Toward a reasonable basis for credible ESG investing
By: Jiří, George
Tags: Wealth Management, Esg Investing, Asset Management, Investment Management, Esg

Toward a reasonable basis for credible ESG investing

To have a reasonable basis for claiming to make decisions consistent with the duty to act in ESG fund investors’ best interest, a manager must gather adequate information to answer two questions: (i) what aggregate utility function do each fund’s investors wish to maximize (e.g., what relative weights do they place on climate change, gender, race, etc.), and (ii) how does each actual and prospective investee company perform against targets consistent with the maximization of that utility function. Jiří (George) Daniel Jun 17·8 min read

Note: this piece was originally written as an MBA class assignment, structured as a hypothetical letter to BlackRock CEO Laurence D. Fink. However, it would apply similarly to a number of major investment management firms.

Dear Mr. Fink,

I write to you as an investor in your funds, a student of finance, and a member of the broader investing community, in the hope that I might persuade you to take more concrete action to further the credibility of ESG investing — both by BlackRock ESG funds and as a general matter.

I should state upfront that I am not concerned with the argument that ESG might improve financial returns. If that were true, ESG would have long been incorporated into corporate governance and investment management. Instead, I wish to focus on the governance of ESG investment decision making, including what it means to act in ESG investors’ best interest, what information it requires, and how the trade-offs it presents are resolved. I argue that, for ESG investing to be credible, it must be based on robust information about both investee companies and fund investors, which I believe is currently lacking at BlackRock and elsewhere in the investment management industry.

The two actions I propose to you are: (i) to design a technology platform capable of periodically ascertaining the priority of your ESG fund investors’ preferences with regard to non-financial performance, and (ii) to refrain from investing your ESG funds into companies that fail to make sufficient, accurate, consistent, and timely disclosure of the information required to form a reasonable basis for investment by an ESG fund — i.e., into companies that fail to adopt SASB and TCFD standards.

I believe both of these actions not only are necessary for you to effectively discharge your fiduciary duty to your ESG fund investors, but also can both benefit your business and produce significant positive externalities for financial markets and for society at large.

Problem Overview

You market a range of ESG funds alongside a corresponding range of traditional funds. By doing so, you in each case at the very least implicitly acknowledge that the ESG fund’s investment objectives are multifaceted — i.e., incorporate additional factors that are other than financial. Shareholders presumably choose to invest in your ESG funds, as opposed to their non-ESG counterparts, because these broader objectives better represent their interests — i.e., the utility they wish to maximize does not strictly equate to wealth.

In order to have a reasonable basis for claiming to make decisions consistent with your duty to act in your ESG fund investors’ best interest, you must therefore be able to answer two questions: (i) what aggregate utility function do each fund’s investors wish to maximize (e.g., what relative weights do they place on climate change, gender equity, racial equity, biodiversity and animal welfare, etc.), and (ii) how does each actual and prospective investee company perform against targets consistent with the maximization of that utility function. I would argue that you cannot, at present, credibly answer either of those questions.

That is, your ability to effectively discharge your fiduciary duty to your ESG fund investors is impaired. However, you have the capability and the power to change that.

Investor Preferences

BlackRock has long been known as a technology leader. Beginning in the 1990’s, it capitalized on the increasing availability of computing power to build a cutting-edge portfolio management platform, Aladdin, contributing to a transformational increase in financial market sophistication. Today, the wide diffusion of computers and internet access among consumers makes it more possible and less costly than ever before to solicit input — even from billions of people, and even in near-real time. Building and distributing digital fund investor preference questionnaires is well within your reach. Yet you do not ask your ESG fund investors what they want. You should make this your next technology development frontier — or else, indeed, risk disruption by one of a large and growing army of FinTech challengers that might.

Investee Disclosures

Traditionally, your fiduciary responsibility to the investors in your funds would have entailed exercising your funds’ voting power so as to maximize shareholder wealth. It is impossible to do this without access to sufficient, accurate, consistent, and timely disclosure of financial information. Today, this matter does not require your attention; governments impose such requirements across your investable universe. If your firm had existed in the 1920’s, however, it would have been incumbent upon you to demand such disclosure as a precondition of your investment. As a fiduciary, you could never, in good conscience, have invested in a company that failed to make the requisite financial disclosures. Note that the same can be said even today for private-market investors, who require such disclosures even when governments do not.

Environmental and social reporting standards today arguably stand where their financial analogs did in the 1920’s, and the judgment you make should, in turn, be analogous.

