How Reliable are Corporate ESG Ratings?

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Environmental, Social, and Corporate Governance (ESG) investing has grown in popularity in recent years. As a result of major investment firms and individual stockholders making ethical and social considerations in their investing, firms and corporations have developed ESG rating matrices to grade publicly traded companies on their commitment to diversity and the fight against climate change.

These ranking systems, however, have raised eyebrows in light of recent news that major tobacco companies are receiving higher ESG scores than the electric car manufacturer, Tesla. Serious questions are being raised about the reliability of these rating systems as tools for investors, and whether a company's focus on diversity and inclusion on its board of directors should be considered an ethical investment, even if its main product is responsible for millions of deaths every year. 


Justin Danhof, Head of Corporate Governance, Strive Asset Management

Prof. Lynn LoPucki, Levin, Mabie & Levin Professor of Law, University of Florida Levin College of Law

Paul Watkins, Managing Partner, Fusion Law

Moderator: James Lloyd, Acting Deputy Attorney General for Civil Litigation, Texas Attorney General's Office


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As always, the Federalist Society takes no position on particular legal or public policy issues; all expressions of opinion are those of the speaker.

Event Transcript



Ryan Lacey:  Hello, and welcome to this Federalist Society webinar. This afternoon, Tuesday, August 15, 2023, we discuss "How Reliable are Corporate ESG Ratings?" My name is Ryan Lacey, and I'm an Associate Director with the In-House Counsel Network at The Federalist Society. As always, please note that all expressions of opinion are those of our experts on today's call. Today, we are fortunate to have an excellent panel moderated by James Lloyd, who I'll introduce very briefly. 


      James Lloyd is the Acting Deputy Attorney General for civil litigation in the Texas Attorney General's office. James also serves as Chief of the Antitrust Division, leading the enforcement of state and federal antitrust laws.  After our speakers give their opening remarks, we will turn to you, the audience, for questions. If you have a question, please enter it into the Q&A feature at the bottom of your screen, and we will handle questions as we can, towards the end of today's program.  With that, thank you for being with us today.  James, the floor is yours.


James Lloyd:  Thank you, Ryan.  Really appreciate it.  We're glad to be here today to discuss one of the hot topics that sort of develops on a week-by-week basis.  So we thought we'd get together a group of experts to help explore this area. Environmental, social, and corporate governance investing has grown in popularity in recent years with major investment firms and individual stockholders making ethical and social considerations in their investing.  So, firms and corporations have developed ESG rating matrices to help grade publicly traded companies on their commitment to various targets, including climate change.


      So today we have three experts to help us explore these ESG ratings, how they're being implemented, and how their impact on corporate finance and investment has played out.  We have Professor Lynn LoPucki. He's the Mabie and Levin Professor of Law at the University of Florida Levin College of Law. We have Paul Watkins, managing partner of Fusion Law, and Justin Danhof, the head of corporate governance at Strive Asset Management.


      I think we'll kick it off with Professor LoPucki.  Professor LoPucki, you've taken a closer look at the landscape for ESG implementation and scoring. Can you help us set the stage and lay out the current state of play for ESG scores?


Prof. Lynn LoPucki:  Thank you, James.  There are more than 600 organizations that produce ESG ratings and rankings. Some of them are topic-specific, like Greenpeace on the environment, CPA-Zicklin on political spending, or Violation Tracker on compliance.  The biggest, though, are composite rankings, composite rankings that purport to tell us who's the most ESG, who it is that are the good guys and who are the bad guys. And the largest include MSCI, Novata, Dow Jones Sustainability Index, Bloomberg ESG data service, Sustainalytics Company, and Thompson Reuters ESG Research Data.  Newsweek is another one.  They're kind of in-between directly going to the public versus supplying information to investors.


Now, ESG products are expensive.  And so there has to be a secret sauce in each one of them. And so they're secret. We get glimpses of them, but we don't get to pick through the innards.  There's a lot of information. But, at bottom, they're black boxes. When we get a glimpse, sometimes it's disturbing.  Tobacco companies rank above Tesla.  Tesla makes electric vehicles. How can that possibly be? Well, this strange information system arose from the corporate social responsibility movement. CSR caught on with the corporations somewhere around 2011. Corporations realized it was good business to be perceived as socially responsible, even if they were maximizing shareholder value.


CSR morphed into ESG sometime later.  We still argue in academia about whether they're the same thing. I think they really are. There are two motivations and they're intertwined: doing good and making money. ESG had pretty much uniformly positive press until a year or two ago when it got politicized.  The big institutional investors argued that with ESG data, they could make higher profits. The opponents argued that ESG isn't profitable. What's going on is that the institutional investors are spending clients' money on social causes.  So here we are.


Ryan Lacey:  I think you're on mute, James.


James Lloyd:  There we go. Thank you, Professor. I appreciate it. I think it's really helpful for us to get the basis for some of the rationale behind the scoring matrices, and not only how, but kind of getting behind that curtain. I know Paul has worked closely to take a look behind that curtain to see how it's being implemented, what are the rationales behind it, and to see how that implementation piece is both impacting compliance and regulatory frameworks.


I'm partial to Paul, too, because he's also had a background as working in the Attorney General of Arizona's shop. And I know that we've seen a number of attorneys general continuing to look into these to make sure that the impact on consumers and investors is both fair and on an open level that people can engage with.  So, Paul, I was hoping you could help us. Walk us through what you've seen as you've taken a deeper dive at how these are being implemented.


