Proxy Advisory Firms And The ESG Risk
Warren Buffett presciently noted that “only when the tide goes out do you discover who’s been swimming naked.” The Dow, S&P 500, and Nasdaq are all now in bear market territory, so the tide has undoubtedly receded. And true to Mr. Buffett’s wisdom, the unsustainability of many fashionable investment trends during the long bull market are at long last being revealed. The Environmental, Social, and Governance (ESG) trend tops the list.
Many prominent Wall Street banks are major cheerleaders for ESG, but such support is not surprising. ESG enables portfolio managers to sell investments that are virtually the same as other broad-based index funds yet charge fees that are multiples higher. However, these investment portfolios face a strict market test over the long-term – should ESG not provide stronger financial returns, as is likely, these funds will suffer financial outflows and eventually close.
A less well-known, but potentially more damaging advocate of ESG, are proxy advisory firms. Proxy advisory firms help institutional investors manage the herculean task that arises due to the requirement (or belief that they are required) to vote on all proxy measures at shareholder meetings. Proxy advisory firms do the legwork and advise institutional investors on how to vote on the thousands of shareholder resolutions that arise every year. The two largest firms (ISS and Glass Lewis) control 97 percent of the proxy advisory market – effectively, the proxy advisory market is controlled by a duopoly.
Numerous ESG programs are raised via these shareholder proposals that include requirements to report the company’s greenhouse gas emissions or implement diversity plans. According to Katten Capital Markets, ESG proposals are growing and received a record level of support in 2021 “reaching 36.3 percent across all ESG categories”. These included 105 environmental proposals and 133 social proposals.
Corporate ESG programs enhance shareholder value if they reflect consumers’ desires or enhance worker productivity. Implementing these programs helps companies efficiently provide customers with the products they desire in the manner they want it produced. Theoretically, such ESG proxy measures warrant support, but they are also unnecessary. Implementing programs that enhance corporate profits is the age-old guiding principle for corporate management and no new ESG management principles are required to achieve these ends.
Therefore, ESG as a management paradigm is only necessary when the proposed ESG programs are financially harmful to the company – the company would not adopt the program without explicit pressure from ESG advocates. Implementing programs that reduce profitability is a serious violation of management’s fiduciary responsibility.
Several studies document that ESG-related proxy measures typically harm financial returns. One study in the Journal of Financial Economics examined the impact from activist public pension funds on the market values of a sample of Fortune 500 companies finding that increased activism by public pension funds is negatively correlated with stock returns. Further, the firms receiving proposals from activist public pension funds promoting social agendas were valued 14 percent lower than similar companies without such agendas.
The oft-claimed response to the above is that shareholders voted for the proxy measures, therefore the corporation is simply listening to the desires of its owners. Such claims are incorrect, however, because the majority of “shareholders” voting on these proxies are institutional investors that generally vote the recommendations from ISS and Glass Lewis – a practice referred to as robo-voting.
Robo-voting ESG issues is problematic because both proxy advisory firms also provide ESG consulting services to corporations. Since proxy advisory firms also provide ESG services, they suffer from a clear bias in support of ESG initiatives. Essentially, the two firms that advocate for ESG services and profit from ESG activities also advise shareholders how to vote on ESG proxy measures.
Moreover, the two major proxy advisory firms establish their ESG position without adequate transparency and using a one-sized fits all approach. In reality, these programs can be detrimental for many individual companies. For instance, when examining the influence of the proxy advisory firms, the American Council for Capital Formation concluded that the ESG recommendations from the proxy advisory firms particularly “disadvantages small and mid-sized companies, in favor of larger companies that have the resources to comply”.
While particularly burdensome for the smaller and mid-size public companies, the negative impacts touch the entire market too. A study by the Manhattan Institute found that public pension shareholder activism pushed by proxy advisory firms negatively impact share value.
Despite the rhetoric, ESG programs are typically detrimental to corporate performance and rarely achieve their lofty aims. Consequently, the proxy advisory firms’ predisposition to view these programs positively creates long-term risks for companies that, if not reversed, will persist long after the current bear markets have run their course.