Let us assume that you make the necessary effort to map the aggregate utility function for the investors in each of your ESG funds. In the absence of sufficient, accurate, consistent, and timely disclosure of information on the environmental and social dimensions of investee company performance, you cannot measure how each actual and prospective investee company performs against targets consistent with the maximization of that utility function. That is, you cannot purport to make investment and voting decisions consistent with your duty to act in your ESG fund investors’ best interest.

Yet such is the present state of affairs. Your own Investment Stewardship Annual Report 2020 claims your advocacy for investees’ adoption of SASB and TCFD standards, but the fact remains that, as of 2020, only 341 companies globally (of which 198 in the United States) have adopted the former , with adoption of the latter unclear (though TCFD claims the rather vague “support” of 1,340 companies). Perhaps this explains why, according to research by Morningstar, BlackRock votes relatively little on ESG initiatives, and why there appears to be no difference in this regard between your ESG funds and their non-ESG counterparts , even though you nudge investors toward the former and charge higher fees for them.

Some investors may claim that their proprietary information gathering and analysis can compensate where direct disclosure may be lacking or non-standardized. Given BlackRock’s business model, i.e., passive investment, with low cost achieved through economies of scale, it would not be credible for you to claim this as your approach. Passive funds, by definition, free ride on market efficiency brought about by the actions of others, and low cost means limited resources devoted to anything other than pure index replication, including corporate governance.

Still, your scale gives you the power to effect change, even by the actions of your ESG funds alone (as it would not be appropriate to leverage non-ESG funds in doing so). In the US, total ESG AUM has increased by 42% since 2018, now makes up 33% of the total , and is likely to continue growing rapidly.

You should signal to the market that you will not invest your ESG funds into companies that fail to provide you with a reasonable informational basis for making such an investment — i.e., that fail to adopt SASB and TCFD standards. Because your ESG funds are already invested in a large number of companies, and to avoid disruption from a sudden shrinkage of the investable universe, you may consider making an accommodation for existing holdings. In such cases, you should, either unilaterally or (preferably) in cooperation with other ESG-focused passive fund managers, introduce resolutions demanding that your investees adopt the relevant standards. You should make clear that, if a company fails to adopt within a reasonable time frame (i.e., not longer than implementation would strictly require — perhaps a maximum of three to five years), you will fully divest that company’s shares from your ESG funds.

This would directly benefit your ESG fund investors, as it would enable you to have reasonable confidence that your investment and voting decisions are consistent with investors’ best interest. In addition, it would produce a positive externality in that the improved information made available to all investors, including those that are more active in its use, would serve to make markets more efficient with respect to the assessment of, and accountability for, ESG performance. That would make ESG as an overall proposition less vague and more credible, likely attracting previously skeptical investors and thus growing the market, including the share captured by your own firm.

Naturally, you may argue that setting standards is a role best played by governments. That may be true, but I do not propose that you promulgate these standards to impose ESG investing on all your investors, much less society at large. The effect of my proposed action would be to draw a clear contrast between companies that choose to be transparent and eligible for ESG investment, and those that do not, but that remain eligible for investment by individuals without an ESG mandate. Indeed, with proper disclosure, one might envisage a world in which investors could choose funds based on a tiered (i.e., non-binary) scale reflecting the extent to which they care about ESG performance (and indeed, perhaps each component thereof) relative to financial wealth. I submit to you that either of these worlds would show greater respect for investor choice and property rights than that currently in place, without being prejudicial to investors and citizens not interested in ESG.

Still, you may be tempted to avoid controversy by waiting for governments to act. We may, indeed, be witnessing tentative steps in some countries. However, your investor base is global, invests across countries, and needs sound disclosures now. Moreover, the creeping nature of the climate change problem, in particular, renders unlikely the occurrence of a modern, global “Black Tuesday” that would shock governments into decisive action on ESG disclosure as the original Black Tuesday of 1929 did for financial disclosure. Particularly on a global scale, you may be waiting for Godot.

Ultimately, I believe the question is one of motivation. ESG is currently opaque. Do you wish to keep it so, in order to take advantage for your firm’s short-term gain without regard for investor welfare, as indeed many of your predecessors did in the 1920’s? Or do you want to take action in a manner consistent both, and I stress this, with the best interest of the (ESG fund) investors for whom you act as agent, and with the longer-term interest of society at large? I hope that, in the spirit of the Business Roundtable statement you and some of your peers graciously signed in 2019, I may have influenced you toward the latter.

Sincerely,

Jiří Daniel