Paul Watkins:  Absolutely. And thanks so much for the opportunity to be on this program and have this conversation.  And I agree with the professor that the information's opaque. And so all I have is what's on the publicly-facing websites and in documents and so forth. But I just want to leave the listeners with maybe some data points to hang on. And happy to post these if it's helpful. There was a letter that was sent by the Utah attorney general and treasurer to S&P about a year ago. And S&P, of course, just recently said, "Hey, we're done with our ESG ratings. We're not doing that anymore."


      But a year ago, these officials sent them a letter and said, "Hey, your ratings are really funny. At the time of the Russian invasion, you were rating all the Russian companies higher than their American counterparts.  Russian banks, higher than U.S. banks, even though they'd been sanctioned for what they did in Crimea.  Russian oil companies, higher than Exxon, higher than Chevron.  Russian Costco, higher.  You look at China, same thing.  Sinopec has a higher rating than Exxon. A Chinese semiconductor company has a higher rating than Texas Instruments. What's going on here? This is clearly -- not only is it not useful, but it's actively misleading. And I think it's important to just sort of put a marker there that this is how unhelpful and misleading the process is right now. 


      And then, if you look at academic research on this, there's a paper called "Aggregate Confusion" by Professor Florian Berg about the divergence of ESG ratings. And if you look at MSCI and you look at Sustainalytics, they're all over the place. The coefficients are somewhere between .38 to .7. So, it really depends on who's looking at the material. It's entirely subjective. And, of course, ESG does not overperform.


The data point I like to use is an op-ed that Terrence Keely wrote, because he used to work at BlackRock and so that's very much sort of the heart of the ESG engine within the industry. And he says, over the past five years, ESG is underperforming by 250 basis points. If you look at an article by Julie Segal in the Institutional Investor from 2020, she went back ten years and says it's underperforming by somewhere between 150 and 250 basis points.


Why is that? It's because ESG is inherently political. These are subjective political criteria. If you look at the MSCI ratings, if you go on the website right now, the first two questions are "Does this company have a -- are they aligned?  Do they have a goal to reach net zero by 2050? And are their operations aligned with keeping global warming at 1.5 degrees?" Now, those are interesting questions. For some people, they're crucial questions. Other people might want to know, is this company aligned with Rand Paul's idea for a flat tax?  It may be an interesting idea.  This is not economically material. And the reason it's not economically material is that the world is not on track to get to net zero by 2050.


There's a great New York Times article from last year, November 8, 2022.  It looks at the four largest emitters: China, India, the U.S. and Russia. And it says nobody's on track. The U.N. Environment Program comes out with a report every year tracking progress.  It says we need to make dramatic changes, or we're never going to reach this. So, measuring a company on whether they are in line with this goal is just not financially material. If you look at the -- I'm just going to randomly pick two companies that have green S ratings on MSCI: InBev and Target, both doing great, relationships with the community and customers, according to MSCI.


Well, that's not true. Bud Light sales are tanking. Target sales are tanking. Because it turns out that what MSCI may be measuring as a great position with respect to social issues, that may not be what Target and Bud Light's customers want. Again, these are subjective political criteria essentially measuring how aligned are you with the Green New Deal? How aligned are you with progressive democrat policies? That may be an interesting data point. It's not a financial data point. In many respects, it's not a material data point. And it's not something that agencies or institutional investors should be investing time in.


James Lloyd:  Paul, how have you seen the impact play out where you have well-meaning intentions with a lot of firms that do want to implement goals that both their customers and their shareholders may find valuable, but then also find that it doesn't need to be a part of an ESG factor. Have you seen where a lot of the companies want to do this, but they're actually being directed in a direction that's almost artificial, compared to what their goals are? Because I know that there has sometimes been a conflict between perfectly well-meaning, in intention, to be better for the environment, to help people see a product that helps protect a certain goal.  Yet, the ESG ratings actually distract them from that mission. Have you seen that play out with some of the corporate folks?


Paul Watkins:  There are all sorts of factors that are real financial factors that could fall under an ESG rubric: employee retention, environmental violations, all sorts of things. If that were all ESG was: material, financial, just categorizing existing material financial factors, then it wouldn't be adding anything.  You wouldn't have statements from MSCI saying, "ESG is something we consider alongside financial factors. The whole goal is that there's something new. And that is where the divergence that you're highlighting comes in.


      And the new thing is, particularly on the E, is alignment with net zero greenhouse gas emissions. And this is just an absurd thing to be measuring companies on. You're essentially measuring a company on how little of your product are you selling?  Scope 3 GHS emissions are, if you're an oil company, how much oil you're selling.  So, the less you sell, the higher you score. Well, that's not really going to correlate with positive financial performance. Maybe the best example is coal companies. If ESG is worth anything, it should be able to predict the financial returns of coal companies.


So, in 2020, Larry Fink writes a letter, and he says, "We're getting out. By the middle of 2020, we're getting out of coal companies." And if you look at the seven largest U.S. coal companies, if you look at their stock price in the middle of 2020, and their stock price now -- and this is coming from a letter that attorneys general wrote to BlackRock a couple months ago.  And they made this argument: if you compare those stock prices, those coal companies have increased an average of 1000 percent.  If ESG can't get coal right, what can it get right.


