ESG disclosure requirements will hurt economic dynamism

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The United States continues to grapple with the aftermath of the Covid-19 recession, rising inflation, attempts by Congress and the Biden administration to drastically expand the size and reach of the federal government, and mountains of public debt that continue to grow at a dangerously rapid rate. rate.

By comparison, the new regulations issued by the Securities and Exchange Commission (SEC) under the chairmanship of Gary Gensler appear to be a low impact event. Yet the deluge of new rules and restrictions that an activist SEC chairman could impose on businesses and investors is nonetheless a threat to the country’s prosperity. The likely SEC regulation on environmental, social and governance (ESG) disclosure requirements illustrates the risks.

There is a growing belief that focusing on ESG issues helps companies outperform those that don’t. The implication is that ESG screening allows investors to outperform their financial benchmarks and their non-ESG peers. Under President Gensler’s leadership, it appears the SEC accepts this premise. If the agency acts on these beliefs and creates new ESG reporting requirements, businesses and investors will be forced to endure costly additional regulations that will hamper business performance for years to come.

These regulations are likely to require companies to disclose their progress in meeting environmental, social and governance goals. Despite their seemingly uncontroversial premise, such regulations will create significant problems for businesses and investors.

For starters, the definition of ESG is vague when put into practice. Take the example of environmental problems. Presumably, President Gensler will want to require companies to disclose their impact on global greenhouse gas (GHG) emissions. But how can a business know this impact? Management may be able to account for the company’s investments in solar panels for its head office or the number of low-emission vehicles it purchases. However, the impact of these actions on the company’s net emissions is a very different question.

Another problem is how to measure the impact of a company on one set of ESG objectives (e.g. environmental issues) versus its actions on another set of ESG targets (e.g. social issues? ). Does a solar panel manufacturer automatically achieve approved ESG status even if it sources raw materials from mines that depend on slavery and child labor? What about the impact of the mine on the environment? If not, is a fossil fuel company that promotes greater gender and race equity an ESG investment?

Because of these realities, more precise disclosure requirements require an excessive number of assumptions. Each hypothesis contains unknown errors, and how these errors combine is also unknown. As a result, forcing companies to provide more detailed and standardized information will impose higher costs on companies, but will result in more precise, but less accurate, information for investors.

Then there is the issue of the SEC’s ability to properly manage these various issues. Like private organizations, federal agencies work best when they focus on their core mission. Unlike private organizations, there is no direct feedback mechanism to ensure that federal agencies do not expand their operations beyond their comparative advantages or that their core missions are always value-added. . In the case of the SEC, ESG issues extend beyond their core competencies.

According to SECOND their mission is to “protect investors”, “to maintain fair, orderly and efficient markets” and “to facilitate capital formation”. Their role is to protect “main street investors and others who rely on our markets for their financial future”.

Research on the impact of ESG on financial performance and investors, however, is inconclusive at best. Several studies claim that ESG investment strategies can help investors improve their profitability. However, a common weakness of these studies is the uncertainty issues discussed above. This uncertainty makes it difficult to define which companies are ESG compliant and which are not.

Another issue is whether companies are actually following ESG rhetoric. A 2020 paper reviewed investor commitment to ESG principles after adhering to the “United Nations Principles for Responsible Investment (PRI), which is the largest global initiative to mainstream ESG”. The authors found that “only a small number of funds improve ESG, while many others use PRI status to attract capital without making noticeable changes to ESG.”

Such impacts imply that investments labeled ESG may not meet their ESG objectives. However, since they can attract more capital, the “ESG signal” could improve returns. These complications will bias the results of studies finding a positive association between ESG and company returns.

In line with this reality, many studies find a negative impact on the financial performance of engagement in ESG programs. For example, a 2020 study of Boston College Retirement Research Center found that “the evidence suggests… that social investing: 1) produces lower returns; and 2) is not effective in achieving social goals.

The expertise of this SEC is neither well suited to deciphering these complicated subjects, nor the right place to carry out primary studies on the ESG impact. The uncertainty surrounding the impact of ESG on returns, securities trading and investors means that any new disclosure regulations would likely hurt investors, which would be a blatant violation of the SEC’s mission.

A deep and efficient capital market is one of the competitive advantages of the US economy. Regulations that increase investor uncertainty and impose unnecessary costs on businesses diminish this competitive advantage to the detriment of economic growth and prosperity. Although less visible than other political threats, this negative impact would be felt for many years to come.


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