourage global adoption of the new standards.[34] The International Organization of Securities Commissions ("IOSCO"), in an unusual move to push global convergence, issued a swift directive to member jurisdictions to embrace the ISSB standards.[35]

A single global disclosure framework would ease compliance costs for companies that otherwise would be subject to multiple regimes, but it also would aggravate the problems created by such a mandatory ESG framework. If common a global framework guides companies world-over to prioritize things other than corporate value maximization, creates a convergence in global decisions about capital flows, and imposes a universal layer of rigidity on corporate and investor decision-making, markets will lose the heterogeneity and adaptability that they need to fund innovative solutions to new and intractable problems. If every hitchhiker gets in the same jeep, we might all drive off the cliff together.

1. Conclusion

Asset managers, companies, and governments too often use the ambiguity swirling about ESG to their advantage and to the disadvantage of the constituencies-investors, shareholders, and citizens, respectively-they serve. What can we do to free ourselves of the ESG constraint on economic growth? First, we can reject the highly prescriptive ESG frameworks that so many jurisdictions are imposing on companies today in favor of a return to a principles-based disclosure regime that does not isolate and elevate an issue simply because it bears the ESG label. Second, we can insist that asset managers, corporations, and governments using other people's assets to further an ESG objective show the link to financial value of that particular ESG objective or explain clearly that obtaining the ESG objective comes at a financial cost. Third, let us heed another hitchhiker's guide, this one to the galaxy: Don't Panic![36] We can solve the panoply of very serious problems we face. The best way to do so is to allow capital to flow in response to all of humanity's input, rather than in response to regulatory directives, even ones calling themselves ESG. A free economy encourages people to think carefully about what is important to them and to care deeply about what other people need and want.

Corporations will survive or fail depending on whether they serve others well. A sprawling maze of standardized and inflexible ESG mandates is likely to undermine, not add to, companies' natural inclination to meet the needs of others quickly and effectively. These ESG metrics only divert their attention to issues that regulators care about.

Let me close with another hitchhiking story, this one not about me, but about a family I know. On vacation, the family had hiked seven miles out of town. While the parents were investigating non-walking options for getting the exhausted family back to town, their two pre-teen daughters took matters into their own hands. The older one, without explaining why, urged her little sister to stick her thumb out. A car stopped, and the driver offered the family a ride. The girls' parents, not aware that their daughters had hitched the ride, after an assessment of the situation, gratefully accepted the seemingly unsolicited kindness of a stranger. My friends are savvy travelers, and I am happy to report that their inadvertent hitchhiking adventure worked out well, but inadvertent ESG hitchhiking, where people have hopped into the ESG-mobile without much thought, has led us to a bad place. Conferences like this one are an opportunity to stop and think about whether there is a better way of getting to our goal of a safer, cleaner, healthier, more prosperous world.

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