James Lloyd:  Yeah, thank you for highlighting that, too.  I think, Professor, we'll come back to you in a bit to get your thoughts on if you've seen how it works and how it can work better. But in the meantime, I think a great segue to Justin, who spent that time with the investors who've seen that impact play out on the investment community and have seen how it impacts returns and how it impacts what the investors are looking for, which is value back to the investors, or maybe even value delivery on some of their goals. I'd be curious to see, Justin, how have you seen that play out, particularly in your company, Strive?


Justin Danhof:  Yeah, I appreciate it, James.  I appreciate all the fellow panelists, The Federalist Society and all the participants. It shows the interest level in this topic is growing, because it really is important. And I think one thing we need to highlight at the outset, what Paul was really getting at is ESG is promoting somebody's values. Right? And the values all change, depending on who that somebody is. It's not necessarily about driving value. So, at Strive, our sole mission in the governance department, through our investment stewardship, is driving shareholder value, not promoting someone else's values. There's a place for that. And other folks are already entering into that market. 


But then, when we look at the ESG ratings systems and the ESG industrial complex writ large, what are the ratings systems doing?  What are the asset managers that use ESG doing? They're using their metrics as both a carrot and a stick to change corporate behavior. And again, think logically.  If ESG were material— and in some instances, it will be to a company — it would already be accretive to value, and business managers would be making decisions along those lines. You wouldn't need ESG raters to use their ratings system as a carrot and a stick to change behavior if it was already driving value.


      Let's look at how most of these ratings systems work. They're negative ratings systems. That is, as Paul was saying, "Do you check this box?"  And so, on the E, "Have you aligned your business policies with the Paris Climate Accords or not? If not, we're going to deduct some points." On the S, what does this look like?  "Well, you haven't instituted racial and gender quotas for your C suite.  We're going to ding you there, dock you by Y percent." On the G, "Your CEO earned too much compared to your median salaried income last year, and your board doesn't have three diverse people in the sense of affirmative action." Well, there, they're going to dock you by X, Y, and Z.


      Again, these exercises are about hitting a target. So the folks that should be the most upset by, really, this scam that is the ESG rating industrial complex are the folks that really believe in ESG. Because this is equivalent to teachers who teach for the test. You're not giving the students the underlying knowledge and skill development to get to the conclusion. You're just teaching to the test, and getting them to the right answer.  So, again, there's a lot of instances where this is just a check-the-box observation that is hollow.


But that's not always the case, because the ESG ratings systems aren't the only player in the game. So they work in conjunction with shareholder activists who are putting on politicized shareholder proposals at growing numbers year after year, with the assistance of the U.S. Securities and Exchange Commission which laxed their rules in 2021 for shareholder proposals. It's in conjunction with blue state pension funds — CalPERS, New York State Common Retirement Fund — that have gone all in on the push for ESG.


Large asset managers — you take BlackRock, State Street, Vanguard and Fidelity — they have $25 trillion in assets under management. That's greater than the GDP of the United States of America.  And, again, they're pushing a lot of these ESG values, not value.  And sometimes there actually is underlying implementation, and that's worse. So, one example I can give is in 2022, BlackRock made one of its investment stewardship top priorities as having companies tie executive compensation to ESG. MSCI, they have that in their rating system. So does ISS, Institutional Shareholder Services.


We're now at the point where more than 70 percent of the companies in the S&P 500 tie a portion of the pay of their executives to things like ESG and the DEI.  I'll give you one really good example: Southwest Airlines. They have a big portion of their executive bonuses that are tied to three things: response recovery, system improvements, and ESG, which they define as DEI and sustainability. Well, you may recall that in December of 2022, Southwest planes were grounded for ten days.  This didn't happen to other airlines. Other airlines were not affected by this. They had a short window, but they grounded 16,000 flights.


The CEO and the other named executive officers of Southwest still got a significant portion of their bonus, although they admit they failed on response recovery, and they failed on system improvements. But they outperformed by 250 percent on their ESG score. Here's the problem. You can put metrics on response recovery. You can put metrics on system improvements. You read through the proxy statement, you dig deep, you have no idea what they mean by sustainability and diversity, equity, and inclusion.


So we've got a business environment put on by large asset managers under the banner of ESG where in more than 70 percent of the companies in the S&P 500, the named executive officers have rigged the system and given themselves an out, under the banner of ESG, to still get their bonuses and to still get paid during times of bad performance. And remember, ESG, it's just a tool under the banner of stakeholder capitalism. And there, the investment community has already given us the results. They're black and white. 


In the 1980s, Europe adopted the stakeholder capitalism model. Since that time — you can break down the numbers — America, under the legal shareholder primacy obligation, has outperformed our European counterparts on an annualized rate of 3.25 percent. We have a crisis with lots of pensions and lots of retirement systems here in the United States of America already. What would layering on full-in stakeholder capitalism look like?  Well, it would look like a disaster. Quite simply put, $100,000 invested in a full stakeholder capitalism model over 40 years would yield you $1.6 million.


Shareholder primacy, on the other hand, that would turn into 5.4 million.  So this would be a disaster to go fully in on the stakeholder capitalism model here in the United States of America. And again, we can talk about why the ratings are so uncorrelated later, but there's three main effects that we need to talk about: scope divergence, weight divergence, and then, rater effect. So, what do I mean by those?  Well, the same study that Paul mentioned earlier really broke down what these mean. Scope divergence is --


James Lloyd:  Okay, Justin.  It looks like we might have lost you a little bit there with your sound. Let's do, on YouTube, back on, and give you a chance to connect again. But in the meantime, I think it was very helpful to hear what Justin had to share with us. 


Justin Danhof:  Sorry about that. 


James Lloyd:  Here you go.  You're back.  Let's go.


Justin Danhof:  Yeah, so, just quickly, scope divergence -- what categories are you even picking?  And at the top level, some of the top six picked ESG, so three top levels. Others picked up to seven top levels, and then they had two layers below that. And there were over 905 different categories, different taxonomies that were used.  And so, that's one divergence that's a problem. The second is weight divergence.  As the professor mentioned earlier, some rating agencies care a lot more about environmental issues.  Some care a lot more about social issues. So they're going to weight them differently when it comes to their scoring. That's actually the largest divergence.


And then, how does Tesla get dinged so badly?  Well, this is the rater effect, known as the halo effect, where a rating agency has a good feeling about a company because their CEO might say all of the right things. Well, Elon Musk doesn't say all of the right things about ESG, does he? He's not a very big fan of ESG. He's not a big fan of the proxy advisory services or the ESG rating industrial complex. And so, the raters just sort of ding him for that. And so, in the end, ESG fails on its own terms, and the ratings systems are simply part of that phenomenon. And at Strive, we're just glad that more folks are speaking up on this issue and trying to get American business back to where it belongs, and that's shareholder primacy.


James Lloyd:  You know, I think that a return to the basic principles has value, and it's very helpful to see exactly the impact that it's had. Because I know, for a lot of people, our next question for the group is going to be, where do we go from here? So where do we take this if we do have people who say, if you walked up to a 28-year-old or a 42-year-old or even an 80-year-old, and you ask, "What do you want? Would you like to invest in a company that does care about these factors?" But then you also have to return back as to what is the basic duty that we have to you?  As a fiduciary, we focus on the returns. And, in other areas, for example, we'll use antitrust.


The antitrust world that I'm a part of a lot on our enforcement side, we have to come back with the question of -- a lot of times we get asked, "Well, can we have exceptions to work together and collude in a way that helps fulfill some of these goals? We had to go back to the baseline question of we have to see competition on the merits that drives consumer value, that drives the prices. Because we have to go back to at least one core aspect in order to keep the law-and-order framework that we have around industries.


      And, for us, that goes back to the question a lot of times is who makes this decision?  As you said before.  So, in some instances, we say "Is it for the government? Is it for these groups to do it? And a lot of us come back to, well, that's just going to raise prices across the board in that world. So, it's not even just about returns.  It's about increasing prices in a way that's artificial. For example, I've said it before where if you have a goal that you want cage-free eggs, that's fine. I like to buy cage-free eggs and I pay more for them.


But it's not the decision of the antitrust regulators or the securities regulators to go ahead and say, "Yes, we are going to give a blind eye to things that raise prices because, sure, we can create an incentive in a regulatory system that incentivizes every grocery store to look like Whole Foods. But that's not fair to consumers who are just trying to put food on their family's table with limited income, to say "you are now required to shop at a Whole Foods level where everything delivers at a sort of benchmark of environmental and holistic and organic goals.


And so, for us, on the antitrust side, we've had a struggle to figure out who makes those decisions and who's allowed to. I'm glad to hear that that kind of plays out in the corporate space as well, as we implement it. Now, I'm going to open it up to the group.  But, Professor, I know you've taken a look at this. Where do we go from here, then? If there is a goal, if you're in one of these corporate settings and you're trying to implement these programs, or if you're trying to push back on them, how have you seen that play out?


Prof. Lynn LoPucki:  Well, let me say first that, on the big picture, I'm very much in agreement with both Paul and Justin that there is a lot of garbage into these composite rankings and a lot of garbage out coming from the composite rankings. But that doesn't mean you can just throw away the idea of measuring ESG, because there are some things that are just unquestionably good. For example, this is my best shot, is stranded assets. If somebody is calculating which companies are most likely to have stranded assets, that could be very valuable information in picking the companies that are going to succeed over the future.


So, as to where we go, I think where we go is we have to get rid of the composite rankings and go back, well, unbundle them, and go back to justification for each individual ranking that's being put forward, each basis for ranking.  You want something that's objective.  What I've been working on is greenhouse gas emissions, as reported by the companies. I think that's valuable information.  People can use that information. And they can also understand what that information is.  So I have this stakeholder takeover project where I'm going to supply that information to consumers so that they can spend their money on the companies that they want to spend their money on. 


James Lloyd:  Have you found that there is a connection to the consumer, to the ESG goals and metrics? For example, I know, when we give our money to a pension fund to manage that money, as a shareholder, I don't know if the consumer eventually finds out about what these ESG scores are. How they learn. I know there's plenty of reports. And I think a lot of the companies are trying to do better at sharing what their targets are. But have you seen so far where the consumers are actually connected to the goals that are purported to be a goal of the consumer?


Prof. Lynn LoPucki:  That's a big fight we're having in academia, most of my colleagues say consumers don't care. They're not going to buy things on the basis of ESG of the companies that are selling them. And I think differently. And the only way to find out which of us is right is to put out a grocery shopper app -- GHG shopper, it's called. It's an app you can take to the grocery store and shop for groceries. We'll put that out, and we'll see how many consumers actually use it. And it reports back to a web page, so the whole world will be able to see how many there were who actually reported. And that's, I think, the only way to figure out whether consumers are interested enough to actually take action.


James Lloyd:  And it's the free-market piece there. Let the market decide.


Paul Watkins:  Absolutely. And I think it's a very different conversation if we're talking about something that's voluntary and consumer driven. But when we're talking about ESG, we're not talking about something that's voluntary and consumer driven.  This is regulator driven --


Prof. Lynn LoPucki: Yeah.


Paul Watkins:  -- and government driven. It's driven by governments as market participants. Justin was talking about Climate Action 100 and some of the groups that asset managers have organized And if you go to the Climate Action 100 web page, and you click on "How we got here," they are very transparent that the California pension fund went to the French Mission at the U.N., and they said, "Hey, we want to start implementing these environmental policies and we need big institutional investors to join with us."


"And once we get those big institutional investors to commit to net zero, then we will add a requirement — which is part of Climate Action 100 — that if you're a big institutional investor then you ask your asset managers to make the same net zero commitment.  And, that way, we can leverage our assets through Wall Street to actually start changing corporate behavior, which we cannot do on our own."  And when you look at the SEC rule, and they say "there's investor interest," and this is in the Lawrence Cunningham comments, the first part of the comment. They're citing all of these astroturf institutional investor-driven organizations for the basis of the SEC rule. So ESG is driven by government as a market participant.


If you look at the retail investors — and there's another survey that was filed by Consumers’ Research that surveyed retail investors — they said they viewed climate change as the least important of a long list of investment factors.  Because ordinary people are trying to make money before they're trying to push an agenda. But governments are inherently political. So we need to disentangle that. I am all on board with getting ESG out of the financial system. But even if we come down -- and I think this demonstrates how political ESG is. So, potentially, stranded assets could be a material financial factor if you believed that there was the political will to implement regulatory policies to get to net zero. There would be a lot of stranded assets.


But there's not the political will, and no country is doing it. Now, compare that to stranded assets from China invading Taiwan. China says, or our intelligence tells us, by 2027, China wants to have the ability to invade Taiwan. China, by its own terms, says, "Hey, we're not even going to be reducing emissions until 2030. And if you look at their track record, they're not even close to reducing emissions. They approved as many coal plants last year -- they approved half of the U.S.'s coal plant capacity in the last year. So they are accelerating emissions. They're not reducing them.


So why is there all this focus on preparing for stranded assets for a world that gets to net zero greenhouse gas emissions instead of focus on preparing for a world where China invades Taiwan?  Why is that? If you were just to impartially analyze what is going to result in stranded assets, you would put way more weight on China invading Taiwan.  It's more likely. It's more catastrophic. So why isn't the weight placed there? And then, if you look at the steps that companies have to take to get to net zero, the supply chain that they buy into flows directly through Taiwan.


Seventy to eighty percent of all the wind and solar components are manufactured from China. And if you trace through that supply chain, you're getting 60 percent of rare earths coming from China. The renewable energy supply chain is a Chinese supply chain. So when you say there's risk of stranded assets, so we need to get companies to net zero, you are also saying that risk is substantially greater than the risk of China invading Taiwan and decoupling from China. And I don't think anyone can make that decision.


Prof. Lynn LoPucki:  But we can do both, can't we? I would like to see both indexes out there, both ways of calculating the stranded assets. And I've always thought of the stranded assets not coming from government action, but the stranded assets coming from rising water in the ocean.


Paul Watkins:   So that's a very different -- I'm sorry.  I didn't mean to cut you off, Professor. Was that--?


Prof. Lynn LoPucki:  No.  I was finished.


Paul Watkins:  That is very different, as far as measuring companies' exposure to changing climate.  That is an entirely different category that I don't think is a material part of the MSCI ratings. If you go back, again, the first question is, "What is the company's commitment to reduce its carbon emissions?"  The second question is, "Would the company's emissions goals be enough to keep global warming to 1.5 degrees?" So, these are all about changing company behavior to change the temperature of the climate.


That's what I'm saying. There's no financial basis for that. If you want to assume the climate will change, and therefore companies need to be prepared with additional insurance or they need to move their facilities, I think that's an entirely different conversation. But that is not what the disclosure is about. That's not what the SEC Climate Rule is about. And that's not what the ESG ratings are about.  They're about changing company behavior to change the climate. 


Justin Danhof:  And that's just the point. The reason that so much of these decisions are being foisted on business is because governments have failed to act. So I often say what's being litigated on the corporate proxy ballot has a due place on a ballot. It's just a political ballot in November, not a corporate annual shareholder meeting.  So, what do I mean by that?  These are aggrieved political and judicial activists that haven't been able to achieve what they've wanted on Capitol Hill and the state houses. 


      So, every time cap-and-trade came up in the United States House and Senate, it went down. The Green New Deal, it went down.  The political will was not there. And when we talk about sticking on the E of ESG, when we talk about investment risk, there's a lot of asset managers that like to say climate risk is investment risk. But talk about two axes meeting together at the [inaudible 00:36:48]


Prof. Lynn LoPucki:  I think we've lost audio. 


James Lloyd:  Yeah, Justin, it looks like we have to reset you again. I think we need an ESG T-rating with technology on the last piece.


Justin Danhof:  Yeah, that's right.  But think about the axes we're asking to meet up — international law, so both domestic law, international law and temperature on two different horizons meeting at the same artificial destination — that's crazy investment risk that you are going to put your dollars on those two axes to perfectly meet.  I don't know about you, James, but I can't predict what Capitol Hill is going to do tomorrow, let alone what they're going to do in 2035, 2045, 2050. And so, to make your investment thesis based on those two philosophies, I think, more to Paul's other point, and sort of a corollary to this, China risk is investment risk.

When you're investing in a VIE that is based in the Cayman Islands and you don't actually own the underlying shares that are in a China company — I know it's a little off-topic — but China risk and ESG are intricately linked and intricately tied. That's why, from day one, at Strive — this is not a Strive promo — but we have always said we'll never do business in mainland China because of that risk. And I think that when we talk about materiality a lot of disclosure is actually missing in this space. Where there's ESG reports coming out of every company, that have a tremendous amount of disclosure if you care about those issues, you can find it. But a lot of companies that have deep ties to China — including the Starbucks of the world, the Disneys of the world — their disclosure is really lacking.  So I think the professor, Paul, and I all agree that more disclosure is a good thing.  It's just, we need to disclose what's material. 


James Lloyd:  So it sounds a lot like the tail was wagging the dog in a sense, particularly in a world where risk was always being incorporated into investment decisions, except now we're attempting to incorporate it all into a number. And what's behind that number is not clear to either investors or, I think, probably even to pension funds at times, too. I know those conversations. Some of the attorneys general are looking into those to determine what are those conversations — both on a consumer protection perspective, and on an antitrust perspective —to make sure that the right outcomes are being delivered. 


      Now, you mentioned earlier about how it's either government-driven or it's driven by another force. I really just want to -- I'm kind of curious to the group. Where is this motivation coming from now? Where is the most incentive? If you're in a C-suite right now, is it coming from you in the C-suite? Or is it coming from government pressure?  Or is it coming from ratings pressure?  Is it coming from pension fund pressure? Or somewhere else?


Paul Watkins:  I can expand on the answer I gave to that initially.  I think, at root, it is government pressure filtered through Wall Street. Again, if you look at Climate Action 100, it's blue-state pension funds and foreign pension funds, Japan's pension fund, which is the largest in the world, who get Wall Street to make net zero commitments, and who have created a scoring system for public companies. Are you aligned with net zero by 2050?  It's the same scoring system that ISS uses in their votes for boards of directors. And that's not an accident, because if you look at another coordinated group of asset managers, the Net Zero Asset Managers Initiative, commitment number eight is to pressure ratings agencies, credit agencies, financial institutions, to incorporate ESG metrics into what they do.


So it's governments acting as market participants to exert pressure on the financial industry, which is a very centralized industry, and to therefore drive capital and affect corporate behavior. Individual investors don't really care that much. And these documents are all out in the open. You can look at the Glascow Financial Alliance for Net Zero with a press release that they issued when they started the group.  They said, "Hooray, now we have $130 trillion.  We have enough money to get to net zero globally, because we have a group of insurance companies, we have a group of banks: J.P. Morgan, Citi, Morgan Stanley, Goldman Sachs, Bank of America, Wells Fargo.


They're all making the same net zero commitments and saying, "We're going to align all our lending with net zero." So, you've got the insurance companies. You've got the banks. You've got the asset managers.  You put all those assets together, you get $130 trillion. Now we can drive the global economy and we can achieve this political goal that no one would vote for because it's impossible, and because the consequences for the consumer are absolutely catastrophic. So that's where the demand's coming from. And that's why it's inherently political.


Prof. Lynn LoPucki:  I think it's coming from --


James Lloyd:  When you say it's from the country's perspective -- Professor, go ahead.


Prof. Lynn LoPucki:  Yeah, I think it's coming from the public. And it's coming from the public who are concerned about the environment, for example, concerned about social issues, and businesses who want to be perceived as socially responsible, as on the side of the public. The trouble I have with Paul's theory of where it's coming from is, what about BlackRock? They're a business. They have to compete. How is it that they suddenly have all of this flexibility to do whatever they want and let other people influence them in what they're doing? Where is the market in response to this?


My own view is in accord with late Professor Lynn Stout who said "We're not sociopaths in our personal lives. We wouldn't pollute a river for our company to make a million dollars when it's going to cost a billion to clean up the river. And it's actually going to get cleaned up. So why should we be sociopaths in our investing? That we ought to make a system in which people can know about companies where they stand on the issues that people are concerned about.


Paul Watkins:   Can I just respond to the BlackRock point real quickly?


James Lloyd:  Yeah, absolutely.


Paul Watkins:  So, the way that asset manager makes money is much different from the way the client makes money. The asset manager makes money by accumulating as many assets under management as possible and then charging a fee across those assets. So, what they want to do is raise the volume of assets.  The largest asset owners in the world are governments. If you add up the assets of the top hundred asset owners, over 80 percent of those assets are pension funds or sovereign wealth funds. And a large percentage have made net zero commitments.


So if you're a large asset manager and your business model is spreading compliance costs over the largest possible pool of assets, then you have to care a lot about what California and New York and Japan and Norway are saying. And if they're saying, "We want you to sign this document," then you sign it. Now, the problem is, if half the country says, "We don't like that. We don't think you should have signed that. Now we don't want to do business with you." But that is a recent phenomenon.  Before two years ago, half the country was quiet.  And so, it was a one-way bet. All you had to do was keep the blue-state pensions happy. You could manage their money, and you could manage red state money. And that was the path to making as much money as possible. 


Now it's tricky. Now there's, potentially, competition.  You've got new entrants like Strive. You've got Vanguard, which has dropped out of these groups. But that is a very recent phenomenon. I think the market is starting to work. And we'll see where that shakes out. And there may be some other market forces coming into play that the Professor's talking about.  But that is a new phenomenon. And because that pushback did not exist, that is the reason why there was so much universal support for these things, why Climate Action 100 was able to get up to $68 trillion and vote in a new board at ExxonMobile before anybody paid attention.


Prof. Lynn LoPucki:  What about investors within their own pension plan?  I know that, in some of the plans that I'm in, I have a choice about who should do the investing. And a choice, for example, would be Fidelity or maybe BlackRock. Aren't they competing in that sense?


Paul Watkins:  So, absolutely. Those top 100 are over 20 percent of all investable assets.  If you can get all the large institutional investors to do the same thing, then you have a dominant market system. And expecting, okay, the individual investor is going to care enough to start switching funds because they saw that BlackRock says they're going to vote and engage with public companies to get them to net zero and they don't like that, over time, sure, that may have an impact. But that's going to be a much slower impact. And it's going to take a long time to develop, compared to capturing those large institutional investors. 


Justin Danhof:  Yeah, and Professor --


James Lloyd:  And I think the free-market solution is what we saw with, like, electricity, where now a lot of the green grid was allowed to thrive by just giving consumers the choice at their point of decision-making to say whether they want green or not. And they make that choice based on pricing, which actually drove pricing down in Texas on green grids, because they said, "Once you become competitive, then we'll go green." And I think it actually did benefit both the green electrical grids and then also benefit consumers, because it drove prices down.  Justin, do you have something?


Justin Danhof:  Yeah, just one narrow point to the professor's comment about 401k and choices. An interesting side door shareholder proposal popped up in the last two years, asking companies to align their 401k policies with other environmental commitments that they've already made, so, if they had lined up with the international agencies’ net zero or Paris or what have you. And, oddly enough, BlackRock, that votes in favor of a whole lot of ESG resolutions, voted against that one. Why? Well, because they don't want to do the same thing with their 401ks. So they're not going to foist that upon another company when they know that they don't want to do that themselves. And they would harm their own 401k offerings.


And so that's just an interesting narrow point. But a broader point -- you mentioned BlackRock, and Paul talks about the last two years. There's been a slower, longer fight to shine the light on it. But no more light has been shone in the last 18 months on any issue, other than ESG. And no company has changed their behavior more or at least tried to optically change their behavior more in the last 18 months than BlackRock itself. So Larry Fink says he's no longer even going to say, "ESG."  They're not putting ESG in their documents. Their 2022 voter guide for proxy voting, all ESG all the time. 2023, hit control F.  It's not in their voter guide. And they're giving back the vote as fast as they can.


They have what they call a voter's choice program. Right now, it's not much of a choice, because you have 14 options that include ESG slates from ISS and Glass Lewis. But the reason they have to give back the vote, or at least try, is because they pulled a bait-and-switch. Up until 2018, they weren't voting in a very aggressively ESG manner.  2018 is when CalPERS, Norges Bank, New York State Common Retirement Fund, went to BlackRock with their demands, and that's when he changed his tone in his annual letter to other CEOs saying "We're going to get much more aggressive in our proxy voting, "specifically on the E of ESG that year.  So he has to give them the option to opt out, because most of the investors that have been around for a long time in BlackRock actually never opted in. It was a bait-and-switch. They were lied to.


James Lloyd:  So, to start addressing some questions we have coming in, and one of them is kind of interesting to help us see if there's a way that a corporation can get to prioritizing some of these issues if they really do care about ESG. One of them directed a question at the professor to say, "What are your thoughts on public companies recasting or reincorporating as public benefit corporations if they want to prioritize ESG?" Somebody said, "Wouldn't that be a solution?" How have you seen those play out?


Prof. Lynn LoPucki:  Well, there are very few public companies that have chosen to become benefit companies. I'm not sure it really makes any difference for the company to become a benefit company. They start making reports, for example, but if you're a Delaware corporation and you become a benefit corporation, you basically operate exactly the same as you always did, except that you're filling out this report and giving it to shareholders. So I don't think it's really a meaningful change.


James Lloyd:  And so that's not one of the solutions we would be looking for. Let's see some other questions that are sort of getting the sense of the viewers out there. So, let's say, with the system that we have, if we move forward with the current state of the ESG raters right now, what is the best way to create some sort of accountability then, for the ESG raters, the proxy advisors, the pension funds, and asset managers? I know that's sort of an ongoing question right now that everybody's working through, with one of the first questions being, "Does it impact returns?" And sort of seeing that on different levels. And we've seen certain responses that it may or may not. Does anybody have any thoughts on how there can be better accountability for the ratings?


Prof. Lynn LoPucki:  Well, I've got my dog in that race.


James Lloyd:  Go ahead, Professor.


Prof. Lynn LoPucki:  Sorry. I got my dog in that race.  Stakeholder takeover that we've got to break the composite ratings down into individual ratings that are important, of importance to people. And then the markets for products and services can inform the companies as to what the public wants them to do, or what their customers want them to do.


Justin Danhof:  I'd say there's two answers to that question. One, transparency. As we all said at the beginning, these are all very opaque. If folks knew what was going in that was feeding what was coming out, that would be one thing. But the second thing I would say is stop feeding the beast. Where do ESG ratings come from? They come from questionnaires, largely, some publicly available information. But lots of it comes from questions. I'll give you a true-life example. 


At Strive, for our products to work, we need to get on the wirehouses. A major wirehouse sent us a due diligence questionnaire that was 20 percent due diligence. The other 80 percent was ESG and DEI. Guess what? We answered the 20 percent and sent them a letter explaining why we weren't going to answer any of the other questions, period. They still let us on the wirehouse. So you don't actually have to feed the beast. Everyone gets these ESG questionnaires. Fortune 500 companies have entire departments that all they do is respond to survey questions. Stop responding to the questions. You're feeding the beast.


James Lloyd:  How about in terms of accountability?  Paul, I know you've worked in this area. We have a question that says, "To the extent that the government pension funds pursue ESG investments and receive lower returns, aren't taxpayers ultimately on the hook when pensions aren't able to meet their obligations?" And it sort of ties in with another question we have. Let's see, taxpayers being on the hook, but then there's also, somebody said "Can there be a breach of contract action there?" So, I think, what are some of the legal pathways that we're starting form up to create accountability, as well?


Paul Watkins:   Yeah, this is a Federalist Society Teleforum, so the answer to every question, of course, is federalism. And so, I think federalism is often thought of as some states will have less of a regulatory burden, or something like that. But one thing that states do — and, of course, you know this; this is my old job and your current job — states bring enforcement actions. And a lot of this phenomena is created by the fact that there's a lot of enforcement from blue states, and there's much less enforcement from red states. And what we've just talked about here, we've just talked about a completely meaningless indicator that is slapped on just about every financial product there is. And there's been no enforcement on that.


There's maybe a little bit from the SEC, saying, "Well, there's a little bit of greenwashing going on." So I think some legislation and some enforcement would go a long way to solving a lot of these problems and creating accountability. There need to be actual financial metrics. There are government pension funds pursuing ESG, I know the New York pensions are being sued by Eugene Scalia at Gibson Dunn. And that's specifically over divesting from fossil fuels. Again, most of ESG is not buying a fund that's labeled "ESG."


It's not divesting from companies that aren't ESG. It's taking a generic S&P 500 fund and then meeting with the CEOs and voting the shares to align that company with net zero or to align that company with some other ESG metric. And so, you're not seeing, necessarily, lower returns on that fund. You're seeing lower returns for the market as a whole. Because the S&P 500 has to worry about all these financially immaterial criteria that their largest investors are asking them to pay attention to. So it's dragging down companies as a whole. And so it's not just as simple as looking at financial returns of different funds.


James Lloyd:  I think that speaks to another question we had about what are some of the political biases that could be layered onto it? But another good question. We'll close out, because we're running out of time. I think we could make this an entire week-long panel. And, hopefully, at one point, I think, as part of our ongoing conversations we have is to bring in some of the asset managers and the ratings folks to help us work through this. I think there's a genuine interest to get to the right place here, and to channel what is, in many instances, sometimes positive interest, but to do it properly.


And to close us out with one last question we have here, "What happens when we put ourselves in an uneven playing field when we actually do try to implement some of these well-meaning principles?" For example, they ask, "Why do we acquiesce to businesses with countries that will never implement social and environmental justice policies?" The questioner asks, "For example, Norway. They want to ban cattle farms. The farmers argue that they would lose their income and the country would have to waste greenhouse gasses bringing in beef from other countries."


He also notes, too, countries that will never implement any sort of LGTQ protections. All the while, we still do business with those countries and the ratings don't accurately reflect that and just end up harming our own domestic companies who are doing their best to implement them. Do we have any thoughts on that sort of a competitive playing field writ large for people who will never implement these?


Justin Danhof:  Well, again, a lot of the goal of stakeholder capitalism is put American exceptionalism, American capitalism, on par with where Europe has already put itself. And so, what are you going to do in that environment? You're going to increase the power of authoritarian regimes. So that's just it. A full road down ESG and stakeholder capitalism, the future state of the world is authoritarian regimes with a lot more power. That's scary. But that's where we're headed if we keep going down this path.


James Lloyd:  Anybody else? Any closing comments? We've got a couple more minutes left.


Paul Watkins:  Yeah. This is really, the net effect of ESG is at the expense of the United States, to the benefit of China. Again, China approved more than 90 gigatons of coal construction last year. That's more than half of the U.S. total capacity. They are all in on making sure they have as much reliable energy as they need. And any mandates that require wind, that require solar, that require ingredients that we won't mine, we could mine, but we're not going to mine, we're not going to process, we can't set up refineries -- we've completely lost the capacity to build that industrial base. We could do it. It's possible. But we're not doing it. It would require a radical change for us to do it. Any efforts to impose those mandates before we have the ability to source those things is just weakening this country's national security and empowering China.


James Lloyd:  Well, it looks like, with that, it's the end of our time. We really appreciate the professor, Paul, and Justin joining us for this debate and this conversation, really, because it's a deeply meaningful and impactful issue for our country. And I think that's why we enjoy having these forums to be able to get people together and viewers from all over the country to sort of be informed on these issues, to stay engaged, and to stay involved. So we appreciate all the viewers at home for joining us. And thank you for everybody's time.


Prof. Lynn LoPucki: Thank you for inviting us.


Ryan Lacey:  I couldn't agree more, James.  And on behalf of The Federalist Society, I would like to thank our panel for the benefit of their valuable time and expertise. And I would love to thank the audience for joining us and participating, particularly with those great questions. We welcome listener feedback by email at [email protected]. And, as always, keep an eye out on our website and your emails for announcements about upcoming webinars and other in-person events. Thank you all for joining us today. We are adjourned.